45249374 Business Associations Fall 2010 Fendler Outline

JRC/Fall 2010/Fendler/Business Assoc.

BUSINESS ASSOCIATIONSFall 2010/Prof. Fendler/Joshua R. Collums

Business Associations (7th Ed.) by Klein, Ramseyer & Bainbridge

CHAPTER ONE: AGENCY

I. Who is an Agent?A. Restatement (Third) of Agency § 1.01 Agency Defined

Agency is the fiduciary relationship that arises when one person (a “principal”) manifest’s assent to anotherperson (an “agent”) that the agent shall act on the principal’s behalf and subject to the principal’s control, andthe agent manifests assent or otherwise consents so to act.

B. Restatement (Third) of Agency § 1.02 Parties’ Labeling and Popular Usage NotControllingAn agency relationship arises only when the elements stated in § 1.01 are present. Whether a relationship ischaracterized as agency in an agreement between parties or in the context or industry or popular usage is notcontrolling.

C. Restatement (Third) of Agency § 1.03 ManifestationA person manifests assent or intention through written or spoken words or other conduct.

D. Gorton v. Doty (Idaho 1937)1. Issue. Was the coach, Garst, the agent of appellant while and in driving her car from Soda

Springs to Paris, and in returning to the point where the accident occurred?2. Broadly speaking, “agency” indicates the relation which exists where one person acts for

another. It has these three principal forms: a. The relation of the principal and agent.b. The relation of master and servant; andc. The relation of employer or proprietor and independent contract.

3. Agency. The relationship which results from the manifestation of consent by one person toanother that the other shall act on his behalf and subject to his control, and consent by theother so to act.a. Manifestation of consent by P that A will act:

(1) On P’s behalf(2) Subject to P’s Control

b. A’s consent so to act.4. This court has not held that the relationship of principal and agent must necessarily involve

some matter of business, but only that where one undertakes to transact some business ormanage some affair for another by authority and on account of the latter, the relationshipof principal and agent arises.

5. Appellant could have driven car herself. Instead, she designated the driver (Garst) and, indoing so, made it a condition precedent that the person she designated should drive hercar.a. Appellant consented that Garst should act for her and in her behalf, in driving her

car to and from the game from her act in volunteering the use of her car upon theexpress condition that he should drive it.

b. Garst consented to so act for the appellant by driving the car.6. It is not essential to the existence of authority that there be a contract between principal

and agent or that the agent promise to act as such, nor is it essential to the relationship orprincipal and agent that they, or either, receive compensation.a. There must be an agreement but it does not necessarily have to rise to the level of

a legal contract.7. The fact of ownership alone, regardless of the presence or absence of the owner in the car

at the time of the accident, establishes a prima facie case against the owner for the reason

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that the presumption arises that the driver is the agent of the owner. 1

8. Dissenting Opinion. a. An agent is one who acts for another by authority from him, one who undertakes

to transact business or manage some affair for another by authority and onaccount of the latter. Agency means more than mere passive permission. Itinvolves a request, instruction or command.

E. A. Gay Jenson Farms Co. v. Cargill, Inc. (Minn. 1981) (Lender Liability)1. Plaintiffs Argument. Plaintiffs alleged that Cargill was jointly liable for Warren’s indebtedness

as it had acted as principal for the grain elevator.2. Issue. Whether Cargill, by its course of dealing with Warren, became liable as principal on

contracts made by Warren with plaintiffs.3. Rule. Agency is the fiduciary relationship that results from the manifestation of consent by

one person to another that the other shall act on his behalf and subject to his control, andconsent by the other so to act.a. In order to create an agency, there must be an agreement, but not necessarily a

contract between the parties.(1) An agreement may result in the creation of an agency relationship

although the parties did not call it an agency and did not intend the legalconsequences of the relation to follow.

b. The existence of the agency may be proved by circumstantial evidence whichshows a course of dealing between the two parties.(1) When an agency relationship is to be proven by circumstantial evidence,

the principal must be shown to have consented to the agency since onecannot be the agent of another except by consent of the latter.

4. Creditor/Debtor. A creditor who assumes control of his debtor’s business may becomeliable as principal for the acts of the debtor in connection with the business.2

a. Security holder’s mere veto power v. Becoming a principal.3

5. Buyer/Supplier v. Principal/Agenta. One who contracts to acquire property from a third person and convey it to

another is the agent of the other only if it is agreed that he is to act primarily forthe benefit of the other and not for himself.(1) Factors indicating that one is a supplier, rather than an agent, are :4

(a) That he is to receive a fixed price for the property irrespectiveof price paid to him. This is the most important.

(b) That he acts in his own name and receives title to the propertywhich he thereafter is to transfer.

Willi v. Schaefer Hitchcock Co. (Idaho 1933).1

A creditor who assumed control of his debtor’s business for the mutual benefit of himself and his debtor2

may become a principal, with liability for the acts and transactions of the debtor in connection with the business. Restatement (Second) of Agency § 14 O.

“A security holder who merely exercises a veto power over the business acts of his debtor by 3

preventing purchases or sales above specified amounts does not thereby become a principal. However, if he takesover the management of the debtor’s business either in person or through an agent, and directs what contracts may ormay not be made, he becomes a principal, liable as a principal for the obligations incurred thereafter in the normalcourse of business by the debtor who has now become his general agent. The point at which the creditor becomes aprincipal is that at which he assumes de facto control over the conduct of his debtor, whatever the terms of the formalcontract with his debtor may be. Id., cmt. a.

Id., § 14 K, cmt. a.4

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(c) That he has an independent business in buying and sellingsimilar property.

II. Liability of Principal to Third Parties in ContractsA. The Agent’s Authority

1. 2 Broad Classifications of Power5

a. Actual (Real) – arises from the manifestation of consent from the principal to theagent (not to a third person) that the agent should act for the principal.(1) Express Authority – actual authority contained within the “four corners”

of the agency agreement between the principal and the agent, i.e.,authority expressly granted by the principal to the agent.

(2) Implied Authority – An agent’s authority includes not only the authorityexpressly granted by the principal to the agent, but also any authorityimplied by the agent from the words or conduct between the principaland the agent.

b. Apparent (Ostensible) – a principal will be bound by his agent’s unauthorized actsif the principal has manifested to a third party, through words or conduct, that theagent has authority, and the third party reasonably believes on this manifestation.(1) An agent cannot create apparent authority by his own manifestations.

The manifestations must be from the principal to the third party.(Conduct and silence can be a manifestation from the principal).(a) Exception. If the principal gives the agent express authority to

tell third parties that he has authority.2. Mill Street Church of Christ v. Hogan (Ky. 1990) (Implied Authority)

a. Implied v. Apparent Authority. Implied authority is actual authority circumstantiallyproven which the principal actually intended the agent to possess and includessuch powers as are practically necessary to carry out the duties actually delegated. Apparent authority on the other hand is not actual authority but is the authoritythe agent is held out by the principal as possessing. It is a matter of appearance onwhich third parties come to rely.(1) Implied Authority Rule. In examining whether implied authority exists, it

is important to focus upon the agent’s understanding of his authority. Itmust be determined whether the agent reasonably believes because ofpresent or past conduct of the principal that the principal wishes him toact in a certain way or to have certain authority. (a) Nature of task/job. The nature of the task or job may be

another factor to consider. Implied authority may be necessaryto implement the express authority.

(b) Prior similar practices. The existence of prior similar practices isone of the most important factors. Specific conduct by theprincipal in the past permitting the agent to exercise similarpowers is crucial.

b. Burden/Standard of Proof. The person alleging agency and resulting authority hasthe burden of proving that it exists. Agency cannot be proven by a merestatement, but it can be established by circumstantial evidence including the actsand conduct of the parties such as the continuous course of conduct of the partiescovering a number of successive transactions.

c. Subagent. One agent appoints someone else who will also be an agent of theprincipal.(1) When a principal engages an agent to perform a task, the principal has in

effect delegated the task to the agent. If the agent, acting with authority,in turn delegates part of all of that task to an agent of its own, then the

The power to bind is equal. The principal is equally bound whether based on actual or apparent authority.5

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second agent becomes a subagent of the original principal.3. Power of Position. Sometimes the principal’s sole manifestation to the third party may be to

put an agent in a particular role. In light of local custom and standard business practices,that role may by itself cause a third party to believe reasonably that the agent has certainauthority.

4. Highland Capital Management, LP v. Schneider (2d Cir. 2010).a. An agent must have authority, whether apparent, actual or implied, to bind his

principal.b. Actual Authority

(1) Under New York law, an agent has actual authority if the principal hasgranted the agent the power to enter into contracts on the principal’sbehalf, subject to whatever limitations the principal places on this power,either explicitly or implicitly.6

c. Apparent Authority(1) Where an agent lacks actual authority, he may nonetheless bind his

principal to a contract if the principal has created the appearance ofauthority, leading the other contracting party to reasonably believe thatactual authority exists.

(2) Apparent authority exists when a principal, either intentionally or bylack of ordinary care, induces a third party to believe that an individualhas been authorized to act on its behalf.

(3) Essential to the creation of apparent authority are words or conduct ofthe principal, communicated to a third party, that give rise to theappearance and belief that the agent possesses authority to enter into atransaction.

(4) However, the mere creation of an agency does not automatically investthe agent with ‘apparent authority’ to bind the principal withoutlimitation. A party cannot claim that an agent acted with apparentauthority when it knew, or should have known that the agent wasexceeding the scope of its authority.

5. Watteau v. Fenwick (Q.B. 1892) (Inherent Agency Power).a. Once it is established that the defendant was the real principal, the ordinary

doctrine as to principal and agent applies that the principle is liable for all the actsof the agent which are within the authority usually confided to an agent of thatcharacter, notwithstanding limitation.(1) It is said that it is only so where there has been a holding out of

authority–which cannot be said of a case where the person supplying thegoods knew nothing of the existence of a principal. But I do not thinkso. Otherwise, in every case of undisclosed principal, or at least in everycase where the fact of there being a principal was undisclosed, the secretlimitation of authority would prevail and defeat the action of the persondealing with the agent and then discovering that he was an agent andhad a principal.

6. Inherent Agency Power. In some situations, an agent has neither actual nor apparentauthority, and estoppel does not apply. Yet the agent’s position creates the potential formischief with third parties. To deal with such situations (and others as well), the R.2d andsome courts use the doctrine of inherent agency power. The doctrine imposes enterpriseliability; that is, it places the loss on the enterprise that stands to benefit from the agency

Actual authority is created by direct manifestations from the principal to the agent, and the extent of 6

the agent’s actual authority is interpreted in light of all circumstances attending those manifestations, including thecustoms of business, the subject matter, any formal agreement between the parties, and the facts of which both partiesare aware.

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relationship.7. Restatement (Second) of Agency § 8A. Inherent Agency Power.

Inherent agency power is a term used in the restatement of this subject to indicate the power of anagent which is not derived from authority, apparent authority or estoppel, but solely from the agencyrelation and exists for the protection of persons harmed by or dealing with a servant or other agent.

8. Restatement (Second) of Agency § 194 states that an undisclosed principal is liable for actsof an agent “done on his account, if usual or necessary in such transactions, althoughforbidden by the principal.”

9. Under the Restatement (Second) of Agency § 195, “An undisclosed principal who entrustsan agent with the management of his business is subject to liability to third persons withwhom the agent enters into transactions usual in such business and on the principal’saccount, although contrary to the directions of the principal.”

10. The Restatement (Third) of Agency rejected the concept of inherent agency power infavor of a rule directly targeted at cases like Watteau:a. Restatement (Third) of Agency § 2.06. Liability of Undisclosed

Principal.(1) An undisclosed principal is subject to liability to a third party who is justifiably inducedto make a detrimental change in position by an agent acting on the principal’s behalf andwithout actual authority if the principal, having notice of the agent’s conduct and that itmight induce others to change their positions, did not take reasonable steps to notify them ofthe facts.(2) An undisclosed principal may not rely on instructions given an agent that qualify orreduce the agent’s authority to less than the authority a third party would reasonably believethe agent to have under the same circumstances if the principal had been disclosed.

B. Ratification1. Ratification. Occurs when a principal affirms a previously unauthorized act. Ratification

validates the original unauthorized act and produces the same legal consequences as if theoriginal act had been authorized.a. Ratification can take place in the following ways:

(1) Expressly(2) Implied > Accept benefits(3) Implied > Silence/Inaction(4) Lawsuit to enforce the contract

b. Ratification is an “all or nothing” principle. 2. Restatement (Third) of Agency § 4.01. Ratification Defined.

(1) Ratification is the affirmance of a prior act done by another, whereby the act is given effect as ifdone by an agent acting with actual authority.(2) A person ratifies an act by

(a) manifesting assent that the act shall affect the person's legal relations, or(b) conduct that justifies a reasonable assumption that the person so consents.

(3) Ratification does not occur unless(a) the act is ratifiable as stated in § 4.03,(b) the person ratifying has capacity as stated in § 4.04,(c) the ratification is timely as stated in § 4.05, and(d) the ratification encompasses the act in its entirety as stated in § 4.07.

3. Botticello v. Stefanovicz (Conn. 1979).a. Agency is defined as “the fiduciary relationship which results from manifestation

of consent by one person to another that the other shall act on his behalf andsubject to his control, and consent by the other so to act....” Restatement(Second) of Agency § 1.(1) Three elements required to show the existence of an agency

relationship:(a) a manifestation by the principal that the agent will act for him;(b) acceptance by the agent of the undertaking; and

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(c) an understanding between the parties that the principal will bein control of the undertaking.

b. The existence of an agency relationship is a question of fact.(1) Marriage =/= Agency. Marital status cannot in and of itself prove the

agency relationship. The fact that one spouse tends more to businessmatters than the other does not, absent other evidence of agreement orauthorization, constitute delegation of power as to an agent.

c. Ratification is defined as “the affirmance by a person of a prior act which did notbind him but which was done or professedly done on his account. Restatement(Second) § 82.(1) Ratification requires “acceptance of the results of the act with an intent

to ratify, and with full knowledge of all the material circumstances.”(2) Before the receipt of benefits may constitute ratification, the other

requisites for ratification must first be present. Thus, if the originaltransaction was not purported to be done on account of the principal,the fact that the principal receives its proceeds does not make him aparty to it. Restatement (Second) of Agency § 98, comment f.(a) Walter at no time purported to be acting on his wife’s behalf, as

is essential to effective subsequent ratification, and Mary is notbound by the terms of the agreement, and specific performancecannot be ordered as to her.

4. Ratification is a means by which the principal can say, “my agent didn’t have the right toenter into this contract, but I’m glad she did so. Accordingly, I’ll affirm the transactionand agree to be bound by the contract.”

C. Estoppel1. Hoddeson v. Koos Bros. (N.J. 1957).

a. The liability of a principal to third parties for the acts of an agent may be shownby proof disclosing:(1) express or real authority which been definitely granted.(2) implied authority, that is, to do all that is proper, customarily incidental

and reasonably appropriate to the exercise of the authority granted; and(3) apparent authority, such as where the principal by words, conduct, or

other indicative manifestations has “held out” the person to be his agent.(a) General rule that the apparency and appearance of authority

must be shown to have been created by the manifestations ofthe alleged principal, and not alone and solely by proof of thoseof the supposed agent.

(b) Assuredly the law cannot permit apparent authority to beestablished by the mere proof that a mountebank in factexercised it.

b. Broadly stated, the duty of the proprietor also encircles the exercise of reasonablecare and vigilance to protect the customer from loss occasioned by the deceptionsof an apparent salesman.(1) The rule that those who bargain without inquiry with an apparent agent

do so at the risk and peril of an absence of the agent’s authority has apatently impracticable application to the customers who patronize ourmodern department stores.

(2) Our concept of modern law is that where a proprietor of a place ofbusiness by his dereliction of duty enables one who is not his agentconspicuously to act as such and ostensibly to transact the proprietor’sbusiness with a patron in the establishment, the appearances being ofsuch a character as to lead a person of ordinary prudence and circumspection tobelieve that the impostor was in truth the proprietor’s agent, in suchcircumstances the law will not permit the proprietor defensively to avail

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himself of the impostor’s lack of authority and thus escape liability forthe consequential loss thereby sustained by the customer.

2. Restatement (Third) of Agency § 2.05. Estoppel to Deny Existence of AgencyRelationship.A person who has not made a manifestation that an actor has authority as an agent and who is nototherwise liable as a party to a transaction purportedly done by the actor on that person's account issubject to liability to a third party who justifiably is induced to make a detrimental change in positionbecause the transaction is believed to be on the person's account, if

(1) the person intentionally or carelessly caused such belief, or(2) having notice of such belief and that it might induce others to change their positions, theperson did not take reasonable steps to notify them of the facts.

D. Agent’s Liability on the Contract1. Restatement (Third) of Agency § 6.01. Agent for Disclosed Principal.

When an agent acting with actual or apparent authority makes a contract on behalf of a disclosedprincipal,

(1) the principal and the third party are parties to the contract; and(2) the agent is not a party to the contract unless the agent and third party agree otherwise.

2. Restatement (Third) of Agency § 6.02. Agent for Unidentified Principal.When an agent acting with actual or apparent authority makes a contract on behalf of an unidentifiedprincipal,

(1) the principal and the third party are parties to the contract; and(2) the agent is a party to the contract unless the agent and the third party agree otherwise.

3. Restatement (Third) of Agency § 6.03. Agent for Undisclosed Principal.When an agent acting with actual authority makes a contract on behalf of an undisclosed principal,

(1) unless excluded by the contract, the principal is a party to the contract;(2) the agent and the third party are parties to the contract; and(3) the principal, if a party to the contract, and the third party have the same rights,liabilities, and defenses against each other as if the principal made the contract personally,subject to §§ 6.05–6.09.

4. Restatement (Third) of Agency § 6.10. Agent’s Implied Warranty of Authority.A person who purports to make a contract, representation, or conveyance to or with a third party onbehalf of another person, lacking power to bind that person, gives an implied warranty of authority tothe third party and is subject to liability to the third party for damages for loss caused by breach of thatwarranty, including loss of the benefit expected from performance by the principal, unless

(1) the principal or purported principal ratifies the act as stated in § 4.01; or(2) the person who purports to make the contract, representation, or conveyance gives noticeto the third party that no warranty of authority is given; or(3) the third party knows that the person who purports to make the contract, representation,or conveyance acts without actual authority.

5. When is an agent liable on a contract? It depends on the type of principal.7

a. Disclosed – Agent is not personally liable.(1) Exceptions. (1) If the parties intend the agent to be personally liable on

the contract he will be personally liable. However, a parole evidencerule issue may arise, therefore, it is best to expressly set out in thecontract the agent’s liability. (2) The agent had no authority to enterinto the contract and the principal did not ratify. This would be abreach of the agent’s implied warranty of authority.

The rules on contract liability are default rules. They can be overridden by express or implied agreement7

between the agent and third party.

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b. Partially Disclosed (Unidentified) – Agent is personally liable8

c. Undisclosed – Agent is personally liable.6. Atlantic Salmon A.S. v. Curran (Mass. App. 1992)

a. If the other party [to a transaction] has notice that the agent is or may be actingfor a principal but has no notice of the principal’s identity, the principal forwhom the agent is acting is a partially disclosed principal. Restatement (Second)of Agency § 4(2).

b. Unless otherwise agreed, a person purporting to make a contract with another fora partially disclosed principal is a party to the contract.

c. It is the duty of the agent, if he would avoid personal liability on a contractentered into by him on behalf of his principal, to disclose not only that he isacting in a representative capacity, but also the identity of his principal.(1) It was not the plaintiffs’ duty to seek out the identity of the defendant’s

principal; it was the defendant’s obligation fully to reveal it.(a) “The duty rests upon the agent, if he would avoid personal

liability, to disclose his agency, and not upon others to discoverit. It is not, therefore, enough that the other party has themeans of ascertaining the name of the principal; the agent musteither bring to him actual knowledge or, what is the samething, that which to a reasonable man is equivalent toknowledge or the agent will be bound. There is no hardship tothe agent in this, as he always has it in his power to relievehimself from personal liability by fully disclosing his principaland contracting only in the latter’s name. If he does not dothis, it may well be presumed that he intended to make himselfpersonally responsible.

d. Administratively Dissolved. If the corporation has been administratively dissolved itis because it has failed to pay its franchise taxes.(1) Those who act on behalf of an administratively dissolved corporation are

personally liable.(2) Paying fees to reinstate will not backdate any actions.

7. Arkansas. In Arkansas there is a great deal of emphasis on how the contract is signed, i.e.,whether the contract is signed in a representative capacity or in a personal capacity.a. Examples:

1. By: John Doe Agent (or President, Manager, etc.)

2. By: John Doe John Doe, Agent

3. By: John Doe

John Doe is personally liable under #3 but is not personally liable9

under #1 & #2. 8. General Agent/Special Agent.

a. General Agent. If a principal authorizes an agent “to conduct a series oftransactions involving a continuity of service,” the law calls the agent a general

The rationale is one of expectations. Without knowing the identity of the principal, the third party is8

presumably relying on the trustworthiness, creditworthiness, and bona fides of the agent.

Arkansas courts would invoke the parole evidence rule and exclude external testimony about the parties’9

intent.

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agent.b. Special Agent. If a principal authorizes the agent only to conduct a single

transaction, or to conduct a series of transactions that do not involve “continuityof service,” then the law calls the agent a special agent.

III. Liability of Principal to Third Parties in TortA. Servant Versus Independent Contractor

1. Restatement (Second) of Agency § 1. Agency; Principal; Agent.(1) Agency is the fiduciary relation which results from the manifestation of consent by one person toanother that the other shall act on his behalf and subject to his control, and consent by the other so toact.(2) The one for whom action is to be taken is the principal.(3) The one who is to act is the agent.

2. Restatement (Second) of Agency § 2. Master; Servant; IndependentContractor.(1) A master is a principal who employs an agent to perform service in his affairs and who controls orhas the right to control the physical conduct of the other in the performance of the service.(2) A servant is an agent employed by a master to perform service in his affairs whose physical conductin the performance of the service is controlled or is subject to the right to control by the master.(3) An independent contractor is a person who contracts with another to do something for him but whois not controlled by the other nor subject to the other’s right to control with respect to his physicalconduct in the performance of the undertaking. He may or may not be an agent.

3. Restatement (Second) of Agency § 219. When Master is Liable for Torts of HisServants.(1) A master is subject to liability for the torts of his servants committed while acting in the scope of their employment.(2) A master is not subject to liability for the torts of his servants acting outside the scope of theiremployment, unless:

(a) The master intended the conduct or the consequences, or(b) The master was negligent or reckless, or(c) The conduct violated a non-delegable duty of the master, or(d) The servant purported to act or to speak on behalf of the principal and there was relianceupon apparent authority, or he was aided in accomplishing the tort by the existence of theagency relation.

4. Restatement (Second) of Agency § 220. Definition of Servant.(1) A servant is a person employed to perform services in the affairs of another and who with respect tothe physical conduct in the performance of the services is subject to the other’s control or right tocontrol.(2) In determining whether one acting for another is a servant or an independent contractor, thefollowing matters of fact, among others, are considered:

(a) the extent of control which, by the agreement, the master may exercise over the details ofthe work; (b) whether or not the one employed is engaged in a distinct occupation or business;(c) the kind of occupation, with reference to whether, in the locality, the work is usuallydone under the direction of the employer or by a specialist without supervision;(d) the skill required in the particular occupation;(e) whether the employer or the workman supplies the instrumentalities, tools, and the placeof work for the person doing the work;(f) the length of time for which the person is employed;(g) the method of payment, whether by the time or by the job;(h) whether or not the work is part of the regular business of the employer;(i) whether or not the parties believe they are creating the relation of master and servant;and(j) whether the principal is or is not in business.

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5. Restatement (Third) of Agency § 2.04. Respondeat Superior.An employer is subject to liability for torts committed by employees while acting within the scope oftheir employment.

Comment (a). Terminology and cross-references. This Restatement does not use theterminology of “master” and “servant.” Section 7.07(3) defines “employee” for purposesof this doctrine. Section 7.07(2) states the circumstances under which an employee has actedwithin the scope of employment. Section 7.08 states the circumstances under which aprincipal is subject to vicarious liability for a tort committed by an agent, whether or not anemployee, when actions taken with apparent authority constituted the tort or enabled theagent to conceal its commission.

6. Restatement (Third) of Agency § 7.01. Agent’s Liability to Third Party.An agent is subject to liability to a third party harmed by the agent's tortious conduct. Unless anapplicable statute provides otherwise, an actor remains subject to liability although the actor acts as anagent or an employee, with actual or apparent authority, or within the scope of employment.

7. Respondeat Superior. A venerable doctrine which imposes strict, vicarious liability on aprincipal when:10

a. An agent’s tort has caused physical injury to a person or propertyb. The tortfeasor agent meet the criteria to be considered a “servant” (or under the

R.3d, “employee”) of the principal, andc. The tortious conduct occurred within the servant/employee’s “scope of

employment.”8. Rationales. The doctrine of respondeat superior rests on three rationales: enterprise

liability, risk avoidance, and risk spreading.a. Enterprise Liability. Links risk and benefits and hold accountable for risk-creating

activities the enterprise that stands to benefit from those activities.b. Risk Spreading. The master can: (i) anticipate the risk inherent in its enterprise;

(ii) spread the risk through insurance; (iii) take into account the cost of insurancein setting the price for its goods or services; and (iv) thereby spread the riskamong those who benefit from the goods or services.

c. Risk Avoidance. Creates a strong incentive for the employer/master to use itsposition of control to achieve “risk avoidance.”

9. Under the doctrine of respondeat superior, “master” (employer) is liable for the torts of itsservants (employees).a. A master-servant relationship exists where the servant has agreed:

(1) to work on behalf of the master and(2) be subject to the master’s control or right to control the “physical

conduct” of the servant (that is, the manner in which the job isperformed, as opposed to the result alone).

10. Scope of Employmenta. Even if the tortfeasor is en employee, vicarious liability results only if the tort

occurred within the scope of employment.11. Independent Contractors Are of Two Types: Agent and Non-Agent.

a. Agent-Type. One who has agreed to act on behalf on another, the principal, butnot subject to the principal’s control over how the result is accomplished (that is,over the “physical conduct” of the task).

b. Non-Agent. One who operates independently and simply enters into arm’s lengthtransactions with others.

12. Humble Oil & Refining Co. v. Martin (Tex. 1949). (Master/Servant Relationship [Liable])a. Even if the contract between Humble and Schneider were the only evidence on

The injured party may also assert claims of direct responsibility against the principal. In any event, the10

tortfeasor agent will be directly liable. Being an agent does not immunize a person from tort liability. A tortfeasor ispersonally liable, regardless of whether the tort was committed on the instruction from or to the benefit of a principal.

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the question, the instrument as a whole indicates a master-servant relationshipquite as much as, if not more than, it suggests an arrangement betweenindependent contractors.(1) For example, paragraph 1 includes a provision requiring Schneider “to

make reports and perform other duties in connection with the operation of saidstation that may be required of him from time to time by Company.

b. Obviously, the main object of the enterprise was the retail marketing of Humble’sproducts with title remaining in Humble until delivery to the consumer. Thiswas done under a strict system of financial control and supervision by Humble,with little or no business discretion reposed in Schneider except as to hiring,discharge, payment and supervision of a few station employees of a more or lesslaborer status.

c. This case differs from The Texas Company v. Wheat. That case clearly showed a“dealer” type of relationship in which the lessee in charge of the filling stationpurchased from his landlord, The Texas Company, and sold as his own, and wasfree to sell at his own price and on his own credit terms, the company productspurchased, as well as the products of other oil companies. The contracts containedno provision requiring the lessee to perform any duty The Texas Company mightsee fit to impose upon him, nor did the company pay any part of the lessee’soperating expenses, nor control the working hours of the station.

13. Hoover v. Sun Oil Company (Del. 1965). (No Master/Servant Relationship [Not Liable])a. While Petersen (Sun’s representative) did offer advice to Barone on all phases of

his operation, it was usually done on request and Barone was under no obligationto follow the advice. Barone’s contacts and dealings with Sun were many andtheir relationship intricate, but he made no written reports to Sun and he aloneassumed the overall risk of profit or loss in his business operation. Baronindependently determined his own hours of operation and the identity, pay saleand working conditions of his employees, and it was his name that was posted asproprietor.

b. The legal relationships arising from the distribution systems of major oil-producing companies are in certain respects unique. As stated in an annotationcollecting many of the cases dealing with this relationship:(1) “This distribution system has grown up primarily as the result of

economic factors and with little relationship to traditional legal conceptsin the field of master and servant, so that it is perhaps not surprising thatattempts by the court to discuss the relationship in the standard termshave led to some difficulties and confusion.”

c. In some situations traditional definitions of principal and agent and of employerand independent contractor may be difficult to apply to service station operators,but the undisputed facts of the case at bar make it clear that Barone was anindependent contractor.

d. Test. The test be applied is that of whether the oil company has retained the rightto control the details of the day-to-day operation of the service station; control orinfluence over results alone being views as insufficient.

14. Murphy v. Holiday Inns, Inc. (Va. 1975). (Franchise Relationship)a. When an agreement, considered as a whole, establishes an agency relationship,

the parties cannot effectively disclaim it by formal “consent.” The relationship ofthe parties does not depend upon what the parties themselves call it, but rather inlaw what it actually is.

b. In determining whether a contract establishes an agency relationship, the criticaltest is the nature and extent of the control agreed upon.

c. The plaintiff pointed to several provision and rules of the agreement which he

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claimed satisfied the control test to establish the principal-agent relationship.11

d. Franchising. Franchising is a system for the selective distribution of goods and/orservices under a brand name through outlets owned by independent businessmen,called “franchisees.” Although the franchisor supplies the franchisee with know-how and brand identification on a continuing basis, the franchisee enjoys the rightto profit and runs the risk of loss. The franchisor controls the distribution of hisgoods and/or services through a contract which regulates the activities of thefranchisee, in order to achieve standardization.(1) The fact that an agreement is a franchise contract does not insulate the

contracting parties from an agency relationship. If a franchise contract soregulates the activities of the franchisee as to vest the franchisor withcontrol within the definition of agency, the agency relationship ariseseven though the parties expressly deny it.

e. Having carefully considered all of the regulatory provisions in the agreement, weare of the opinion that they gave defendant no “control or right to control themethods or details of doing the work, and, therefore, agree with the trial courtthat no principal-agent or master-servant relationship was created.(1) The purpose of the provisions was to achieve system-wide uniformity of

commercial service, and optimum public good will, all for the benefit ofboth contracting parties.

15. Restatement § 1 indicates, as stated by the Holiday Inns court, that control is an essentialelement of the definition of agency relationship, whether one is dealing with a servant oran independent contractor. A key distinction between the servant and independentcontractor types of agents, however, is the differing natures and degrees of controlexercised by the principal. See Restatement § 220.

16. Restatement (Third) of Agency § 1.02. Parties’ Labeling and Popular UsageNot Controlling.An agency relationship arises only when the elements stated in § 1.01 are present. Whether arelationship is characterized as agency in an agreement between parties or in the context of industry orpopular usage is not controlling.

17. Vandemark v. McDonald’s Corp. (N.H. 2006).a. The weight of authority construes franchiser liability narrowly, finding that absent

a showing of control over security measures employed by the franchisee, thefranchiser cannot be vicariously liable for the security breach.(1) Wendy Hong Wu v. Dunkin’ Donuts, Inc. (E.D.N.Y. 2000).

(a) The court specifically examined whether Dunkin’ Donuts hadcontrol over the alleged “instrumentality” that cause the harm.

b. “The evidence demonstrates that although the defendant maintained authority toinsure the uniformity and standardization of products and services offered by the[franchise] restaurant, such authority did not extend to control of securityoperations. Thus, there was no genuine issue of material fact as to whether the

That licensee construct its motel according to plans, specifications, feasibility studies, and locations11

approved by licensor; That licensee employ the trade name, signs, and other symbols of the ‘system’ designated bylicensor; That licensee pay a continuing fee for use of the license and a fee for national advertising of the ‘system’;That licensee solicit applications for credit cards for the benefit of other licensees; That licensee protect and promotethe trade name and not engage in any competitive motel business or associate itself with any trade association designedto establish standards for motels; That licensee not raise funds by sale of corporate stock or dispose of a controllinginterest in its motel without licensor's approval; That training for licensee's manager, housekeeper, and restaurantmanager be provided by licensor at licensee's expense; That licensee not employ a person contemporaneously engagedin a competitive motel or hotel business; and That licensee conduct its business under the ‘system’, observe the rulesof operation, make quarterly reports to licensor concerning operations, and submit to periodic inspections of facilitiesand procedures conducted by licensor's representatives.

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defendant exercised control over the relevant security policies at the [franchisee’s]restaurant through adopting the QSC Play Book.”

B. Tort Liability and Apparent Agency1. Miller v. McDonald’s Corp. (Ore. App. 1997).

a. Actual Agency. The kind of actual agency relationship that would make defendantvicariously liable for 3K’s negligence requires that defendant have the right tocontrol the method by which 3K performed its obligations under theAgreement.12

(1) A number of courts have applied the right to control test to a franchiserelationship.(a) “If in practical effect, the franchise agreement goes beyond the

stage of setting standards, and allocates to the franchisor theright to exercise control over the daily operations of thefranchise, an agency relationship exists.”

(2) We believe that a jury could find that defendant retained sufficientcontrol over 3K’s daily operations that an actual agency relationshipexisted. The Agreement did not simply set standards that 3K had tomeet. Rather, it required 3K to use the precise methods that defendantestablished. Defendant enforced the use of those methods by regularlysending inspectors and by its retained power to cancel the Agreement.

b. Apparent Agency13

(1) Restatement (Second) of Agency § 267.(a) “One who represents that another is his servant or other agent

and thereby causes a third person justifiably to rely upon thecare or skill of such apparent agent is subject to liability to thethird person for harm caused by the lack of care or skill of theone appearing to be a servant or other agent as if her weresuch.”

(2) We have not applied § 267 to a franchisor/franchisee situation, butcourts in a number of other jurisdictions have done so in ways that wefind instructive. In most case the courts have found that there was a juryissue of apparent agency. The crucial issues are whether the putativeprincipal held the third party out as an agent and whether the plaintiffrelied on that holding out.

2. Restatement (Third) of Agency § 7.08. Agent Acts With Apparent Authority.A principal is subject to vicarious liability for a tort committed by an agent in dealing orcommunicating with a third party on or purportedly on behalf of the principal when actions taken bythe agent with apparent authority constitute the tort or enable the agent to conceal its commission.

C. Scope of Employment1. Restatement (Second) of Agency § 228. General Statement.

(1) Conduct of a servant is within the scope of employment if, but only if:(a) it is of the kind he is employed to perform;(b) it occurs substantially within the authorized time and space limits;(c) it is actuated, at least in part, by a purpose to serve the master, and(d) if force is intentionally used by the servant against another, the use of force is not

Under the right to control test it does not matter whether the putative principal actually exercises control;12

what is important is that it has the right to do so.

Apparent agency is a distinct concept from apparent authority. Apparent agency creates an agency13

relationship that does not otherwise exist, while apparent authority expands the authority of an actual agent. In thiscase, the precise issue is whether 3K was defendant’s apparent agent, not whether 3K had apparent authority.

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unexpectable by the master.(2) Conduct of a servant is not within the scope of employment if it is different in kind from thatauthorized, far beyond the authorized time or space limits, or too little actuated by a purpose to servethe master.

2. Restatement (Second) of Agency § 229. Kind of Conduct Within Scope ofEmployment.(1) To be within the scope of the employment, conduct must be of the same general nature as thatauthorized, or incidental to the conduct authorized.(2) In determining whether or not the conduct, although not authorized, is nevertheless so similar toor incidental to the conduct authorized as to be within the scope of employment, the following mattersof fact are to be considered:

(a) whether or not the act is one commonly done by such servants;(b) the time, place and purpose of the act;(c) the previous relations between the master and the servant;(d) the extent to which the business of the master is apportioned between different servants;(e) whether or not the act is outside the enterprise of the master or, if within the enterprise,has not been entrusted to any servant;(f) whether or not the master has reason to expect that such an act will be done.(g) the similarity in quality of the act done to the act authorized;(h) whether or not the instrumentality by which the harm is done has been furnished by themaster to the servant;(i) the extent of departure from the normal method of accomplishing an authorized result;and(j) whether or not the act is seriously criminal.

3. Restatement (Third) of Agency § 7.07. Employee Acting Within Scope ofEmployment.14

(1) An employer is subject to vicarious liability for a tort committed by its employee acting within thescope of employment.(2) An employee acts within the scope of employment when performing work assigned by the employeror engaging in a course of conduct subject to the employer's control. An employee's act is not withinthe scope of employment when it occurs within an independent course of conduct not intended by theemployee to serve any purpose of the employer.(3) For purposes of this section,

(a) an employee is an agent whose principal controls or has the right to control the mannerand means of the agent's performance of work, and(b) the fact that work is performed gratuitously does not relieve a principal of liability.

4. Unauthorized Conduct. Unauthorized conduct can be within the scope of employment.a. Restatement (Second) of Agency § 230. Forbidden Acts.

An act, although forbidden, or done in a forbidden manner, may be within the scope ofemployment.

5. Travel. Comment 3 to R.3d § 7.07 explains that “In general, travel required to performwork, such a travel from an employer’s office to a job site or from one job site to another,is within the scope an employee’s employment, while traveling to and from work is not.”

6. Frolic and Detour. Agency law has a pair of labels to distinguish small-scale deviations fromsubstantial ones.a. Detour. The employee remains within the scope of employment (and

consequently respondeat superior still applies).b. Frolic. A substantial deviation puts the employee outside the scope of

The R.3d is less formulaic. Note that R.3d has revised the R.2d’s third condition–substituting “an14

independent course of conduct not intended by the employee to serve any purpose of the employer” for “actuated, atleast in part, by a purpose to serve the master.” The R.3d also rejects the R.2d’s condition–“substantially within theauthorized time and space limits”–as antiquated.

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employment.7. Ira S. Bushey & Sons, Inc. v. United States (2d Cir. 1968).

a. The Government relies on Restatement of Agency 2d § 228(1) which says that“conduct of a servant is within the scope of employment if, but only if: (c) it isactuated, at least in part, by a purpose to serve the master.”(1) In Nelson v. American-West African Line (2d Cir. 1936), Judge Learned

Hand concluded that a drunken boatswain who routed the plaintiff outof his bunk with a blow, saying “Get up, you big son of a bitch, andturn to,” and the continued to fight, might have thought he was actingin the interest of the ship.

(2) It would be going too far to find such a purpose here; while Lane’sreturn to the Tamaroa was to serve his employer, no one has suggestedhow he could have though turning the wheels to be, even if–which isby no means clear–he was unaware of the consequences.

b. Motive Test No Longer Viable. In light of the highly artificial way in which themotive test has been applied, the district judge believed himself obliged to test thedoctrine’s continuing vitality by referring to the larger purposes respondeatsuperior is supposed to serve.(1) A policy analysis, however, is not sufficient to justify this proposed

expansion of vicarious liability.(a) Whatever may have been the case in the past, a doctrine that

would create such drastically different consequences for theactions of the drunken boatswain in Nelson and those thedrunken seaman here reflects a wholly unrealistic attitudetowards the risks characteristically attendant upon the operationof a ship.

(b) Not Negligence Standard of Foreseeability. Put another way,Lane’s conduct was not so “unforeseeable” as to make it unfairto charge the Government with responsibility. We agree witha leading treatise that “what is reasonably foreseeable in thiscontext (of respondeat superior) is quite a different thing fromthe foreseeably unreasonable risk of harm that spells negligence.

c. Test. The proper test here bears far more resemblance to that which limitsliability for workmen’s compensation than to the test for negligence. Theemployer should be held to expect risks, to the public also, which arise out of and in thecourse of his employment of labor.

d. Factors of Importance to J. Friendly:(1) Foreseeability – Well known that sailors on shore leave drink like

Irishmen.(2) Economics – Judge Friendly says that the trial court’s economic analysis

may be valid but it is unknown what effect allocation would have.(3) Justice – Justice requires this. The employer ought not to get a benefit

and be able to simultaneously disclaim the risk.(4) Proximity – Geographically, seems to be a concern of Judge Friendly(5) Risks associated with enterprise v. Risk attendant on the activities of the

community in general(6) Because of the employment, unusual circumstances are encountered,

e.g., the job is inherently stressful.8. Clover v. Snowbird Ski Resort (Utah 1991). (Frolic & Detour)

a. Ski resort restaurant chef/supervisor, while skiing between resort restaurantlocations, severely injured another skier after ignoring warning signs andlaunching off a jump. The trial court granted summary judgment to the resort onthe theory that the employee was not acting within the scope of his employment.

b. The Supreme Court concluded that summary judgment should not have been

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granted in favor of the ski resort and remanded for trial.(1) The court rejected an alternative argument by the plaintiff, based on

Bushey, that the employer’s liability should depend “not on whether theemployer’s conduct is motivated by serving the employer’s interest, buton whether the employee’s conduct is foreseeable.” The Utah courtnoted simply that this is not the test under Utah case law.

9. The district court’s analysis in Bushey amounted to virtually a rule of strict liability for thetorts of an employee as long as any connection in time and space could be made betweenthe conduct and the employment.a. Judge Friendly affirmed the district court’s result but rejected its rationale, noting

that it was not at all clear that the proposed rule would lead to a more efficientallocation of resources.

10. Manning v. Grimsley (1st Cir. 1981).a. In Massachusetts where a plaintiff seeks to recover damages from an employer for

injuries resulting from an employee’s assault, what must be shown is that theemployee’s assault was in response to the plaintiff’s conduct which was presentlyinterfering with the employee’s ability to perform his duties successfully. This interferencemay be in the form of an affirmative attempt to prevent an employee fromcarrying out his assignments.(1) Miller’s holding that a critical comment by a customer to an employee

did not in the circumstances constitute conduct interfering with theemployee’s performance of his work is obviously distinguishable fromthe case at bar. Miller v. Federated Department Stores, Inc. (Mass. 1973).(a) Constant heckling by fans at a baseball park would be, within

the meaning of Miller, conduct.b. This test relates to the motivation of the employee to serve his or her employer.

11. Restatement (Second) of Agency § 231. Criminal or Tortious Acts.An act may be within the scope of employment although consciously criminal or tortious.

12. Serious Crimes or Torts. Under the traditional view, the master is not liable for the seriouscrime or tort of the servant. An irrebuttable presumption was created that the servant wasnot motivated by a purpose to serve the master.a. The R.2d modifies this (See § 228(d)(1)): “if force is intentionally used by the

servant against another, the use of force is not expectable by the master.”13. Liability of Torts of Independent Contractor. In general, a principal is not vicariously liable for

physical harm caused by the torts of a nonemployee agent (in R.2d terms, an“independent contract agent”).a. Exceptions: (1) inherently dangerous activity (requires special skill to prevent grave

injury); (2) ultrahazardous activity (harm cannot be averted no matter howcareful); (3) nondelegable duties (special relationship, e.g., common carriers,innkeepers/contractual relationships, e.g., landlord-tenant/statutory); and (4) casesthat impose liability with no general rationale (e.g., store security guards and falseimprisonment, store ratified when it did not fire guard, and there is an obligationto protect customers from unwarranted attack).

14. Torts Not Involving Physical Harm. If an agent’s misconduct consists solely of words and thethird party suffers harm only to its emotions, reputation, or pocketbook, the agencyanalysis resembles the approach used for contractual matters. The key rules are those ofactual authority, apparent authority, and inherent agency power. Except for the borderlineareas of malicious prosecution and intentional interference with business relations,respondeat superior is largely irrelevant.a. Defamation. Not whether the principal authorized the agent to defame but rather

to make the statement (Ex. Credit bureaus reporting incorrect creditinformation.)

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IV. Fiduciary Obligation of Agents.A. Duties During Agency

1. Restatement (Third) of Agency § 8.01. General Fiduciary Principle.An agent has a fiduciary duty to act loyally for the principal’s benefit in all matters connected with theagency relationship.

2. Restatement (Third) of Agency § 8.02. Material Benefit Arising Out ofPosition.An agent has a duty not to acquire a material benefit from a third party in connection withtransactions conducted or other actions taken on behalf of the principal or otherwise through the agent’suse of the agent’s position.

3. Restatement (Third) of Agency § 8.03. Acting as or on Behalf of an AdverseParty.An agent has a duty not to deal with the principal as or on behalf of an adverse party in a transactionconnected with the agency relationship.

4. Restatement (Third) of Agency § 8.04. Competition.Throughout the duration of an agency relationship, an agent has a duty to refrain from competingwith the principal and from taking action on behalf of or otherwise assisting the principal's competitors.During that time, an agent may take action, not otherwise wrongful, to prepare for competitionfollowing termination of the agency relationship.

5. Restatement (Third) of Agency § 8.05. Use of Principal’s Property; Use ofConfidential Information.An agent has a duty

(1) not to use property of the principal for the agent's own purposes or those of a third party;and(2) not to use or communicate confidential information of the principal for the agent's ownpurposes or those of a third party.

6. Restatement (Third) of Agency § 8.06. Principal’s Consent.(1) Conduct by an agent that would otherwise constitute a breach of duty as stated in §§ 8.01,8.02, 8.03, 8.04, and 8.05 does not constitute a breach of duty if the principal consents to theconduct, provided that

(a) in obtaining the principal's consent, the agent(i) acts in good faith,(ii) discloses all material facts that the agent knows, has reason to know, orshould know would reasonably affect the principal's judgment unless the principalhas manifested that such facts are already known by the principal or that theprincipal does not wish to know them, and(iii) otherwise deals fairly with the principal; and

(b) the principal's consent concerns either a specific act or transaction, or acts or transactionsof a specified type that could reasonably be expected to occur in the ordinary course of theagency relationship.

(2) An agent who acts for more than one principal in a transaction between or among them has a duty(a) to deal in good faith with each principal,(b) to disclose to each principal

(i) the fact that the agent acts for the other principal or principals, and(ii) all other facts that the agent knows, has reason to know, or should knowwould reasonably affect the principal's judgment unless the principal hasmanifested that such facts are already known by the principal or that the principaldoes not wish to know them, and

(c) otherwise to deal fairly with each principal.7. Restatement (Third) of Agency § 8.07. Duty Created by Contract.

An agent has a duty to act in accordance with the express and implied terms of any contract betweenthe agent and the principal.

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8. Restatement (Third) of Agency § 8.08. Duties of Care, Competence, andDiligence.Subject to any agreement with the principal, an agent has a duty to the principal to act with the care,competence, and diligence normally exercised by agents in similar circumstances. Special skills orknowledge possessed by an agent are circumstances to be taken into account in determining whether theagent acted with due care and diligence. If an agent claims to possess special skills or knowledge, theagent has a duty to the principal to act with the care, competence, and diligence normally exercised byagents with such skills or knowledge.

9. Restatement (Third) of Agency § 8.09. Duty to Act Only Within Scope ofActual Authority and to Comply With Principal’s Lawful Instructions.(1) An agent has a duty to take action only within the scope of the agent's actual authority.(2) An agent has a duty to comply with all lawful instructions received from the principal and personsdesignated by the principal concerning the agent's actions on behalf of the principal.

10. Restatement (Third) of Agency § 8.10. Duty of Good Conduct.An agent has a duty, within the scope of the agency relationship, to act reasonably and to refrain fromconduct that is likely to damage the principal's enterprise.

11. Restatement (Third) of Agency § 8.11. Duty to Provide Information.An agent has a duty to use reasonable effort to provide the principal with facts that the agent knows,has reason to know, or should know when

(1) subject to any manifestation by the principal, the agent knows or has reason to knowthat the principal would wish to have the facts or the facts are material to the agent's dutiesto the principal; and(2) the facts can be provided to the principal without violating a superior duty owed by theagent to another person.

12. Duty of Loyalty. All agents owe a fiduciary duty of loyalty. Agency is emphatically not anarm’s-length relationship.a. Unapproved Benefits. An agent cannot make “secret profits” from the agency

relationship: (1) Forbids compensation from someone other than the principal in

connection with the agent’s duty (kickbacks, bribes, gratuities, etc.)(2) An agent may not become the other party to a transaction with the

principal, unless the agent discloses its role and the principal consent.(3) Not using the position to gain profits from someone with no connection

to the principal.b. No Competition. Agent cannot compete with the principal or act on behalf of a

competitor.c. Agent cannot use principal’s property for his own purposes or the purposes of

someone else.d. Confidential Information. Agent cannot use or communicate the principal’s

confidential information for the agent’s own purposes or those of someone else.13. Reading v. Regem (K.B. 1948).

a. In my judgment, it is a principle of law that, if a servant takes advantage of hisservice and violates his duty of honesty and good faith to make a profit forhimself, in the sense that the assets of which he has control, the facilities which heenjoys, or the position which he occupies, are the real cause of his obtaining themoney as distinct from merely affording the opportunity for getting it, that is tosay, if they play the predominant part in his obtaining the money, then he isaccountable for it to his master.(1) It matters not that the master has not lost any profit nor suffered any

damage, nor does it matter that the master could not have done the acthimself. If the servant unjustly enriched himself by virtue of his servicewithout his master’s sanction, the law says that he ought not to beallowed to keep the money, but it shall be taken from him and given tohis master, because he got it solely by reason of the position which he

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occupied as a servant of his master.b. Distinguish from Service Giving Rise to Opportunity. This case is to be distinguished

from cases where the service merely gives the opportunity of making money. Aservant may, during his master’s time, in breach of his contract, do other things tomake money for himself, such as gambling, but he is entitled to keep that moneyhimself. The master has a claim for damages for breach of contract, but he has noclaim to the money.

14. General Automotive Manufacturing Co. v. Singer (Wis. 1963).a. Singer had broad powers of management and conducted the business activities of

Automotive. In this capacity he was Automotive’s agent and owed a fiduciaryduty to it. Under his fiduciary duty to Automotive, Singer was bound to theexercise of the utmost good faith and loyalty so that he did not act adversely tothe interests of Automotive by serving or acquiring any private interest of hisown. He was also bound to act for the furtherance and advancement of theinterest of Automotive.

b. The title of the activity does not determine the question whether it wascompetitive but an examination of the nature of the business must be made.

c. Rather than to resolve the conflict of interest between his side line business andAutomotive’s business in favor of serving and advancing his own personalinterests, Singer had the duty to exercise good faith by disclosing to Automotiveall the facts regarding this matter. Upon disclosure to Automotive it was in thelatter’s discretion to refuse to accept the orders from Husco or to fill them if possible or tosub-job them to other concerns with the consent of Husco if necessary, and the profit, ifany, would belong to Automotive.

15. Other Dutiesa. Agent to Principal: (1) duty of care; (2) duty of good conduct; (3) duty to act

within authority; (4) duty to obey instruction; (5) duty to indemnify principal foragent’s misconduct; (6) duty to account; and (7) duty to provide information.

b. Principal to Agent: (1) duty to dear fairly and in good faith; (2) duty to pay; (3)duty to indemnify.

B. Duties During and After Termination of Agency: Herein of “Grabbing and Leaving”1. Town & Country House & Home Service, Inc. v. Newberry (N.Y. 1958).

a. The only trade secret which could be involved in this business is plaintiff’s list ofcustomers.(1) Concerning that, even where a solicitor of business does not operate

fraudulently under the banner of his former employer, he still may notsolicit the latter’s customers who are not openly engaged in business inadvertised locations or whose availability as patrons cannot readily beascertained but whose trade and patronage have been secured by years ofbusiness effort and advertising, and the expenditure of time and money,constituting a part of the good will of a business which enterprise andforesight have built up.

C. Attribution1. Agency law provides that in some situations, information that an agent knows or has

received is attributed to the principal–treated as if the principal knew or received theinformation.a. Agent Has Actual/Apparent Authority to Receive Notice. The notice has the same

effect as if it had been made directly to the principal.b. Business Entities. It will have a registered person, a person designated in the

records of the Secretary of State who is authorized to receive legal notices.c. Agent’s Knowledge. If an agent has actual knowledge of a fact concerning a matter

within the agent’s actual authority, the agent’s knowledge is attributed to theprincipal.(1) Exception. The agent’s knowledge is not imputed to the principal if the

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agent was acting adversely to the principal, and the third party knew orhad reason to know that the agent was acting adversely to the principal.

(2) Business Organizations. The law concerning attribution of knowledge isimportant when the principal is an organization, like a corporation orother business entity, that has multiple agents. If the requirements forimputation are otherwise met, the knowledge of all of the agents isimputed to the corporation.

CHAPTER TWO : PARTNERSHIPS

I. What is a Partnership? And Who Are the Partners?A. Partners Compared With Employees

1. Revised Uniform Partnership Act § 202. Formation of Partnership.(a) Except as otherwise provided in subsection (b), the association of two or more persons to carry onas co-owners a business for profit forms a partnership, whether or not the persons intend to form apartnership.(b) An association formed under a statute other than this [Act], a predecessor statute, or a comparablestatute of another jurisdiction is not a partnership under this [Act].(c) In determining whether a partnership is formed, the following rules apply:

(1) Joint tenancy, tenancy in common, tenancy by the entireties, joint property, commonproperty, or part ownership does not by itself establish a partnership, even if the co-ownersshare profits made by the use of the property.(2) The sharing of gross returns does not by itself establish a partnership, even if the personssharing them have a joint or common right or interest in property from which the returns arederived.(3) A person who receives a share of the profits of a business is presumed to be a partner inthe business, unless the profits were received in payment:

(i) of a debt by installments or otherwise;(ii) for services as an independent contractor or of wages or other compensation toan employee;(iii) of rent;(iv) of an annuity or other retirement or health benefit to a beneficiary,representative, or designee of a deceased or retired partner;(v) of interest or other charge on a loan, even if the amount of payment varieswith the profits of the business, including a direct or indirect present or futureownership of the collateral, or rights to income, proceeds, or increase in valuederived from the collateral; or(vi) for the sale of the goodwill of a business or other property by installments orotherwise.

2. Fenwick v. Unemployment Compensation Commission (N.J. 1945).a. There are several elements that the courts have taken into consideration in

determining the existence or nonexistence of the partnership relation:(1) Intention of the parties.

(a) The agreement between the parties is evidential although notconclusive.

(2) Right to share in profits.(a) Sharing of profits will raise a presumption that a partnership

exists. See RUPA § 202(c)(3).(b) However, not every agreement that gives the right to share in

profits is, for all purposes, a partnership agreement.(3) Obligation to share in losses.(4) Ownership and control of the partnership property and business.(5) Community of power in administration.(6) Language in the agreement.(7) Conduct of the parties toward third persons.(8) Rights of the parties on dissolution.

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b. The Uniform Partnership Act defines a partnership as an association of “two ofmore persons to carry on as co-owners a business for profit.”(1) The Act further provides that sharing of profits is prima facie evidence of

partnership but “no such inference shall be drawn if such profits werereceived in payment ... as wages of an employee.”

3. Uniform Partnership Act § 18. Rules Determining Rights and Duties ofPartners.The rights and duties of the partners in relation to the partnership shall be determined, subject to anyagreement between them, by the following rules:

(a) Each partner shall be repaid his contributions, whether by way of capital or advances tothe partnership property and share equally in the profits and surplus remaining after allliabilities, including those to partners, are satisfied; and must contribute towards the losses,whether of capital or otherwise, sustained by the partnership according to his share in theprofits.(b) The partnership must indemnify every partner in respect of payments made and personalliabilities reasonably incurred by him in the ordinary and proper conduct of its business, orfor the preservation of its business or property.(c) A partner, who in aid of the partnership makes any payment or advance beyond theamount of capital which he agreed to contribute, shall be paid interest from the date of thepayment or advance.(d) A partner shall receive interest on the capital contributed by him only from the datewhen repayment should be made.(e) All partners have equal rights in the management and conduct of the partnershipbusiness.(f) No partner is entitled to remuneration for acting in the partnership business, except thata surviving partner is entitled to reasonable compensation for his services in winding up thepartnership affairs.(g) No person can become a member of a partnership without the consent of all the partners.(h) Any difference arising as to ordinary matters connected with the partnership businessmay be decided by a majority of the partners; but no act in contravention of any agreementbetween the partners may be done rightfully without the consent of all the partners.

4. Uniform Partnership Act § 31. Causes of Dissolution.Dissolution is caused:(1) Without violation of the agreement between the partners,

(a) By the termination of the definite term or particular undertaking specified in theagreement,(b) By the express will of any partner when no definite term or particular undertaking isspecified,(c) By the express will of all the partners who have not assigned their interests or sufferedthem to be charged for their separate debts, either before or after the termination of anyspecified term or particular undertaking,(d) By the expulsion of any partner from the business bona fide in accordance with such apower conferred by the agreement between the partners;

(2) In contravention of the agreement between the partners, where the circumstances do not permit adissolution under any other provision of this section, by the express will of any partner at any time;(3) By any event which makes it unlawful for the business of the partnership to be carried on or forthe members to carry it on in partnership;(4) By the death of any partner;(5) By the bankruptcy of any partner or the partnership;(6) By decree of court under section 32.

B. Partners Compared With Lenders1. Liability of Partners. The question of who is a partner is important because of the rule of

partnership law that makes each partner potentially liable for all of the debts of the partnership.

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2. Martin v. Peyton (N.Y. 1927).a. The plaintiff was a creditor of the firm Knauth, Nachod & Kuhne, and claimed

that the defendants, who had made investments in the firm, were partners and, assuch, liable for its debts.

b. There is no hint that the transaction is not a loan of securities with a provision forcompensation.(1) Until the securities were returned, the directing management of the firm

was to be in the hands of John R. Hall, and his life to be insured for$1,000,000, and the polices were to be assigned as further collateralsecurity to the trustees.(a) These requirements are not unnatural. Hall was the one

known and trusted by the defendants. What they requiredseems but ordinary caution. Nor does it imply an associationin the business.

c. The trustees were to be kept advised as to the conduct of the business andconsulted as to important matters. They could inspect the firm books and wereentitled to any information they thought important. Finally, they could veto anybusiness decision they though highly speculative or injurious.(1) This was but a proper precaution to safeguard the loan. The trustees

could not initiate any action as a partner could. They could not bindthe firm by any action of their own.

d. Each member of the K.N. & K. firm was to assign to the trustees their interest inthe firm. No loan by the firm to any member was permitted and the amounteach may draw was fixed. No other distributions of profit were to be made. There was no obligation that the firm continue business and it could be dissolvedat any time.(1) There is nothing here not properly adapted to secure the interest of the

respondents as lenders.e. The “indenture” is substantially a mortgage of the collateral delivered by K.N. &

K. to the trustees to secure the performance of the “agreement.” It certainly doesnot strengthen the claim that the respondents were partners.

f. The “option” permits the trustees, of any of them, or their assignees or nomineesto enter the firm at a later date if they desire to do so by buying 50 percent or lessof the interests therein of all or any of the member at a stated price. Or acorporation may, if the trustees and members agree, be formed in the place of thefirm.(1) This provision is somewhat unusual, yet it is not enough in itself to

show that on June 4, 1921, a present partnership was created, nor takingthese various papers as a whole do we reach such a result.

3. The risk of liability for Peyton, Perkins, and Freeman would have been avoided if K.N. &K. had been organized as a corporation.a. Under that form of organization, the equity investors (the counterparts of

partners) enjoy “limited liability”– that is, they are not personally liable for thedebts of the firm and therefore stand to lose only the amount they have investedin it.

b. The same would be true if they had formed a limited liability company or limitedliability partnership. These forms of business organization, however, wereunavailable at the time this transaction occurred.

C. Partnership v. Contract1. Southex Exhibitions, Inc. v. Rhode Island Builders Association, Inc. (1st Cir. 2002).

a. Under Rhode Island law, a “partnership” is “an association of two (2) or morepersons to carry on as co-owners a business for profit...”

b. The record evidence indicating a nonpartner relationship cannot be dismissed asinsubstantial:

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(1) Southex insists that the 1974 Agreement contains ample indicia that apartnership was formed, including: (1) a 55-45% sharing of profits; (2)mutual control over designated business operations, such as show dates,admission prices, choice of exhibitors, and “partnership” bank accounts;and (3) the respective contributions of valuable property to thepartnership by the partners.

(2) The 1974 Agreement is simply entitled “Agreement,” rather than“Partnership Agreement.”

(3) Rather than an agreement for an indefinite duration, it prescribed afixed (albeit renewable) term.

(4) Rather than undertake to share operating costs with RIBA, SEM notonly agreed to advance all monies required to produce the shows, but toindemnify RIBA for all show-related losses as well.(a) State law normally presumes that partners share equally or at

least proportionately in partnership losses.(5) Southex not only entered into contract but conducted business with

third parties, in its own name, rather than in the name of the putativepartnership. As a matter of fact, their mutual association was nevergiven a name.

(6) Similarly, the evidence as to whether either SEM or RIBA contributedany corporate property, with the intent that it become jointly-ownedpartnership property is highly speculative, particularly since their mutualendeavor simply involved a periodic event, i.e., an annual home show,which neither generated, nor necessitated, ownership interests insignificant tangible properties, aside from cash receipts.

c. “Partnership” is a notoriously imprecise term, whose definition is especiallyelusive in practice. Since a partnership can be created absent any writtenformalities whatsoever, its existence vel non normally must be assessed under a“totality-of-the-circumstances” test.

d. Profit Sharing Does Not Have to Compel Finding of Partnership. Similarly, eventhough the UPA explicitly identifies profit sharing as a particularly probativeindicium of partnership formation, and some courts have even held the absence ofprofit sharing compels a finding that no partnership existed, it does not necessarilyfollow that evidence of profit sharing compels a finding of partnershipinformation.(1) Even though the UPA specifies five instances in which profit sharing

does not create a presumption of partnership formation, Southex cites(and we have found) no authority for the proposition that theevidentiary presumption created by profit sharing can be overcome onlyby establishing these five exceptions, rather than by competent evidenceof other pertinent factors indicating the absence of an intent to form apartnership (e.g., lack of mutual control over business operations, failureto file partnership tax returns, failure to prescribe loss-sharing).

e. The term “partner” is frequently defined with a view to its context. Moreimportantly, the labels the parties assign, while probative of partnershipformation, are not necessarily dispositive as a matter of law, particularly in thepresence of countervailing evidence.

D. Partnership by Estoppel1. Young v. Jones (D.S.C. 1992)

a. Plaintiffs assert that PW-Bahamas and PW-US [the Price Waterhouse partnershipin the United States] operate as a partnership, i.e., constitute an association ofpersons to carry on, as owners, business for profit. In the alternative, plaintiffscontend that if the two associations are not actually operating as partners they areoperating as partners by estoppel.

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b. As a general rule, persons who are not partners as to each other are not partners asto third persons.(1) Partnership by Estoppel. However, a person who represents himself, or

permits another to represent him, to anyone as a partner in an existingpartnership or with other not actual partners, is liable to any such personto whom such a representation is made who has, on the faith of therepresentation, given credit to the actual or apparent partnership.

II. The Fiduciary Obligations of PartnersA. Introduction

1. Meinhard v. Salmon (N.Y. 1928).15

a. Duty of Loyalty. Joint adventurers, like copartners, owe to one another, while theenterprise continues, the duty of the finest loyalty. Many forms of conductpermissible in a workaday world for those acting at arm’s length, are forbidden tothose bound by fiduciary ties. A trustee is held to something stricter than themorals of the market place. Not honesty alone, but the punctilio of an honor themost sensitive, is then the standard of behavior.

b. Uncompromising rigidity has been the attitude of courts of equity whenpetitioned to undermine the rule of undivided loyalty by the “disintegratingerosion” of particular exceptions.

c. The trouble with Salmon’s conduct is that he excluded his coadventurer from anychance to compete, from any chance to enjoy the opportunity for benefit that hadcome to him alone by virtue of his agency.(1) All these opportunities were cut away from the plaintiff through

another’s intervention.(2) The very fact that Salmon was in control with exclusive powers of

discretion charged him the more obviously with the duty of disclosure,since only through disclosure could opportunity be equalized.

d. A different question would be here if there were lacking any nexus of relationbetween the business conducted by the manager and the opportunity brought tohim as an incident of manager.(1) Here the subject-matter of the new lease was an extension and

enlargement of the subject-matter of the old one. A managingcoadventurer appropriating the benefit of such a lease without warningto his partner might fairly expect to be reproached with conduct thatwas underhand, or lacking, to say the least, in reasonable candor, if thepartner were to surprise him in the act of signing the new instrument.

e. Judge Andrews’ Dissent(1) It seems to me that the venture . . . had in view a limited object and was

to end at a limited time. There was no intent to expand it into a fargreater undertaking lasting for many years. Doubtless in it Mr.Meinhard has an equitable interest, but in it alone.

2. Revised Uniform Partnership Act § 404. General Standards of Partner’sConduct.(a) The only fiduciary duties a partner owes to the partnership and the other partners are the duty ofloyalty and the duty of care set forth in subsections (b) and (c).(b) A partner's duty of loyalty to the partnership and the other partners is limited to the following:

(1) to account to the partnership and hold as trustee for it any property, profit, or benefitderived by the partner in the conduct and winding up of the partnership business or derivedfrom a use by the partner of partnership property, including the appropriation of apartnership opportunity;

Although Meinhard v. Salmon involved a joint venture rather than a partnership, Cardozo’s words are15

equally applicable to partnerships.

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(2) to refrain from dealing with the partnership in the conduct or winding up of thepartnership business as or on behalf of a party having an interest adverse to the partnership;and(3) to refrain from competing with the partnership in the conduct of the partnership businessbefore the dissolution of the partnership.

(c) A partner's duty of care to the partnership and the other partners in the conduct and winding up ofthe partnership business is limited to refraining from engaging in grossly negligent or reckless conduct,intentional misconduct, or a knowing violation of law.(d) A partner shall discharge the duties to the partnership and the other partners under this [Act] orunder the partnership agreement and exercise any rights consistently with the obligation of good faithand fair dealing.(e) A partner does not violate a duty or obligation under this [Act] or under the partnership agreementmerely because the partner's conduct furthers the partner's own interest.(f) A partner may lend money to and transact other business with the partnership, and as to each loanor transaction the rights and obligations of the partner are the same as those of a person who is not apartner, subject to other applicable law.(g) This section applies to a person winding up the partnership business as the personal or legalrepresentative of the last surviving partner as if the person were a partner.

B. Opting Out of Fiduciary Duties1. Perretta v. Promethus Development Company, Inc. (9th Cir. 2008).

a. Under California law, the general partner of a limited partnership has the samefiduciary duties as a partner in any other partnership.16

b. Not all self-interested transactions violate the duty of loyalty. The question is notwhether the interested partner is benefitted, but whether the partnership or theother partners are harmed.(1) Partnerships is a fiduciary relationship, and partners may not take

advantages for themselves at the expense of the partnership. Thus, a partnerwho seek a business advantage over another partner bears the burden ofshowing complete good faith and fairness to the other.(a) Ratification. One way a self-interested partner may meet this

burden is to have disinterested partners ratify its actions. 17

Upon a showing of proper ratification by the partners, anyclaim against the partner for a violation of the duty of loyalty isextinguished.

c. Under California law, a transaction with an interested partner would beinconsistent with the interested partner’s duty of loyalty and would requireunanimous approval of the partners–unless the partnership agreement providesdifferently.(1) California law permits a partnership agreement to vary or permit

ratifications of the duty of loyalty only if the provision doing so is not

(b) A partner’s duty of loyalty to the partnership and the other partners includes all of the following:16

(1) To account to the partnership and hold as trustee for it any property, profit or benefit derived bythe partner in the conduct and winding up of the partnership business or derived from a use by thepartner of partnership property or information, including the appropriation of a partnershipopportunity.(2) To refrain from dealing with the partnership in the conduct or winding up of the partnershipbusiness as or on behalf of a party having an interest adverse to the partnership...

There is no breach of fiduciary duty if there has been a full and complete disclosure, if the partner who17

deals with the partnership property first discloses all of the facts surrounding the transaction to the other partners andsecures their approval and consent.

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“manifestly unreasonable.”(a) A comment to the 2001 Uniform Limited Partnership Act,

explaining the provision allowing ratification upon a specifiedvote of the limited partners, notes: “The Act does not requirethat the authorization or ratification be by disinterested partners,although the partnership agreement may so provide.i) The court disagrees. To the extent ratification

represents an exception to California’s general policyof “thorough and relentless” scrutiny of self-dealing,we are confident that a California court wouldconstrue it narrowly, with particular skepticismtoward any aspect that might hint of unfairness.

ii) California statutes in related areas of the law supportthe idea that interested partners should not be allowedto count their votes in a ratification vote.

iii) Allowing an interested partner to participate in aratification election subverts the very purpose ofratification itself.

(b) We hold that a partnership agreement provision that allows aninterested partner to count its votes in a ratification vote wouldbe “manifestly unreasonable” within the meaning of the statute.

2. Revised Uniform Partnership Act § 103. Effect of Partnership Agreement;Nonwaivable Provisions.

(a) Except as otherwise provided in subsection (b), relations among the partners andbetween the partners and the partnership are governed by the partnership agreement. To theextent the partnership agreement does not otherwise provide, this [Act] governs relationsamong the partners and between the partners and the partnership.(b) The partnership agreement may not:

(1) vary the rights and duties under Section 105 except to eliminate the duty toprovide copies of statements to all of the partners;(2) unreasonably restrict the right of access to books and records under Section403(b);(3) eliminate the duty of loyalty under Section 404(b) or 603(b)(3), but:

(i) the partnership agreement may identify specific types or categories ofactivities that do not violate the duty of loyalty, if not manifestlyunreasonable; or(ii) all of the partners or a number or percentage specified in thepartnership agreement may authorize or ratify, after full disclosure of allmaterial facts, a specific act or transaction that otherwise would violatethe duty of loyalty;

(4) unreasonably reduce the duty of care under Section 404(c) or 603(b)(3);(5) eliminate the obligation of good faith and fair dealing under Section 404(d),but the partnership agreement may prescribe the standards by which theperformance of the obligation is to be measured, if the standards are notmanifestly unreasonable;(6) vary the power to dissociate as a partner under Section 602(a), except torequire the notice under Section 601(1) to be in writing;(7) vary the right of a court to expel a partner in the events specified in Section601(5);(8) vary the requirement to wind up the partnership business in cases specified inSection 801(4), (5), or (6);(9) vary the law applicable to a limited liability partnership under Section106(b); or(10) restrict rights of third parties under this [Act].

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C. Grabbing and Leaving1. Meehan v. Shaughnessy (Mass. 1989).

a. It is well settled that partners owe each other a fiduciary duty of the utmost goodfaith and loyalty. As a fiduciary, a partner must consider his or her partners’welfare, and refrain from acting for purely private gain.

b. We have stated that fiduciaries may plan to compete with the entity to whichthey owe allegiance provided that in the course of such arrangements they do nototherwise act in violation of their fiduciary duties.

c. A partner has an obligation to render on demand true and full information of allthings affecting the partnership to any partner.

d. ABA Committee on Ethics and Professional Responsibility Informal Opinion1457 sets forth ethical standards for attorneys announcing a change in professionalassociation.(1) The ethical standard provides any notice explain to a client that he or

she has the right to decide who will continue the representation.III. Partnership Property

A. Putnam v. Shoaf (Ct. App. Tenn. 1981).1. Under the Uniform Partnership Act, ... her partnership property rights consisted of her (1)

rights in specific partnership property, (2) interest in the partnership and (3) right toparticipate in management.a. The right in “specific partnership property” is the partnership tenancy possessory

right of equal use or possession by partners for partnership purposes. Thispossessory right is incident to the partnership and the possessory right does notexist absent the partnership.

b. The real interest of a partner, as opposed to that incidental possessory right beforediscussed, is the partner’s interest in the partnership which is defined as “his shareof the profits and surplus and the same is personal property.” Therefore, a co-partner owns no personal specific interest in any specific property or asset of thepartnership. The partnership owns the property or the asset. The partner’sinterest is an undivided interest, as a co-tenant in all partnership property. Thatinterest is the partner’s pro rata share of the net value or deficit of the partnership.(1) For this reason a conveyance of partnership property held in the name of

the partnership is made in the name of the partnership and not as aconveyance of the individual interests of the partners.

B. Revised Uniform Partnership Act § 201. Partnership as Entity.(a) A partnership is an entity distinct from its partners.(b) A limited liability partnership continues to be the same entity that existed before the filing of a statement ofqualification under Section 1001.

C. Revised Uniform Partnership Act § 203. Partnership Property.Property acquired by a partnership is property of the partnership and not of the partners individually.

D. Revised Uniform Partnership Act § 204. When Property is Partnership Property.(a) Property is partnership property if acquired in the name of:

(1) the partnership; or(2) one or more partners with an indication in the instrument transferring title to the property of theperson's capacity as a partner or of the existence of a partnership but without an indication of thename of the partnership.

(b) Property is acquired in the name of the partnership by a transfer to:(1) the partnership in its name; or(2) one or more partners in their capacity as partners in the partnership, if the name of the partnershipis indicated in the instrument transferring title to the property.

(c) Property is presumed to be partnership property if purchased with partnership assets, even if not acquired inthe name of the partnership or of one or more partners with an indication in the instrument transferring title tothe property of the person's capacity as a partner or of the existence of a partnership.(d) Property acquired in the name of one or more of the partners, without an indication in the instrument

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transferring title to the property of the person's capacity as a partner or of the existence of a partnership andwithout use of partnership assets, is presumed to be separate property, even if used for partnership purposes.

E. Revised Uniform Partnership Act § 501. Partner Not Co-Owner of PartnershipProperty.A partner is not a co-owner of partnership property and has no interest in partnership property which can betransferred, either voluntarily or involuntarily.

F. Revised Uniform Partnership Act § 502. Partner’s Transferable Interest in Partnership.The only transferable interest of a partner in the partnership is the partner's share of the profits and losses of thepartnership and the partner's right to receive distributions. The interest is personal property.

G. Revised Uniform Partnership Act § 503. Transfer of Partner’s Transferable Interest.(a) A transfer, in whole or in part, of a partner's transferable interest in the partnership:

(1) is permissible;(2) does not by itself cause the partner's dissociation or a dissolution and winding up of the partnershipbusiness; and(3) does not, as against the other partners or the partnership, entitle the transferee, during thecontinuance of the partnership, to participate in the management or conduct of the partnershipbusiness, to require access to information concerning partnership transactions, or to inspect or copy thepartnership books or records.

(b) A transferee of a partner's transferable interest in the partnership has a right:(1) to receive, in accordance with the transfer, distributions to which the transferor would otherwise beentitled;(2) to receive upon the dissolution and winding up of the partnership business, in accordance with thetransfer, the net amount otherwise distributable to the transferor; and(3) to seek under Section 801(6) a judicial determination that it is equitable to wind up thepartnership business.

(c) In a dissolution and winding up, a transferee is entitled to an account of partnership transactions only fromthe date of the latest account agreed to by all of the partners.(d) Upon transfer, the transferor retains the rights and duties of a partner other than the interest in distributionstransferred.(e) A partnership need not give effect to a transferee's rights under this section until it has notice of the transfer.(f) A transfer of a partner's transferable interest in the partnership in violation of a restriction on transfercontained in the partnership agreement is ineffective as to a person having notice of the restriction at the time oftransfer.

IV. Raising Additional Capital*V. The Rights of Partners in Management

A. Revised Uniform Partnership Act § 401. Partner’s Rights and Duties.(a) Each partner is deemed to have an account that is:

(1) credited with an amount equal to the money plus the value of any other property, net of theamount of any liabilities, the partner contributes to the partnership and the partner's share of thepartnership profits; and(2) charged with an amount equal to the money plus the value of any other property, net of theamount of any liabilities, distributed by the partnership to the partner and the partner's share of thepartnership losses.

(b) Each partner is entitled to an equal share of the partnership profits and is chargeable with a share of thepartnership losses in proportion to the partner's share of the profits.(c) A partnership shall reimburse a partner for payments made and indemnify a partner for liabilities incurred bythe partner in the ordinary course of the business of the partnership or for the preservation of its business orproperty.(d) A partnership shall reimburse a partner for an advance to the partnership beyond the amount of capital thepartner agreed to contribute.(e) A payment or advance made by a partner which gives rise to a partnership obligation under subsection (c) or(d) constitutes a loan to the partnership which accrues interest from the date of the payment or advance.(f) Each partner has equal rights in the management and conduct of the partnership business.(g) A partner may use or possess partnership property only on behalf of the partnership.

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(h) A partner is not entitled to remuneration for services performed for the partnership, except for reasonablecompensation for services rendered in winding up the business of the partnership.(i) A person may become a partner only with the consent of all of the partners.(j) A difference arising as to a matter in the ordinary course of business of a partnership may be decided by amajority of the partners. An act outside the ordinary course of business of a partnership and an amendment tothe partnership agreement may be undertaken only with the consent of all of the partners.(k) This section does not affect the obligations of a partnership to other persons under Section 301.

B. UPA § 18(e) states that “all partners have equal rights in the management and conduct of thepartnership business,” and § 18(h) provides that “any difference arising as to ordinary mattersconnected with the partnership business may be decided by a majority of the partners.”18

1. Thus, if there are three partners and they disagree as to an “ordinary” matter, the decisionof the majority controls. The majority can deprive the minority partner.

2. If however, there are only two partners, there can be no majority vote that will beeffective to deprive either partner of authority to act for the partnership.

C. National Biscuit Company v. Stroud (N.C. 1959).1. In Johnson v. Bernheim, this Court said: A and B are general partners to do some given

business; the partnership is, by operation of law, a power to each to bind the partnership inany manner legitimate to the business. If one partner goes to a third person to buy anarticle on time for the partnership, the other partner cannot prevent it by writing to thethird person not to sell to him on time. And what is true in regard to buying is true inregard to selling. What either partner does with a third person is binding on the partnership.a. It is otherwise where the partnership is not general, but is upon special terms, as

that purchases and sales must be with and for cash. There the power to each isspecial, in regard to all dealings with third persons at least who have notice of theterms.

2. G.S. § 59.39(1). Partner Agent of Partnership as to Partnership Businessa. “Every partner is an agent of the partnership for the purpose of its business, and

the act of every partner, including the execution in the partnership name of anyinstrument, for apparently carrying on in the usual way the business of thepartnership of which he is a member binds the partnership, unless the partner soacting has in fact no authority to act for the partnership in the particular matter,and the person with whom he is dealing has knowledge of the fact that he has nosuch authority.”

3. G.S. § 59.45 provides that “all partners are jointly and severally liable for the acts andobligations of the partnership.”

4. G.S. § 59.48. Rules Determining Rights and Duties of Partners.a. (e) All partners have equal rights in the management and conduct of the

partnership business.”b. (h) Any difference arising as to ordinary business matters connected with the

partnership business may be decided by a majority of the partners; but no act incontravention of any agreement between the partners may be done rightfullywithout the consent of all the partners.

5. Freeman, as a general partner with Stroud, with no restrictions on his authority to actwithin the scope of the partnership business so far as the agreed statement of facts shows,had under the Uniform Partnership Act “equal rights in the management and conduct ofthe partnership business.” Stroud, his co-partner, could not restrict the power andauthority of Freeman to buy bread for the partnership as a going concern, for such apurchase was an “ordinary matter connected with the partnership business,” for thepurpose of its business and within its scope, because in the very nature of things Stroud wasnot, and could not be, a majority of the partners.

6. In Crane on Partnership it is said: “In cases of an even division of the partners as to whether

To the same effect is RUPA §§ 103, 401(f) and (j).18

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or not an act within the scope of the business should be done, of which disagreement athird person has knowledge, it seems that logically no restriction can be placed upon thepower to act. The partnership being a going concern, activities within the scope of thebusiness should not be limited, save by the expressed will of the majority deciding adisputed question; half of the members are not a majority.”

D. Summers v. Dooley (Idaho 1971).1. UPA § 18(h) provides: “Any difference arising as to ordinary matters connected with the

partnership business may be decided by a majority of the partners.”2. UPA § 18(e) provides: “The rights and duties of the partners in relation to the partnership

shall be determined, subject to any agreement between them, by the following rules . . .All partners have equal rights in the management and conduct of the business.”a. This section bestows equal rights in the management and conduct of the

partnership business upon all of the partners. The concept of equality betweenpartners with respect to management of business affairs is a central theme andrecurs throughout the Uniform Partnership law. (1) Thus, the only reasonable interpretation of § 18(h) is that business

difference must be decided by a majority of the partners provided noother agreement between the partners speaks to the issues.

3. In the case at bar one of the partners continually voiced objection to the hiring of the thirdman. He did not sit idly by and acquiesce in the actions of his partner. Under thesecircumstances it is manifestly unjust to permit recovery of an expense which was incurredindividually and not for the benefit of the partnership but rather for the benefit of onepartner.

E. Day v. Sidley & Austin (D.D.C. 1975).1. Fraud.

a. The misrepresentation regarding plaintiff’s status cannot support a cause of actionfor fraud, however, because plaintiff was not deprived of any legal right as a resultof his reliance on this statement.

b. Plaintiff’s allegations of an unwritten understanding cannot now be heard tocontravene the provisions of the Partnership Agreement which seeminglyembodied the complete intentions of the parties as to the manner in which thefirm was to be operated and managed.

c. Nor can plaintiff have reasonably believed that no changes would be made in theWashington office since the S & A Agreement gave complete authority to theexecutive committee to decide questions of firm policy, which would clearlyinclude establishment of committees and the appointment of members andchairpersons.

2. Breach of Fiduciary Dutya. An examination of the case law on a partner’s fiduciary duties reveal that courts

have been primarily concerned with partners who make secret profits at theexpense of the partnership.(1) Partners have a duty to make a full and fair disclosure to other partners

of all information which may be of value to the partnership.(2) The essence of a breach of fiduciary duty is that one partner has

advantaged himself at the expense of the firm.(3) The basic fiduciary duties are:

(a) a partner must account for any profit acquired in a mannerinjurious to the interests of the partnership, such ascommissions or purchases on the sale of partnership property.

(b) a partner cannot without the consent of the other partners,acquire for himself a partnership asset, nor may he divert to hisown use a partnership opportunity.

(c) he must not compete with the partnership within the scope ofbusiness.

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b. What plaintiff is alleging in the instant case, however, concerns failure to revealinformation regarding changes in the internal structure of the firm. No court hasrecognized a fiduciary duty to disclose this type of information, the concealmentof which does not produce any profit for the offending partners nor any financialloss for the partnership as a whole.(1) Note. Day would have been in better shape under the Revised Uniform

Partnership Act § 403(c)(1) which provides: “Each partner and thepartnership shall furnish to a partner, and to the legal representative of a deceasedpartner or partner under legal disability: (1) without demand, any informationconcerning the partnership's business and affairs reasonably required for the properexercise of the partner's rights and duties under the partnership agreement or this[Act].”

F. Technically, under the UPA §§ 29 and 31, the old partnership is dissolved by the retirement of anypartner and when the remaining partners continue their practice a new partnership is formed.1. “Continuation” agreement: an agreement obligating the remaining partners to continue to

associate with one another as partners under the existing agreement (or, perhaps, somevariation of it).

G. Under RUPA § 601, if a partner retires pursuant to an appropriate provision in the partnershipagreement (and in various other situations), there is a “dissociation” rather than a “dissolution.”1. The partnership continues as to the remaining partners and the dissociated partner is

entitled, in the absence of an agreement to the contrary, to be paid an amount determinedas if “on the date of dissociation, the assets of the partnership were sold at a price equal tothe greater of the liquidation value or the value based on a sale of the entire business as agoing concern without the dissociated partner,” plus the interest from the date ofdissociation. § 701(a) and (b).

VI. Partnership DissolutionA. The Right to Dissolve

1. Uniform Partnership Act § 31. Causes of Dissolution.Dissolution is caused:(1) Without violation of the agreement between the partners,

(a) By the termination of the definite term or particular undertaking specified in theagreement,(b) By the express will of any partner when no definite term or particular undertaking isspecified,(c) By the express will of all the partners who have not assigned their interests or sufferedthem to be charged for their separate debts, either before or after the termination of anyspecified term or particular undertaking,(d) By the expulsion of any partner from the business bona fide in accordance with such apower conferred by the agreement between the partners;

(2) In contravention of the agreement between the partners, where the circumstances do not permit adissolution under any other provision of this section, by the express will of any partner at any time;(3) By any event which makes it unlawful for the business of the partnership to be carried on or forthe members to carry it on in partnership;(4) By the death of any partner;(5) By the bankruptcy of any partner or the partnership;(6) By decree of court under section 32.

2. Uniform Partnership Act § 32. Dissolution by Decree of Court.(1) On application by or for a partner the court shall decree a dissolution whenever:

(a) A partner has been declared a lunatic in any judicial proceeding or is shown to be ofunsound mind,(b) A partner becomes in any other way incapable of performing his part of the partnershipcontract,(c) A partner has been guilty of such conduct as tends to affect prejudicially the carrying onof the business,

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(d) A partner wilfully or persistently commits a breach of the partnership agreement, orotherwise so conducts himself in matters relating to the partnership business that it is notreasonably practicable to carry on the business in partnership with him,(e) The business of the partnership can only be carried on at a loss,(f) Other circumstances render a dissolution equitable.

(2) On the application of the purchaser of a partner's interest under sections 28 or 29[in original;probably should read “section 27 or 28.”]:

(a) After the termination of the specified term or particular undertaking,(b) At any time if the partnership was a partnership at will when the interest was assignedor when the charging order was issued.

3. Revised Uniform Partnership Act § 601. Events Causing Partner’s Dissociation.A partner is dissociated from a partnership upon the occurrence of any of the following events:(1) the partnership's having notice of the partner's express will to withdraw as a partner or on a laterdate specified by the partner;(2) an event agreed to in the partnership agreement as causing the partner's dissociation;(3) the partner's expulsion pursuant to the partnership agreement;(4) the partner's expulsion by the unanimous vote of the other partners if:

(i) it is unlawful to carry on the partnership business with that partner;(ii) there has been a transfer of all or substantially all of that partner's transferable interestin the partnership, other than a transfer for security purposes, or a court order charging thepartner's interest, which has not been foreclosed;(iii) within 90 days after the partnership notifies a corporate partner that it will be expelledbecause it has filed a certificate of dissolution or the equivalent, its charter has been revoked,or its right to conduct business has been suspended by the jurisdiction of its incorporation,there is no revocation of the certificate of dissolution or no reinstatement of its charter or itsright to conduct business; or(iv) a partnership that is a partner has been dissolved and its business is being wound up;

(5) on application by the partnership or another partner, the partner's expulsion by judicialdetermination because:

(i) the partner engaged in wrongful conduct that adversely and materially affected thepartnership business;(ii) the partner willfully or persistently committed a material breach of the partnershipagreement or of a duty owed to the partnership or the other partners under Section 404; or(iii) the partner engaged in conduct relating to the partnership business which makes it notreasonably practicable to carry on the business in partnership with the partner;

(6) the partner's:(i) becoming a debtor in bankruptcy;(ii) executing an assignment for the benefit of creditors;(iii) seeking, consenting to, or acquiescing in the appointment of a trustee, receiver, orliquidator of that partner or of all or substantially all of that partner's property; or(iv) failing, within 90 days after the appointment, to have vacated or stayed theappointment of a trustee, receiver, or liquidator of the partner or of all or substantially all ofthe partner's property obtained without the partner's consent or acquiescence, or failingwithin 90 days after the expiration of a stay to have the appointment vacated;

(7) in the case of a partner who is an individual:(i) the partner's death;(ii) the appointment of a guardian or general conservator for the partner; or(iii) a judicial determination that the partner has otherwise become incapable of performingthe partner's duties under the partnership agreement;

(8) in the case of a partner that is a trust or is acting as a partner by virtue of being a trustee of atrust, distribution of the trust's entire transferable interest in the partnership, but not merely by reasonof the substitution of a successor trustee;(9) in the case of a partner that is an estate or is acting as a partner by virtue of being a personalrepresentative of an estate, distribution of the estate's entire transferable interest in the partnership, but

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not merely by reason of the substitution of a successor personal representative; or(10) termination of a partner who is not an individual, partnership, corporation, trust, or estate.

4. Revised Uniform Partnership Act § 602. Partner’s Power to Dissociate;Wrongful Dissociation.(a) A partner has the power to dissociate at any time, rightfully or wrongfully, by express willpursuant to Section 601(1).(b) A partner's dissociation is wrongful only if:

(1) it is in breach of an express provision of the partnership agreement; or(2) in the case of a partnership for a definite term or particular undertaking, before theexpiration of the term or the completion of the undertaking:

(i) the partner withdraws by express will, unless the withdrawal follows within90 days after another partner's dissociation by death or otherwise under Section601(6) through (10) or wrongful dissociation under this subsection;(ii) the partner is expelled by judicial determination under Section 601(5);(iii) the partner is dissociated by becoming a debtor in bankruptcy; or(iv) in the case of a partner who is not an individual, trust other than a businesstrust, or estate, the partner is expelled or otherwise dissociated because it willfullydissolved or terminated.

(c) A partner who wrongfully dissociates is liable to the partnership and to the other partners fordamages caused by the dissociation. The liability is in addition to any other obligation of the partnerto the partnership or to the other partners.

5. Owen v. Cohen (Cal. 1941).a. General rule that trifling and minor differences and grievances which involve no

permanent mischief will not authorize a court to decree a dissolution of apartnership.

b. However, courts of equity may order the dissolution of a partnership where thereare quarrels and disagreements of such a nature and to such extent that allconfidence and cooperation between the parties has been destroyed or where oneof the parties by his misbehavior hinders a proper conduct of the partnershipbusiness.(1) It is not only large affairs which produce trouble. The continuation of

overbearing and vexatious petty treatment of one partner by anotherfrequently is more serious in its disruptive character than would be largerdifferences which would be discussed and settled.

c. UPA § 32.(1) “(1) On application by or for a partner the court shall decree a

dissolution whenever...(d) ... it is not reasonably practicable to carry on thebusiness in partnership with [the other partner].”

6. Buyout of Dissociated Partner. If a partner’s dissociation does not result in dissolution,RUPA § 7.01 provides as a default rule that the dissociated partner is entitled to be boughtout: “the partnership shall cause the dissociated partner’s interest in the partnership to bepurchased.” Unless otherwise provided in the partnership agreement, “[t]he buyout ismandatory. The ‘cause to be purchased language is intended to accommodate a purchaseby the partnership, one or more of the remaining partners, or a third party.”

7. Revised Uniform Partnership Act § 801. Events Causing Dissolution andWinding Up of Partnership Business.A partnership is dissolved, and its business must be wound up, only upon the occurrence of any of thefollowing events:(1) in a partnership at will, the partnership's having notice from a partner, other than a partner who isdissociated under Section 601(2) through (10), of that partner's express will to withdraw as a partner,or on a later date specified by the partner;(2) in a partnership for a definite term or particular undertaking:

(i) within 90 days after a partner's dissociation by death or otherwise under Section 601(6)through (10) or wrongful dissociation under Section 602(b), the express will of at least half

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of the remaining partners to wind up the partnership business, for which purpose a partner'srightful dissociation pursuant to Section 602(b)(2)(i) constitutes the expression of thatpartner's will to wind up the partnership business;(ii) the express will of all of the partners to wind up the partnership business; or(iii) the expiration of the term or the completion of the undertaking;

(3) an event agreed to in the partnership agreement resulting in the winding up of the partnershipbusiness;(4) an event that makes it unlawful for all or substantially all of the business of the partnership to becontinued, but a cure of illegality within 90 days after notice to the partnership of the event is effectiveretroactively to the date of the event for purposes of this section;(5) on application by a partner, a judicial determination that:

(i) the economic purpose of the partnership is likely to be unreasonably frustrated;(ii) another partner has engaged in conduct relating to the partnership business which makesit not reasonably practicable to carry on the business in partnership with that partner; or(iii) it is not otherwise reasonably practicable to carry on the partnership business inconformity with the partnership agreement; or

(6) on application by a transferee of a partner's transferable interest, a judicial determination that it isequitable to wind up the partnership business:

(i) after the expiration of the term or completion of the undertaking, if the partnership wasfor a definite term or particular undertaking at the time of the transfer or entry of thecharging order that gave rise to the transfer; or(ii) at any time, if the partnership was a partnership at will at the time of the transfer orentry of the charging order that gave rise to the transfer.

8. Revised Uniform Partnership Act § 802. Partnership Continues AfterDissolution.(a) Subject to subsection (b), a partnership continues after dissolution only for the purpose of windingup its business. The partnership is terminated when the winding up of its business is completed.(b) At any time after the dissolution of a partnership and before the winding up of its business iscompleted, all of the partners, including any dissociating partner other than a wrongfully dissociatingpartner, may waive the right to have the partnership's business wound up and the partnershipterminated.In that event:

(1) the partnership resumes carrying on its business as if dissolution had never occurred, andany liability incurred by the partnership or a partner after the dissolution and before thewaiver is determined as if dissolution had never occurred; and(2) the rights of a third party accruing under Section 804(1) or arising out of conduct inreliance on the dissolution before the third party knew or received a notification of the waivermay not be adversely affected.

9. Collins v. Lewis (Tex. 1955).a. Power to Dissolve But Not a Right. We agree with the appellants that there is no

such thing as an indissoluble partnership only in the sense that there always existsthe power, as opposed to the right, of dissolution. But legal right to dissolutionrests in equity, as does the right to relief from the provisions of any legal contract.

10. Page v. Page (Cal. 1961).a. The Uniform Partnership Act provides that a partnership may be dissolved “By

the express will of any partner when no definite term or particular undertaking isspecified.”

b. In Owen v. Cohen, the court held that when a partner advances a sum of moneyto a partnership with the understanding that the amount contributed was to be aloan to the partnership and was to be repaid as soon as feasible from theprospective profits of the business, the partnership is for the term reasonablyrequired to pay the loan.(1) It is true that these cases hold that partners may impliedly agree to

continue in business until a certain sum of money is earned, or one or

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more partners recoup their investments, or until certain debts are paid,or until certain property could be disposed of on favorable terms. (a) In each of these cases, however, the implied agreement found

support in the evidence.(b) In the instant case, however, defendants failed to prove any

facts from which an agreement to continue the partnership for aterm may be implied.

c. Power to Dissolve Must Be Exercised in Good Faith. Even though the UniformPartnership Act provides that a partnership at will may be dissolved by the expresswill of any partner, this power, like any other power held by a fiduciary, must beexercised in good faith.(1) A partner at will is not bound to remain in a partnership, regardless of

whether the business is profitable or unprofitable. A partner may not,however, by use of adverse pressure “freeze out” a co-partner andappropriate the business to his own use. A partner may not dissolve apartnership to gain the benefits of the business for himself, unless he fullycompensates his co-partner for his share of the prospective businessopportunity.

B. The Consequences of Dissolution1. Prentiss v. Sheffel (Ariz. 1973).

a. Facts. Plaintiffs owned a 42 ½ % interest each in the partnership (a shopping,while the defendant owned a 15 % interest. The plaintiffs alleged that thedefendant derelict in his duties, in particular that he had failed to contribute hisshare of the losses. The plaintiffs sought to dissolve the partnership. The trialcourt held that a partnership-at-will existed and that it was terminated when theplaintiff froze-out the defendant. The court ordered a sale and the plaintiffs werethe high bidders.

b. Issue. Whether two majority partners in a three-man partnership-at-will, whohave excluded the third partner from partnership management and affairs, shouldbe allowed to purchase the partnership assets at a judicially supervised dissolutionsale.

c. Wrongful Purpose Necessary. While the trial court did find that the defendant wasexcluded from the management of the partnership, there was no indication thatsuch exclusion was done for the wrongful purpose of obtaining the partnership assets inbad faith rather than merely being the result of the inability of the partners toharmoniously function in a partnership relation.

d. Not Injured by Partners’ Participation in Sale. Moreover, the defendant has failed todemonstrate how he was injured by the participation of the plaintiffs in thejudicial sale.(1) Because of the plaintiffs’ bidding in the judicial sale, it appears that the

defendant’s 15% interest in the partnership was considerably enhanced bythe plaintiff’s participation.

e. The defendant has cited no cases, nor has this court found any, which haveprohibited a partner from bidding at a judicial sale of the partnership assets.(1) Not an Attack on the Order to Sell. It should be emphasized that on this

appeal the defendant does not attack the fact that the trial court ordereda sale of the assets. The only area of attack is that plaintiffs have beenallowed to participate and bid in that sale.

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2. Uniform Partnership Act § 38. Rights of Partners to Application of PartnershipProperty.19

(1) When dissolution is caused in any way, except in contravention of the partnership agreement,each partner, as against his co-partners and all persons claiming through them in respect of theirinterests in the partnership, unless otherwise agreed, may have the partnership property applied todischarge its liabilities, and the surplus applied to pay in cash the net amount owing to the respectivepartners. But if dissolution is caused by expulsion of a partner, bona fide under the partnershipagreement and if the expelled partner is discharged from all partnership liabilities, either by paymentor agreement under section 36(2), he shall receive in cash only the net amount due him from thepartnership.(2) When dissolution is caused in contravention of the partnership agreement the rights of the partnersshall be as follows:

(a) Each partner who has not caused dissolution wrongfully shall have,I. All the rights specified in paragraph (1) of this section, andII. The right, as against each partner who has caused the dissolution wrongfully,to damages for breach of the agreement.

(b) The partners who have not caused the dissolution wrongfully, if they all desire tocontinue the business in the same name, either by themselves or jointly with others, may doso, during the agreed term for the partnership and for that purpose may possess thepartnership property, provided they secure the payment by bond approved by the court, orpay to any partner who has caused the dissolution wrongfully, the value of his interest inthe partnership at the dissolution, less any damages recoverable under clause (2a II) of thissection, and in like manner indemnify him against all present or future partnershipliabilities.(c) A partner who has caused the dissolution wrongfully shall have:

I. If the business is not continued under the provisions of paragraph (2b) all therights of a partner under paragraph (1), subject to clause (2a II), of this section,II. If the business is continued under paragraph (2b) of this section the right asagainst his co-partners and all claiming through them in respect of their interestsin the partnership, to have the value of his interest in the partnership, less anydamages caused to his co-partners by the dissolution, ascertained and paid to himin cash, or the payment secured by bond approved by the court, and to be releasedfrom all existing liabilities of the partnership; but in ascertaining the value of thepartner's interest the value of the good-will of the business shall not be considered.

3. Pav-Saver Corporation v. Vasso Corporation (Ill. 1986).a. Facts. PSC owned the trademark and patents for concrete paving machines.

Dale, the inventor of a machine and majority shareholder of PSC and Meersman,owner and shareholder of Vasso, formed Pav-Saver Manufacturing. Dalecontributed services, PSC contributed the patents and trademarks, and Meersmanobtained financing. The partnership agreement contained language granting Pav-Saver the exclusive right to use PSC’s trademarks and patents. The agreementalso stated that if either party terminated, the terminating party would payliquidated damages. In 1976, the agreement was replaced with an identical one,but eliminating the individual partners. PSC terminated the partnership in 1983. The trial court ruled that Vasso was entitled to continue the business and possessthe partnership assets, including the trademark and patents.

b. Uniform Partnership Act § 38 provides:(2) When dissolution is caused in contravention of the partnership agreement therights of the partners shall be as follows:

(a) Each partner who has not cause dissolution wrongfully shall have,

RUPA is essentially the same as UPA. However, a wrongfully dissociate partner is entitled to have19

goodwill included in the calculation.

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***II. The right, as against each partner who has cause dissolutionwrongfully, to damages for breach of the agreement.(b) The partners who have not cause the dissolution wrongfully, I theyall desire to continue the business in the same name, either themselves orjointly with others, may do so, during the agreed term for thepartnership and for that purpose may possess the partnership property,provided they secure the payment by bond approved by the court, orpay to any partner who has caused the dissolution wrongfully, the valueof his interest in the partnership at dissolution, less any damagesrecoverable under clause (2a II) of this section, and in like mannerindemnify him against all present or future partnership liabilities.(c) A partner who has caused the dissolution wrongfully shall have:

*** (II) If the business is continue under paragraph (2b) of this section theright as against his co-partners and all claiming through them in respectof their interest in the partnership, to have the value of his interest in thepartnership, less any damages caused to his co-partners by thedissolution, ascertained and paid to him in cash, or the payment securedby bond approved by the court and to be released from all existingliabilities of the partnership; but in ascertaining the value of the partner’sinterest the value of the good will of the business shall not beconsidered.

c. Despite the parties’ contractual direction that PSC’s patents would be returned toit upon the mutually approved expiration of the partnership, the right to possessthe partnership property and continue in business upon a wrongful terminationmust be derived from and is controlled by the statute.

d. Dissent/Concurrence(1) The partnership agreement is a contract, and event though a partner may

have the power to dissolve, he does no necessarily have the right to doso. Therefore, if the dissolution he causes is a violation of theagreement, he is liable for any damages sustained by the innocentpartners as a result.(a) The innocent partner also has the option to continue the

business in the firm name provided they pay the partner causethe dissolution the value of the interest of his partnership.

(2) While the rights and duties of the partners in relation to the partnershipare governed by the Uniform Partnership Act, the uniform act alsoprovides that such rules are subject to any agreement between the parties(a) The partnership agreement entered into by PSC and Vasso in

pertinent part provides:i) “the property [patents, etc.] shall be returned to PSC at the

expiration of this partnership.”ii) The majority holds this provision is unenforceable

because its enforcement would affect defendant’soption to continue the business. No authority is citedfor such a rule.

(3) I think it clear the parties agreed the partnership only be allowed the useof the patents during the term of the agreement. The agreement havingbeen terminated, the right to use the patents is terminated.

C. The Sharing of Losses*D. Buyout Agreements

1. A buy-out, or buy-sell, agreement is an agreement that allows a partner to end her or hisrelationship with other partners and receive a cash payment, or series of payment, or some

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assets of the firm, in return for her or his interest in the firm.2. Issues

a. Trigger Events: (1) Death; (2) Disability; (3) Will of any partnerb. Obligation to Buy v. Option: (1) Firm; (2) Other Investors; (3) Consequences of

Refusal to Buy [If there is an obligation]/[If there is no obligation].c. Price: (1) Book value; (2) Appraisal; (3) Formula (e.g., five times earnings); (4) Set

price each year; (5) Relation to duration (e.g., lower price in first five years)d. Method of Payment: (1) Cash; (2) Installments (with interest?)e. Protection Against Debts of Partnershipf. Procedure for Offering Either to Buy or Sell: (1) First mover sets price to buy or sell;

(2) First mover forces others to set price3. G & S Investments v. Belman (Ariz. 1984).

a. Facts. Century Park was a limited partnership formed to receive ownership of anapartment complex. Nordale had a 25.5% interest. Nordale became a cokeheadand a hermit. He had coke rage all the time and threatened the other partners. He totally hit on jailbait and refused to pay rent on the apartment the partnershiplet him use after his divorce. Nordale starting make irrational demands. Theother partners finally sought a dissolution of the partnership which would allowthem to carry on the business and buy out Nordale’s interest. Nordale died afterthe filing of the complaint. The complaint was amended to invoke their right tocontinue the partnership and acquire Nordale’s interest under article 19 of thepartnership’s Articles of Limited Partnership.

b. Uniform Partnership Act § 32 authorizes the court to dissolve a partnershipwhen:

***(2) A partner becomes in any other way incapable of performing his part of thepartnership contract.(3) A partner has been guilty of such conduct as tends to affect prejudicially thecarrying on of the business.(4) A partner willfully or persistently commits a breach of the partnershipagreement, or otherwise so conducts himself in matters relating to the partnershipbusiness that it is not reasonably practicable to carry on the business in partnershipwith him.

c. Mere Filing of Complaint Does Not Dissolve. In Cooper v. Isaacs, the court was metwith the same contention made here, to-wit, that the mere filing of the complaintacted as a dissolution. The court rejected this contention. Dissolution wouldoccur only when decreed by the court or when brought about by other acts.

d. Gibson and Smith testified that the parties actually intended and understood“capital account” to mean exactly what it literally says, the account which showsa partner’s capital contribution to the partnership plus profit minus losses.(1) The capital amount is also reduced by the amount of any distributions.(2) The words “capital account” are not ambiguous and clearly mean the

partner’s capital account as it appears on the books of the partnership. e. Partnership buy-out agreements are valid and binding although the purchase price

agreed upon is less or more than the actual value of the interest at the time ofdeath.(1) Modern business practice mandates that the parties be bound by the

contract they enter into, absent fraud or duress. It is not the province ofthis court to act as a post-transaction guardian of either party.

E. Partnership Capital Accounts20

1. Capital Account. As part of the settling-up process, partners are paid the amounts owed “in

See Partnership Capital Accounts Handout.20

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respect of capital.” The bookkeeping devices that track the amount the partnership oweseach partner “in respect of capital” are called capital accounts.

2. Contribution/Distribution. Property contributed to the partnership increases thecontributing partner’s capital account by an amount equal to the fair market value of theasset as of the time of contribution, as do profits allocated to partners from ongoingactivities. Distributions made to partners decreased their respective capital account, as dolosses allocated to partners from ongoing activities.

3. Appreciation/Depreciation. Post-contribution appreciation of depreciation of a contributedasset does not affect the contributing partner’s capital account. The contribution severs thecontributor’s direct connection to the asset; subsequent vicissitudes in the asset’s value are“for the partnership’s account.”

VII. Limited PartnershipA. Holzman v. De Escamilla.(Cal. App. 1948).

1. Facts. Russell and Andrews were limited partners in Hacienda Farms with Escamilla, thegeneral partner. Holzman, the trustee in bankruptcy, brought an action to determine thatRussell and Andrews were liable as general partners to the creditors of the partnership. The evidence showed that Escamilla consulted Russell and Andrews as to which crops togrow and was even overruled as to some of those decisions. In addition, Andrews andRussell asked Escamilla to resign as manager and appointed his replacement. Furthermore,checks drawn on Hacienda’s accounts had to be signed by two of the three partners,therefore, Escamilla had no power to withdraw funds without the signature of at least oneof the other partners.

2. Section 2483 of the Civil Code provides as follows: “A limited partner shall not becomeliable as a general partner, unless, in addition to the exercise of his rights and powers as alimited partner, he takes part in the control of the business.”

3. The foregoing illustrations sufficiently show that Russell and Andrews both took “part inthe control of the business.” a. The manner of withdrawing money from the bank accounts is particularly

illuminating. The two men had absolute power to withdraw all the partnershipfunds in the banks without the knowledge or consent of the general partner.

b. They required him to resign as manager and selected his successor. They wereactive in dictating the crops to be planted, some of them against the wish of thegeneral partner.

B. Revised Uniform Limited Partnership Act § 303(a) now provides that:1. “a limited partner is not liable for the obligations of a limited partnership unless the limited

partner is also a general partner or, in addition to the exercise of his rights and powers as alimited partner, he takes part in the control of the business. However, if the limitedpartner takes part in the control of the business and is not also a general partner, the limitedpartner is liable only to person who transact business with the limited partnership and whoreasonably believe, based upon the limited partner’s conduct, that the limited partner is ageneral partner.

C. Revised Uniform Limited Partnership Act § 303(b) also provides that a limited partner does notparticipate in control “solely by . . . (2) consulting with and advising a general partner with respectto the business of the limited partnership.”

CHAPTER THREE: THE NATURE OF THE CORPORATION

I. Promoters and the Corporate EntityA. Promoter. A “promoter” is a term of art referring to a person who identifies a business opportunity

and puts together a deal, forming a corporation as the vehicle for investment by other people.1. Preincorporation. Promoters may enter into contracts on behalf of the venture being

promoted either before or after articles of incorporation have been filed.a. Corporation Bound? A corporation is not bound by a contract made on its behalf

before it was incorporated unless the corporation agrees to be bound. The

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corporation must “adopt” the contract.21

(1) Express or Implied. It may do so expressly, e.g., where its board ofdirectors passes a resolution expressly adopting the contract. Or it maydo so impliedly, by knowingly accepting the benefits of the contract.

(2) Quasi-Contract/Unjust Enrichment. The other party to the contract maybe able to assert quasi-contract or estoppel claims against thecorporation.

2. Promoter’s Liability. Whether a promoter is personally liable on the contract he makes forthe corporation that has not been formed depends on the parties’ (the third party andpromoter’s) intent.a. Corporation Never Comes Into Existence:

(1) Presumption Promoter Liable. The presumption is that the parties intendthe promoter to be personally liable, so that if the corporation is neverformed, the third party can hold the promoter liable for breach of thecontract.(a) Different Intent. The parties may intend that the promoter is

not liable on the contract, but instead the corporation will bebound to the contract after it is formed and adopts the contract. But this is unlikely, because it would mean that there reallywasn’t a contract at all.

(2) Breach of a Separate Promise. The promoter may have expressly orimpliedly promised the third party that she (the promoter) would useher best efforts to cause the corporation to be formed and to adopt thecontract. If the corporation is never formed and the third party canprove that this was because the promoter failed to use her best efforts,the third party can hold the promoter liable.

b. Promoter’s Liability After the Corporation is Formed:(1) Novation. The presumption that the parties intend the promoter to be

liable on the pre-incorporation contract continues even after thecorporation is formed and even if the corporation adopts the contract. However, the parties may have a different intent: they may intend thatonce the corporation is formed and adopts the contract, the promoterwill be released from liability. This is called a novation: the creditoragrees to accept a new debtor in place of the old.(a) Still Must Prove Intent. The intent to enter into a novation must

be proved. If it is not, the presumption of the promoter’sliability will stand.

c. Defective Incorporation:(1) If the corporation has not been properly formed, logically then, the

business must be operating as a sole proprietorship or a generalpartnership–neither of which afford its owners (shareholders) limitedliability. This would give the third party–who made the contract in thebelief that he was dealing with a corporation, not an individual–anundeserved windfall.

(2) The common law came up with two theories to deal with cases like this:(a) De Facto Corporation. Where there has been a defect in the

incorporation process that prevents the business from beingtreated as a de jure corporation, but (1) thepromoter/shareholder made a good faith effort to incorporatethe business, and (2) carried on the business as though it were a

Some courts describe this action as “ratification,” but technically a corporation cannot ratify acts that21

occurred before its existence.

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corporation, some courts treat the firm as a de facto corporation.i) The State can contest the corporate existence of a de

facto corporation but no one else can.(b) Corporation By Estoppel. Someone who deals with the firm as

though it were a corporation is estopped to deny thecorporation’s existence even though there has been nocolorable attempt to incorporate.

d. Statutory Efforts(1) MBCA § 2.04. Liability for Preincorporation Transactions.

All persons purporting to act as or on behalf of a corporation, knowing there wasnot incorporation under this Act, are jointly and severally liable for all liabilitiescreated while so acting.

(2) On its face, this statute creates promoter liability in all cases in which thepromoter knew, at the time she made the contract, that the corporationwas not in existence. The promoter would not be liable if shemistakenly believed the corporation was in existence at the time shemade the contract.

(3) The promoter is protected in defective incorporation cases, even if therewas no good-faith attempt to form the business (e.g., an attorney washired to incorporate the business and never attempted to do so).

(4) Comments to the MBCA indicate that the principles of estoppel canchange the result that the statute would otherwise indicate (e.g., wherethe third party urged that the contract be made in the name of thenonexistent corporation, the third party may be estopped to imposepersonal liability on the shareholder/promoter, even though theshareholder/promoter knew that the corporation did not yet exist at thetime of contracting).

3. Fiduciary Duties. Promoters of a venture own fiduciary duties to each other and to thecorporation. The duty is essentially the same as the duties owed by a partner to apartnership or partners. A duty of full disclosure is owed to subsequent investors.a. To Corporation. After the corporation is formed it may obtain from the promoter

any benefits or rights the promoter obtained on its behalf.b. To Fellow Promoters. Promoters are essentially partners in the promotion of the

venture, and any benefits or rights one promoter obtains must be shared with co-promoters.

c. To Subsequent Investors. (Based on Old Dominion Copper Mining & Smelting Co. v.Bigelow (Mass. 1909) & Old Dominion Copper Mining & Smelting Co. v. Lewisohn(U.S. 1908)).(1) Under the Massachusetts rule, a corporation may attack an earlier

transaction if the subsequent sale to public investors was contemplated atthe time of the earlier transaction.(a) More widely followed(b) Arguably, the real issue in these cases is whether there was full

disclosure of the transaction at the time the public investorsdecided to make their investments.

(2) Under the federal rule, the corporation may not attack an earliertransaction because all the stockholders at the time consented to thetransaction.

d. To Creditors. Fiduciary concepts may also protect creditors against unfair orfraudulent transactions by promoters. Most of theses transactions also may beattacked on the ground they constitute fraud on creditors.

B. Southern-Gulf Marine Co. No. 9, Inc. v. Camcraft, Inc.1. We believe the defendant, having given its promise to construct the vessel, should not be

permitted to escape performance by raising an issue as to the character of the organization

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to which it is obligated, unless its substantial rights might thereby be affected.a. Estoppel. It is settled, by an overwhelming array of indisputable precedents that,

as a rule, one who contracts with what he acknowledges to be and treats as acorporation, incurring obligations in its favor, is estopped from denying itscorporate existence, particularly when the obligations are sought to be enforced.22

II. The Corporate Entity and Limited LiabilityA. Piercing the Corporate Veil

1. Closely Held Corporations. Piercing is exclusively a doctrine applicable to closely heldcorporations. But piercing may be applied to subsidiary corporations owned by a publiclyheld parent corporation. But in these cases, the separate existence of the subsidiary and notthe parent is ignored.23

2. Legal Tests :24

a. Alter Ego and Instrumentality(1) Requires (a) such unity of ownership and interest between corporation

and stockholder that the corporation has ceased to have separateexistence, and (b) recognition of the separate existence of thecorporation sanctions fraud or leads to an inequitable result.

b. Others: (1) Misrepresentation and Fraud; (2) Personal Guaranty; (3)Undercapitalization; (4) Operation on the Edge of Insolvency; (5) Comminglingand Confusion; (6) Artificial Division of Business Entity; (7) Mere Continuation;and (8) Failure to Follow Corporate Formalities

B. Why Allow Incorporation to Escape Personal Liability1. Less money available to invest if limited liability was not available2. Maximizes the amount to be invested. Encourages investment. (Portfolio Theory).3. Management can take more risk in operating the business.4. Costs:

a. Creditors can incur a cost. b. Externalities.

C. Bartle v. Home Owners Cooperative, Inc. (N.Y. 1955).1. Facts. Defendant (Home Owners) was a co-operative corporation composed of veterans

for the purpose of providing low-cost housing to its members. Defendant was unable tosecure a contractor for construction so it organized Westerlea for that purpose. Westerleafound itself in financial difficulties and four years later went bankrupt. The plaintiff

In Casey v. Galli, 94 U.S. 673 (1877), the rule was stated as follows:22

“Where a party has contracted with a corporation, and is sued upon the contract, neither ispermitted to deny the existence, or the legal validity of such corporation. To holdotherwise would be contrary to the plainest principles of reason and good faith, andinvolve a mockery of justice.”

No reported case of piercing has ever involved the shareholders of a public traded corporation.23

Courts have articulated different tests for piercing the corporate veil, such as the “instrumentality”24

doctrine of the “alter ego” test. These test focus on the use of control or ownership to “commit a fraud or perpetuatea dishonest act” or to “defeat justice and equity.” But these tests provide little guidance, and results in particular casesdo not seem to turn on which test a court employs.

Rather, particular piercing factors seem more relevant even though no one fact emerges as determinative. It is generally believed that courts are more likely to pierce in the following situations: (1) the business is a closely heldcorporation; (2) the plaintiff is an involuntary (tort) creditor; (3) the defendant is a corporate shareholder (as opposedto an individual); (4) insiders failed to follow corporate formalities; (5) insiders commingled business assets/affairs withindividual assets/affair; (6) insiders did not adequately capitalize the business; (7) the defendant actively participated inthe business; and (8) insiders deceived creditors.

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contended that the corporate veil should be pierced.2. The law permits the incorporation of a business for the very purpose of escaping personal

liability.3. Generally speaking, the doctrine of “piercing the corporate veil” is invoked to prevent

fraud or to achieve equity.a. In the instant case there has been neither fraud, misrepresentation, nor illegality.

Defendant’s purpose in placing its construction operation into a separatecorporation was clearly within the limits of our public policy.

4. Dissent. Not only was Westerlea allowed no opportunity to make money, but it wasplaced in a position such that if its business were successful and times remained good, itwould break even, otherwise it would inevitably become insolvent.

D. Walkovszky v. Carlton (N.Y. 1966).1. Facts. Plaintiff was injured when he was run down by a taxi owned by Seon Cab

Corporation. Carlton, the individual defendant, was claimed to be a stockholder of 10corporations, including Seon, each of which had two taxis registered in its name and theminimum insurance required by law on each taxi. The corporations were alleged to beoperated as a single entity, unit and enterprise.

2. The law permits the incorporation of a business for the very purpose of enabling itsproprietors to escape personal liability but, manifestly the privilege is not without its limits.a. Piercing the Corporate Veil. Broadly speaking, the courts will disregard the

corporate form, or, to use accepted terminology, “pierce the corporate veil”,whenever necessary to prevent fraud or to achieve equity.(1) In determining whether liability should be extended to reach assets

beyond those belonging to the corporation, we are guided, as JudgeCardozo noted, by general rules of agency. In other words, wheneveranyone uses control of the corporation to further his own rather than thecorporation’s business, his will be liable for the corporation’s act uponthe principle of respondeat superior applicable even where the agent is anatural person.(a) It is one thing to assert that a corporation is a fragment of a

larger corporate combine which actually conducts the business. It is quite another to claim that the corporation is a “dummy”for its individual stockholders who are in reality carrying on thebusiness in their personal capacities for purely personal ratherthan corporate ends.i) Either circumstance would justify treating the

corporation as an agent and piercing the corporate veilto reach the principal but a different result wouldfollow in each case.a) In the first, only a larger corporate entity

would be held financially responsible while,in the other the stockholder would bepersonally liable. Either the stockholder isconducting the business in his individualcapacity or he is not. If he is, he will beliable; if he is not, then it does notmatter–insofar as his personal liability isconcerned–that the enterprise is actuallybeing carried on by a larger “enterpriseentity.”

b. The individual defendant is charged with having “organized, managed,dominated and controlled” a fragmented corporate entity but there are noallegations that he was conducting business in his individual capacity.(1) Had the taxicab fleet been owned by a single corporation, it would be

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readily apparent that plaintiff would face formidable barriers inattempting to establish personal liability on the part of the corporation’sstockholders. The fact that the fleet ownership has been deliberatelysplit up among many corporations does not ease the plaintiff’s burden inthat respect.

(2) The corporate form may not be disregarded merely because the assets ofthe corporation, together with the mandatory insurance coverage of thevehicle which struck the plaintiff, are insufficient to assure him therecovery sought.

(3) In point of fact, the principle relied upon in the complaint to sustain theimposition of personal liability is not agency but fraud. Such a cause ofaction cannot withstand analysis. If it is not fraudulent for the owner-operator of a single cab operation to take out only the minimumrequired liability insurance , the enterprise does not become either illicitor fraudulent merely because it consists of many such corporations.(a) Plaintiff Erroneously Relied on Fraud Allegation Instead of Agency.

Whatever right he may be able to assert against the partiesother than the registered owner of the vehicle come into beingnot because he has been defrauded but because, under theprinciple of respondeat superior, he is entitled to hold the whoenterprise responsible for the acts of its agents.

c. Dissent. The issue presented by this action is whether the policy of this State,which affords those desiring to engage in a business enterprise the privilege oflimited liability through the use of the corporate device, is so strong that it willpermit that privilege to continue no matter how much it is abused, no matterhow irresponsibly the corporation is operated, no matter what the cost to thepublic. I do not believe that it is.(1) The Legislature [in enacting the minimum liability law] certainly could

not have intended to shield those individuals who organizedcorporations, with the specific intent of avoiding responsibility to thepublic, where the operation of the corporate enterprise yielded profitssufficient to purchase additional insurance.

(2) What I would merely hold is that a shareholder of a corporation vestedwith a public interest, organized with capital insufficient to meetliabilities which are certain to arise in the ordinary course of thecorporation’s business, may be held personally responsible for suchliabilities.

E. There are three legal doctrine that the plaintiff might invoke in a case like Walkovszky: (a) enterpriseliability; (b) respondeat superior (agency); and (c) disregard of the corporate entity (“piercing thecorporate veil”).

F. Sea-Land Services, Inc. v. Pepper Source (7th Cir. 1991).1. Facts. Sea-Land shipped peppers on behalf of The Pepper Source. PS then skipped out on

the freight bill which was substantial. The district court entered a default judgment againstPS for $86,767.70. PS, however, had dissolved in mid 1987 for failure to pay its annualstate franchise tax. In addition, PS had no assets. Therefore, Sea-Land brought an actionagainst Marchese and five business entities he owned: PS, Caribe Crown, Jamar Corp., andSalescaster Distributors. Sea-Land sought to pierce the corporate veil and hold Marchesepersonally liable and then reverse pierce and hold Marchese’s other corporations liable. These corporations, Sea-Land alleged, were alter egos of each other and of Marchese andused to defraud creditors. Sea-Land amended its complaint to add Tie-Net, of whichMarchese owned only half the stock along with Andre. The district court granted Sea-Land’s motion for summary judgment.

2. A corporate entity will be disregarded and the veil of limited liability pierced when tworequirements are met: First, there must be such unity of interest and ownership that the

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separate personalities of the corporation and the individual [or other corporation] nolonger exist; and second, circumstances must be such that adherence to the fiction ofseparate corporate existence would sanction a fraud or promote justice.a. As for determining whether a corporation is so controlled by another to justify

disregarding their separate identities, the Illinois cases focus on four factors:(1) The failure to maintain adequate corporate records or to comply with

corporate formalities;(2) The commingling of funds or assets;(3) Undercapitalization; and(4) One corporation treating the assets of another corporation as its own.

3. Marchese’s Playthings. These corporate defendants are, indeed, little but Marchese’splaythings. Marchese is the sole shareholder of PS, Caribe Crown, Jamar and Salescaster. He is one of two shareholders of Tie-Net. Except for Tie-Net, none of the corporationsever held a single corporate meeting. During his deposition, Marchese did not rememberany of these corporations ever passing articles of incorporation, bylaws, or otheragreements. Marchese runs all of the corporations out of the same, single office, with thesame phone line, the same expense accounts, and the like. Marchese “borrows” moneyfrom these corporations, and they borrow money from each other. Marchese used thebank accounts of the corporations to pay multiple personal expenses.

4. First Prong. In sum, we agree with the district court that there can be no doubt that the“shared control/unity of interest and ownership” part of the test is met in this case:a. Corporate records and formalities have not been maintained; funds and assets

have been commingled with abandon; PS, the offending corporation, and perhapsothers have been undercapitalized; and corporate assets have been moved andtapped and “borrowed” without regard to their source.

5. Second Prong. “Unity of interest and ownership” is not enough; Sea-Land must also showthat honoring the separate corporate existences of the defendants “would sanction a fraudor promote injustice.”a. Although an intent to defraud creditors would surely play a part if established, the

Illinois test does not require proof of such intent. Once the first element of thetest is established, either the sanctioning of a fraud (intentional wrongdoing) or thepromotion of injustice, will satisfy the second element.(1) Promoting Injustice. The prospect of an unsatisfied judgment looms in

every veil-piercing action; why else would a plaintiff bring such anaction? Thus, if an unsatisfied judgment is enough for the “promoteinjustice” feature of the test, then every plaintiff will pass on that score,and the test collapses into a one-step “unity of interest and ownership”test.(a) In Pederson v. Paragon, the court offered the following

summary: “Some element of unfairness, something akin tofraud or deception or the existence of a compelling publicinterest must be present in order to disregard the corporatefiction.”

(b) Generalizing from other Illinois cases, we see that courts thathave properly pierced corporate veils to avoid “promotinginjustice” have found that, unless it did so, some “wrong”beyond a creditor’s liability to collect would result: thecommon sense rules of adverse possession would beundermined; former partners would be permitted to skirt thelegal rules concerning monetary obligation; a party would beunjustly enriched; a parent corporation that caused a sub’sliabilities and its inability to pay for them would escape thoseliabilities; or an intentional scheme to squirrel assets into aliability-free corporation while heaping liabilities upon an asset-

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free corporation would be successful.G. Roman Catholic Archbishop of San Francisco v. Sheffield (Cal. App. 1971).

1. Facts. Sheffield entered into an agreement to buy a St. Bernard dog from Fr. Cretton ofthe Canons Regular of St. Augustine in Switzerland. The price was $175 to be paid in$20 installments with the dog being shipped upon payment of the first installment. Inaddition, Sheffield agreed to pay the $125 freight charge for the dog to be shipped fromGeneva to Los Angeles. Sheffield paid a total of $60 but did not receive the dog. Themonastery told Sheffield that the dog would not be shipped until Sheffield paid the entireamount plus additional “fees.” Sheffield was also told that his $60 would not be refundedbecause of the costs of keeping his account on the books. Sheffield filed suit against theArchbishop of S.F., the Pope, the Vatican, the Canons, and Fr. Cretton under an “alterego” theory.

2. Alter Ego/Piercing the Veil. The terminology “alter ego” or “piercing the corporate veil”refers to situations where there has been an abuse of corporate privilege, because of whichthe equitable owner of a corporation will be held liable for the actions of the corporation. The requirements for applying the “alter ego” principle are thus stated:a. Requirements for Alter Ego Claim. It must be made to appear that the corporation

is not only influenced and governed by that person [or other entity], but that there issuch a unity of interest and ownership that the individuality, or separateness, of suchperson and corporation has ceased, and the facts are such that an adherence to thefiction of the separate existence of the corporation would, under the particularcircumstances, sanction a fraud or promote injustice.(1) Factors to Consider. Among the factors to be considered in applying the

doctrine are the commingling of funds and other assets of the twoentities, the holding out by one entity that it is liable for the debts of theother, identical equitable ownership in the two entities, use of the sameoffices and employees, and use of one as a mere shell or conduit for thesame affairs of the other.

3. Alter Ego Does Not Make Subsidiaries Liable to Other Subsidiaries. The “alter ego” theorymakes a “parent” liable for the actions of a “subsidiary” which it controls, but it does notmean that where a “parent” controls several subsidiaries each subsidiary then becomesliable for the actions of all other subsidiaries. There is no respondeat superior between thesubagents.

4. Unsatisfied Creditor Not Enough to Lead to Inequitable Result (2 Prong). In almost everynd

instance where a plaintiff has attempted to invoke the doctrine he is an unsatisfied creditor. The purpose of the doctrine is not to protect every unsatisfied creditor, but rather to affordhim protection, where some conduct amounting to bad faith makes it inequitable... for theequitable owner of a corporation to hide behind its corporate veil.

H. Parent Corporation/Subsidiary Corporation v. Single Corporation with Divisions1. Generally, the parent, like any other shareholder, is not liable for the debts of the

subsidiary, so the parent can undertake an activity without putting at risk its own assets,beyond those it decides to commit to the subsidiary. Like an individual shareholder,however, a corporate shareholder must be aware of the danger that if not careful, thecreditors of the subsidiary may be able to pierce the corporate veil of the subsidiary. Theparent must also be careful not to become directly liable by virtue of its participation in theactivities of the subsidiary.

I. In re Silicone Gel Breast Implants Products Liability Litigation (N.D. Ala. 1995).1. Facts. MEC became, in 1982, a Delaware corporation, wholly owned by Bristol. In 1988

Bristol bought two other breast-implant manufacturers, Natural Y and Aesthetech. Thepurchase price was paid from a Bristol account though charged to MEC. MEC had aboard of directors, consisting of Bristol’s Health Care Group President. He could not beoutvoted by the other two MEC board members. Former MEC presidents could notrecall MEC having a board. MEC board resolutions were prepared by Bristol officials.Bristol was involved in much of MEC’s operations including: budgeting, employment

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policies and wages, executive hiring, scientific research, testing, legal counsel, publicrelations, marketing (with Bristol’s name and logo), and consolidated federal tax returns.

2. Corporate Controla. The evaluation of corporate control claims cannot, however, disregard the fact

that, no different from other stockholders, a parent corporation isexpected–indeed required–to exert some control over its subsidiary. Limitedliability is the rule, not the exception. (1) However, when a corporation is so controlled as to be the alter ego or

mere instrumentality of its stockholder, the corporate form may bedisregarded in the interests of justice.

(2) Veil-Piercing on Summary Judgment. Ordinarily, the fact-intensive natureof the issue will require that it be resolved only through a trial. Summary judgment, however, can be proper if the evidence presentedcould lead to but one result.

(3) The totality of the circumstances must be evaluated in determiningwhether a subsidiary may be found to be the alter ego or mereinstrumentality of the parent corporation. Although the standards arenot identical in each states, all jurisdictions require a showing ofsubstantial domination.25

(4) Fraud or Like Misconduct (Injustice Requirement). Delaware courts do notnecessarily require a showing of fraud if a subsidiary is found to be themere instrumentality or alter ago of its stockholder. (a) No Showing Required in Tort Cases. In addition, many

jurisdictions that require a showing of fraud, injustice, orinequity in a contract case do not in a tort situation.i) A rational distinction can be drawn between tort and

contract cases. In actions based on contract, thecreditor has willingly transacted business with thesubsidiary although it could have insisted onassurances that would make the parent alsoresponsible. In a tort situation, however, the injuredparty had no such choice; the limitations on corporateliability were, from its standpoint, fortuitous and non-consensual.

b. Direct Liability Claims(1) Restatement (Second) of Torts § 324A: One who undertakes,

gratuitously or for consideration, to render services to another which heshould recognize as necessary for the protection of a third person or histhings, is subject to liability to the third person for physical harmresulting from his failure to exercise reasonable care to perform hisundertakings, if

Among the factors to be considered are whether: (a) the parent and the subsidiary have common directors25

or officers; (b) the parent and the subsidiary have common business departments; (c) the parent and the subsidiary fileconsolidate financial statements and tax returns; (d) the parent finances the subsidiary; (e) the parent caused theincorporation of the subsidiary; (f) the subsidiary operates with grossly inadequate capital*; (g) the parent pays thesalaries and other expenses of the subsidiary*; (h) the subsidiary receives no business except that given to it by theparent; (i) the parent uses the subsidiary’s property as its own*; (j) the daily operation of the two corporations are notkept separate; (k) the subsidiary does no observe the basic corporate formalities, such as keeping separate books andrecords and holding shareholder and board meetings*.

* Indicates those factors which Fendler considers relevant. The court does not explain why the otherfactors are relevant to its determination. Most of the remaining factors are present in every parent/subsidiaryrelationship.

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(a) his failure to exercise reasonable care increases the risk ofharm, or(b) he has undertaken to perform a duty owed by the other tothe third person, or(c) the harm is suffered because of a reliance of the other or thethird person upon the undertaking.

(a) Under this theory, frequently applied in connection with safetyinspectors by insurers or with third-party repairs to equipmentor premises, a duty that would not otherwise have existed canarise when an individual or company nevertheless undertakes toperform some action.

(b) Doctrinally, a cause of action under § 324A does not involvean assertion of derivative liability but one of direct liability,since it is based on the actions of the defendant itself. Theexistence of a parent-subsidiary relationship, while notrequired, is obviously no defense to such a claim.

J. Frigidaire Sales Corp. v. Union Properties, Inc. (Wash. 1977)1. Facts. Frigidaire entered into a contract with Commercial Investors. Mannon and Baxter

were limited partners of Commercial. They were also officers, directors, and shareholdersof Union Properties, Inc., the only general partner of Commercial. Mannon and Baxtercontrolled Union and through that control, they controlled Commercial. Commercialbreached the contract and Frigidaire brought suit against Mannon, Baxter, and Union.

2. Petitioner does not contend that respondent acted improperly by setting up the limitedpartnership with a corporation as the sole general partner. Limited partnerships are astatutory form of business organization, and parties creating a limited partnership mustfollow the statutory requirements.a. In Washington, parties may form a limited partnership with a corporation as the

sole general partner.3. The concern with minimal capitalization is not peculiar to limited partnerships with

corporate general partners, but may arise anytime a creditor deals with a corporation.a. Because out limited partnership statutes permit parties to form a limited

partnership with a corporation as the sole general partner, this concern aboutminimal capitalization, standing by itself, does not justify a finding that the limitedpartners incur general liability for their control of the corporate general partner.

b. If a corporate general partner is inadequately capitalized, the rights of a creditorare adequately protected under the “piercing the corporate veil” doctrine ofcorporation law.

4. Respondents scrupulously separated their actions on behalf of the corporation from theirpersonal actions, therefore, petitioner never mistakenly assumed that respondents weregeneral partners with general liability.

K. In re USACafes, L.P. Litigation, (Del. 1991).1. While I find no corporation law precedents directly addressing the question whether

directors of a corporate general partner owe fiduciary duties to the partnership and itslimited partners, the answer to it seems to be clearly indicated by general principles and byanalogy to trust law.a. While the parties cite no case treating the specific question whether directors of a

corporate general partner are fiduciaries for the limited partnership, a largenumber of trust cases do stand for a principle that would extend a fiduciary dutyto such persons in certain circumstances(1) The problem comes up in trust law because modernly corporations may

serve as trustees of express trusts.(a) “The directors and officers of [a corporate trustee] are certainly

under a duty to the beneficiaries not to convert to their ownuse property of the trust administered by the corporation...

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Furthermore, the directors and officers are under a duty to thebeneficiaries of trusts administered by the corporation not tocause the corporation to misappropriate the property... Thebreach of trust need not, however, be a misappropriation...Any officer who knowingly causes the corporation to commit abreach of trust causing loss...is personally liable to thebeneficiary of the trust...”

(b) The theory underlying fiduciary duties is consistent withrecognition that a director of a corporate general partner bearssuch a duty towards the limited partnership.i) That duty, of course, extends only to dealings with

the partnership’s property or affecting its business, but,so limited, its existence seems apparent on a numberof circumstances..

III. Shareholder Derivative ActionsA. Introduction

1. The derivative suit is a nineteenth-century equity jurisdiction’s ingenious solution thedilemma created by two inconsistent tenets of corporate law: (1) corporate fiduciaries owetheir duties to the corporation as a whole, not individual shareholders, and (2) the board ofdirectors manages the corporation’s business, which includes authorizing lawsuits in thecorporate name.

2. Derivative Suit v. Direct Claim. Unlike a derivative suit, a direct action is not brought onbehalf of the corporation. In a direct action, the loss is to the shareholder directly, while ina derivative suit, the loss to the shareholder is the result of a loss to the corporation.

3. Cohen v. Beneficial Industrial Loan Corp. (U.S. 1949). (Shareholder Derivative Suits’ Origin)a. Facts. Plaintiff, shareholder, brought suit against corporation and its directors for

waste amounting to over $100,000,000. New Jersey had enacted a statute whosegeneral effect was to make a plaintiff having so small an interest (The plaintiff heldan approximated 0.0125% of the outstanding stock) liable for the reasonableexpenses and attorney’s fees of the defense if he fails to make good his complaintand to entitle the corporation to indemnity before the case can be prosecuted.

b. Equity came to the relief of the stockholder, who had no standing to bring civilaction at law against faithless directors and managers. Equity, however, allowedhim to step into the corporation’s shoes and to seek in its right the restitution hecould not demand on his own.(1) It required him first to demand that the corporation vindicate its own

rights, but when, as was usual, those who perpetrated the wrongs werealso able to obstruct any remedy, equity would hear and adjudge thecorporation’s cause through its stockholder with the corporation as adefendant, albeit a rather nominal one.

c. Unfortunately, the remedy itself provided opportunity for abuse, which was notneglected. Suits sometimes were brought not to redress real wrongs, but torealize upon their nuisance.

d. A stockholder who brings suit on a cause of action derived from the corporationassumes a position, not technically as a trustee perhaps, but one of a fiduciarycharacter. He sues, not for himself alone, but as representative of a classcomprising all who are similarly situated. (1) The Federal Constitution does not oblige the state to place its litigating

and adjudicating processes at the disposal of such a representative, at leastwithout imposing standards of responsibility, liability and accountabilitywhich it considers will protect the interests he elects himself to represent. We conclude that the state has plenary power over this type of litigation.

e. Due Process. A state may set the terms on which it will permit litigations in itscourts. No type of litigation is more susceptible of regulation than that of a

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fiduciary nature. And it cannot seriously be said that a state make suchunreasonable use of its power as to violate the Constitution when it providesliability and security for payment of reasonable expenses if a litigation of thischaracter is adjudged unsustainable.

f. Equal Protection. We do not think the state is forbidden to use the amount ofone’s financial interest, which measure his individual injury from the misconductto be redressed, as some measure of the good faith and responsibility of one whoseeks at his own election to act as custodian of the interests of all stockholders,and as an indication that he volunteers for the large burdens of the litigation froma real sense of grievance and is not putting forward a claim to capitalize personallyon it harassment value.

g. Erie Doctrine: Substantive or Procedural? Even if we were to agree that the NewJersey statute is procedural, it would not determine that it is not applicable. (1) This statute is not merely a regulation of procedure. With it or without

it the main action takes the same course. However, it creates a newliability where none existed before, for it makes a stockholder whoinstitutes a derivative action liable for the expense to which he puts thecorporation and other defendants, if he does not make good his claims. Such liability is not usual and it goes beyond payment of what we knowas “costs.” We do not think a statute which so conditions the stockholder’sactions can be disregarded by the federal court as a mere procedural device.

4. Eisenberg v. Flying Tiger Line, Inc. (2d Cir. 1971)26

a. Cohen v. Beneficial Industrial Loan Corp. instructs that a federal court with diversityjurisdiction must apply a state statute providing security for costs if the state courtwould require the security in similar circumstances.

b. Derivative v. Individual. If the gravamen of the complaint is injury to thecorporation the suit is derivative, but “if the injury is one to the plaintiff as astockholder and to him individually and not to the corporation,” the suit isindividual in nature and may take the form of a representative class action. Fletcher, Private Corporation § 5911.

c. Gordon v. Elliman Test. The test formulated by the majority in that case was“whether the object of the lawsuit is to recover upon a chose in action belongingdirectly to the stockholders, or whether it is to compel the performance ofcorporate acts which good faith requires the directors to take in order to performa duty which they own to the corporation, and through it, to its stockholders.”(1) Flying Tiger argues that if the directors had a duty not to merge the

corporation, that duty was owed to the corporation and onlyderivatively to its stockholders.

(2) This test was condemned by commentators. It had the effect ofsweeping away the distinction between a representative and a derivativeaction–in effect classifying all stockholder class actions as derivative. Thecase has been limited to its facts by lower New York courts.

d. Lazare v. Knolls Cooperative Section No. 2, Inc. The court stated that security forcosts could not be required where a plaintiff “does not challenge acts of themanagement on behalf of the corporation. He challenges the right of the presentmanagement to exclude him and other stockholders from proper participation inthe affairs of the corporation. He claims that the defendants are interfering withthe plaintiff’s rights and privileges as stockholders.”

e. New York legislature, in its recodification of corporate statutes, added three

When a shareholder sues in his own capacity, as well as on behalf of other shareholders similarly situated,26

the suit is not a derivative action but a class action. In effect, all of the members of the class have banded togetherthrough a representative to bring their individual direct actions in one large direct action.

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words to the definition of derivative suits contained in § 626. Suits are nowderivative only if brought in the right of a corporation to procure a judgment “inits favor.”

f. In routine merger circumstances the stockholders retain a voice in the operationof the company, albeit a corporation other than their original choice. (1) Here, however, the reorganization deprived him and other minority

stockholders of any voice in the affairs of their previously existingoperating company.

(2) Is it thus clear that Gordon is factually distinguishable from the instantcase. Moreover, a close analysis of other New York cases, theamendment to § 626 and the other major treatises, lead us to concludethat Gordon has lost its viability as stating a broad principle of law.

5. Special Injury Test. In Delaware, many courts long used the so-called “special injury test todetermine whether a suit was direct or derivative. A special injury was defined as a wrongthat “is separate and distinct from that suffered by other shareholders, ... or a wronginvolving a contractual right of a shareholder, such as the right to vote, or to assertmajority control, which exists independently of any right of the corporation.” Moran v.Household Int’l, Inc. (Del. Ch. 1985).a. Rejection of Special Injury Test. The Delaware Supreme Court rejected the special

injury test in favor of a two-pronged standard : (1) who suffered the alleged27

harm, the corporation or the suing stockholders, individually; and (2) who wouldreceive the benefit of any recovery or other remedy, the corporation or thestockholders, individually.

6. Settlement and Attorneys Feesa. Settled Before Judgment. The corporation can pay the legal fees of the plaintiff and

of the defendants. b. Judgment for Money Damages Imposed on Defendants. Except to the extent covered

by insurance, the defendants will be required to pay those damages and to bearthe cost of their defense as well.(1) The corporation may pay the defendants’ expense only if the court

determines that “despite the adjudication of liability but in view of allthe circumstances of the case, [the defendant] is fairly entitled toindemnity.”

7. Individual Recovery in a Derivative Actiona. Sometimes a court awards an individual recovery in a derivative action. In Lynch

v. Patterson (Wyo. 1985), the trial court award the plaintiff damages as a individualin the amount of 30 percent of $266,000, or $79,8000. The Wyoming SupremeCourt upheld this judgment noting that “corporate recovery would simply returnthe funds to the control of the wrongdoers.”

B. The Requirement of Demand on the Directors1. Grimes v. Donald (Del. Sup. Ct. 1996).

a. Distinction Between Direct and Derivative Claims. Although the tests have beenarticulated many times, it is often difficult to distinguish between a derivative andan individual action. The distinction depends upon the nature of the wrongalleged and the relief, if any, which could result if plaintiff were to prevail.28

Tooley v. Donaldson, Lufkin & Jenrette (Del. 2004).27

In Tooley v. Donaldson, Lufkin, & Jenrette, Inc. (Del. 2004), the Delaware Supreme Court clarified the28

standard, holding that in determining whether a stockholder’s claim is derivative or direct, the issue must turn solelyon the following questions: (1) who suffered the alleged harm, the corporation or the suing stockholders, individually;and (2) who would receive the benefit of any recovery or other remedy, the corporation of the stockholders,

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b. Abdication. Directors may not delegate duties which lie “at the heart of themanagement of the corporation.” A court cannot give legal sanction toagreements which have the effect of removing from directors in a very substantialway their duty to use their own best judgment on management affairs.(1) With certain exceptions, an informed decision to delegate a task is as

much an exercise in business judgment as any other. Likewise, businessdecisions are not an abdication of directorial authority merely becausethey limit a board’s freedom of future action. A board which hasdecided to manufacture bricks has less freedom to decide to makebottles. In a world of scarcity, a decision to do one thing will commit aboard to a certain course of action and make it costly and difficult(indeed, sometimes impossible) to change course and do another. Thisis an inevitable fact of life and is not an abdication of directorial duty.

(2) If an independent and informed board, acting in good faith, determinesthat the services of a particular individual warrant large amounts ofmoney, whether in the form of current salary or severance provisions,the board has made a business judgment decision. (a) That judgment normally will receive the protection of the

business judgment rule unless the fact show that such amounts,compared with the services to be received in exchange,constitute waste or could not otherwise be the product of avalid exercise of business judgment.

c. Demand Requirement. If a claim belongs to the corporation, it is the corporation,acting through its board of directors, which must make the decision whether ornot to assert the claim. The derivative action impinges on the managerialfreedom of directors. The demand requirement is a recognition of the fundamentalprecept that directors manage the business and affairs of the corporation.(1) A stockholder filing a derivative suit must allege either that the board

rejected his pre-suit demand that the board assert the corporation’s claimor allege with particularity why the stockholder was justified in nothaving made the effort to obtain board action.(a) Grounds for alleging with particularity that demand would be

futile:i) Reasonable Doubt. “Reasonable doubt” exists that29

the board is capable of making an independentdecision to assert the claim if demand were made. The basis for claiming excusal would normally be that:a) A majority of the board has a material

financial or familial interest.;b) A majority of the board is incapable of acting

independently for some other reason such asdomination of control; or

c) The underlying transaction is not the productof a valid exercise of business judgment.

individually.

Some courts and commentators have questioned why a concept normally present in criminal prosecution29

would find its way into derivative litigation. Yet the term is apt and achieves proper balance. Reasonable doubt canbe said to mean that there is reason to doubt. This concept is sufficiently flexible and workable to provide thestockholder with “the keys to the courthouse” in an appropriate case where the claim is not based on mere suspicionsor state solely in conclusory terms.

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(2) Purposes of the Demand Requirement(a) By requiring exhaustion of intracorporate remedies, the

demand requirement invokes a species of alternative disputeresolution procedure which might avoid litigation altogether.

(b) If litigation is beneficial, the corporation can control theproceedings.

(c) If demand is excused or wrongfully refused, the stockholderwill normally control the proceedings.

(3) Wrongful Refusal Distinguished from Excusal. A stockholder who makes ademand is entitled to know promptly what action the board has taken inresponse to the demand. A stockholder who makes a serious demandand receives only a peremptory refusal has the right to use the “tools athand” to obtain the relevant corporate records, such as reports orminutes, reflecting the corporate action and related information in orderto determine whether or not there is a basis to assert that demandwrongfully refused.(a) The stockholder does not, by making demand, waive the right

to claim that demand has been wrongfully refused.(b) Demand Waives Demand Excusal Argument. A stockholder who

makes a demand can no longer argue that demand is excused. Permitting a stockholder to demand action involving only onetheory or remedy and to argue later that demand is excused asto other legal theories or remedies arising out of the same set ofcircumstances as set forth in the demand letter would create anundue risk of harassment.

2. Marx v. Akers (N.Y. 1996).a. New York Business Corporation Law § 626(c) provides that in any shareholders’

derivative action, “the complaint shall set forth with particularity the efforts of theplaintiff to secure the initiation of such action by the board or the reasons for notmaking such an effort.”(1) Codified a rule of equity developed in early shareholder derivative

action requiring plaintiffs to demand that the corporation initiate anaction, unless such demand was futile, before commencing an action onthe corporation’s behalf.

(2) Purposes of the Demand Requirement. (1) relieve courts from decidingmatters of internal corporate governance by providing corporatedirectors with opportunities to correct alleged abuses, (2) providecorporate boards with reasonable protection from harassment bylitigation on matters clearly within the discretion of directors, and (3)discourage “strike suits” commenced by shareholders for personal gainrather than for the benefit of the corporation.

b. Various Approaches to the Demand Futility Exception:(1) The Delaware Approach:

(a) The two branches of the Delaware test are disjunctive. Oncedirector interest has been established, the business judgmentrule becomes inapplicable and the demand excused withoutfurther inquiry. Whether a board has validly exercise itsbusiness judgment must be evaluated by determining whetherthe directors exercised procedural (informed decisions) andsubstantive (terms of the transactions) due care.

(2) Universal Demand(a) Would dispense with the necessity of making case-specific

determinations and impose an easily applied bright-line rule.(3) New York’s Approach to Demand Futility

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(a) A demand would be futile if a complaint alleges withparticularity that:i) A majority of the directors are interested in the

transaction, ora) Director interest may either be self-interest in

the transaction at issue, or a loss ofindependence because a director with nodirect interest in a transaction is “controlled”by a self-interested director.

ii) The directors failed to inform themselves to a degreereasonably necessary about the transactions, or

iii) The directors failed to exercise their businessjudgment in approving the transaction.

c. A complaint challenging the excessiveness of director compensation must–tosurvive a dismissal motion–allege compensation rates excessive on their face orother facts which call into question whether the compensation was fair to thecorporation when approved, the good faith of the directors setting those rates, orthat a decision to set the compensation could not have been the product of validbusiness judgment.

C. The Role of Special Committees30

1. Auerbach v. Bennett (N.Y. 1979).a. The business judgment rule does not foreclose inquiry by the courts into the

disinterested independence of those members of the board chosen by it to makethe corporate decision on its behalf–here the members of the special litigationcommittee. Indeed the rule shields the deliberations and conclusions of thechosen representatives of the board only if they possess a disinterest independenceand do not stand in a dual relation which prevents an unprejudicial exercise ofjudgment.

b. Courts have consistently held that the business judgment rule applies where somedirectors are charged with wrongdoing, so long as the remaining directors makingthe decision are disinterested and independent.

c. The action of the special litigation committee comprised two components:(1) First, there was the selection of procedures appropriate to the pursuit of

its charge.(a) As to the methodologies and procedures best suited to the

conduct of an investigation of facts and the determination oflegal liability, the courts are well equipped by long andcontinuing experience and practice to make determinations.

(b) While the court may properly inquire as to the adequacy andappropriateness of the committee’s investigative procedures andmethodologies, it may not under the guise of consideration ofsuch factors trespass in the domain of business judgment.i) At the same time those responsible for the procedures

by which the business judgment is reached mayresponsibly be required to show that they havepursued their chosen investigative methods in goodfaith.a) What evidentiary proof may be required to

this end will, of course, depend on the natureof the particular investigation, and the properreach of disclosure at the instance of the

See also Handout/Chart30

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shareholders will relate inversely to theshowing made by the corporaterepresentatives themselves.

ii) Proof, however, that the investigation has been sorestricted in scope, so shallow in execution, orotherwise so pro forma or halfhearted as to constitute apretext or sham, consistent with the principlesunderlying the application of the business judgmentdoctrine, would raise questions of good faith orconceivably fraud which would never be shielded bythat doctrine.

(2) Second, there was the ultimate substantive decision, predicated on theprocedures chosen and the date produced thereby, not to pursue theclaims advanced in the shareholders’ derivative actions.(a) The substantive decision falls squarely within the embrace of

the business judgment doctrine, involving as it did theweighing and balancing of legal, ethical, commercial,promotional, public relations, fiscal and other factors familiar tothe resolution of many if not most corporate problems.

2. Zapata Corp. v. Maldonado (Del. 1981).a. Directors of Delaware corporations derive their managerial decision making

power, which encompasses decisions whether to initiate, or refrain from entering,litigation from 8 Del.C. § 141(a).(1) The business judgment rule, however, is a judicial creation that

presumes propriety, under certain circumstances, in a board’s decision. Viewed defensively, it does not create authority. In this sense the“business judgment” rule is not relevant in corporate decision makinguntil after a decision is made. It is generally used as a defense to anattack on the decision’s soundness.

(2) The two, § 141(a) and the business judgment rule, are related becausethe rule evolved to give recognition to the directors’ business expertisewhen exercising their managerial power under § 141(a).

b. Right of a Plaintiff Stockholder in a Derivative Action. We find that the ChanceryCourt’s determination that a stockholder, once demand is made and refused,possesses an independent, individual right to continue a derivative suit forbreaches of fiduciary duty over objection by the corporation, as an absolute rule,is erroneous.(1) The language in Sohland v. Baker relied on by the Vice Chancellor

negates the contention that the case stands for the broad rule ofstockholder right which evolved below. The Court therein stated that“a stockholder may sue in his own name for the purpose of enforcingcorporate rights in a proper case if the corporation on the demand of thestockholder refuses to bring suit.” Thus, the precise language onlysupports the stockholder’s right to initiate the lawsuit. It does notsupport an absolute right to continue to control it.

(2) In McKee v. Rogers, it was stated as a “general rule” that “a stockholdercannot be permitted to invade the discretionary field committed to thejudgment of the directors and sue in the corporation’s behalf when themanaging body refuses. This rule is a well settled one.(a) Should not be read so broadly that the board’s refusal will be

determinative in every case. Board members, owing a well-established fiduciary duty to the corporation, will not beallowed to cause a derivative suit to be dismissed when itwould be a breach of their fiduciary duty.

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(3) Wrongful Board Refusal. A board decision to cause a derivative suit to bedismissed as detrimental to the company, after demand has been madeand refused, will be respected unless it was wrongful. Absent a wrongfulrefusal, the stockholder in such a situation simply lacks managerialpower.

(4) Demand Futility. A stockholder may sue in equity in his derivative rightto assert a cause of action in behalf of the corporation, without priordemand upon the directors to sue, when it is apparent that a demandwould be futile, that the officers are under an influence that sterilizesdiscretion and could not be proper persons to conduct the litigation.

c. We see no inherent reason why the “two phases” of a derivative suit, thestockholder's suit to compel the corporation to sue and the corporation's suitshould automatically result in the placement in the hands of the litigatingstockholder sole control of the corporate right throughout the litigation. To thecontrary, it seems to us that such an inflexible rule would recognize the interest ofone person or group to the exclusion of all others within the corporate entity.(1) When should an authorized board committee be permitted to cause

litigation, properly initiated by a derivative stockholder in his own right,to be dismissed? Even when demand is excusable, circumstances mayarise when continuation of the litigation would not be in thecorporation's best interests. Our inquiry is whether, under suchcircumstances, there is a permissible procedure under s 141(a) by whicha corporation can rid itself of detrimental litigation. If there is not, asingle stockholder in an extreme case might control the destiny of theentire corporation.

d. Delegation of Authority to Independent Committee. Section 141(c) allows a board todelegate all of its authority to a committee. Accordingly, a committee withproperly delegate authority would have the power to move for dismissal orsummary judgment if the entire board did.(1) Under an express provision of the statute, § 141(c), a committee can

exercise all of the authority of the board to the extent provided in theresolution of the board. Moreover, at least by analogy to our statutorysection on interested directors, 8 Del.C. § 144, it seems clear that theDelaware statute is designed to permit disinterested directors to act forthe board.(a) Interested Board Majority/Independent Committee. We do not

think that the interest taint of the board majority is per se alegal bar to the delegation of the board's power to anindependent committee composed of disinterested boardmembers. The committee can properly act for the corporationto move to dismiss derivative litigation that is believed to bedetrimental to the corporation's best interest.

e. Power of Derivative Suit to Continue In Face of Independent Committee’s Dismissal. Itappears desirable to us to find a balancing point where bona fide stockholderpower to bring corporate causes of action cannot be unfairly trampled on by theboard of directors, but the corporation can rid itself of detrimental litigation.(1) The question has been treated by other courts as one of the “business

judgment” of the board committee. If a “committee, composed ofindependent and disinterested directors, conducted a proper review ofthe matters before it, considered a variety of factors and reached, in goodfaith, a business judgment that the action was not in the best interest ofthe corporation”, the action must be dismissed.(a) We are not satisfied, however, that acceptance of the “business

judgment” rationale at this stage of derivative litigation is a

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proper balancing point(2) We thus steer a middle course between those cases which yield to the

independent business judgment of a board committee and this case asdetermined below which would yield to unbridled plaintiff stockholdercontrol. In pursuit of the course, we recognize that “the final substantivejudgment whether a particular lawsuit should be maintained requires abalance of many factors ethical, commercial, promotional, publicrelations, employee relations, fiscal as well as legal.”(a) Pre-trial motion by the independent committee to dismiss.

This will require a two-step inquiry by the court:i) The independence and good faith of the committee

and the bases supporting its conclusion.a) The corporation should have the burden fo

proving independence, good faith, andreasonableness.

ii) Determine, applying its own independent businessjudgment, whether the motion should be granted.a) Intended to thwart instances where corporate

actions meet the criteria of step one, but theresult does not appear to satisfy its spirit, orwhere corporate actions would simplyprematurely terminate a stockholdergrievance deserving of further considerationin the corporation’s interest.

3. In re Oracle Corp. Derivative Litigation (Del. Ch. 2003).a. Structural Bias. The Delaware court fully adopts the structural bias argument–the

criticism that the use of a committee of “independent” directors is that suchdirectors are not really “independent,” in a psychological sense.

b. The independent inquiry should not “ignore the social nature of humans.” Corporate directors are “generally the sort of people deeply enmeshed in socialinstitutions,” and such directors should not be assumed to be “persons of unusualsocial bravery, who operate heedless to the inhibitions that social norms generatefor ordinary folk.”

IV. The Role and Purposes of CorporationsA. A.P. Smith Mfg. Co. v. Barlow (N.J. 1953).

1. Facts. Stockholders objected the giving of $1,500 to Princeton University. Thecorporation instituted a declaratory judgment action. The stockholders took the positionthat (1) the plaintiff’s certificate of incorporation does not expressly authorize thecontribution and under common-law principles the company does not possess any impliedor incidental power to make it, and (2) the New Jersey statutes which expressly authorizethe contribution may not constitutionally be applied to the plaintiff, a corporation createdlong before their enacted.

2. The common-law rule developed that those who managed the corporation could notdisburse any corporate funds for philanthropic or other worthy public cause unless theexpenditure would benefit the corporation.a. In many instances such contributions have been sustained by the courts within the

common-law doctrine upon liberal findings that the donations tended reasonablyto promote the corporate objectives.

3. It seems to us that just as the conditions prevailing when corporations were originallycreated required that they serve public as well as private interests, modern conditionsrequire that corporations acknowledge and discharge social as well as privateresponsibilities as members of the community within which they operate.

4. New Jersey doctrine that although the reserved power permits alterations in the publicinterest of the contract between the state and the corporation, it has no effect on the

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contractual rights between the corporation and its stockholder and between stockholdersinter se.a. Although later cases have not disavowed the doctrine, it is noteworthy that they

have repeatedly recognized that where justified by the advancement of the publicinterest the reserved power may be invoked to sustain later charter alterationseven though they affect contractual rights between the corporation and itsstockholders and between stockholder inter se.

b. State legislation adopted in the public interest and applied to preexistingcorporations under the reserved power has repeatedly been sustained by theUnited States Supreme Court above the contention that it impairs the rights ofstockholders and violates constitutional guarantees under the FederalConstitution.

B. Business Judgment Rule. The courts have been extremely tolerant in accepting the business judgmentof the officers and directors of corporation, including their business judgment about whether acharitable donation will be good for the corporation in the long run.

C. Internal Affairs Rule. The basic rule of corporate choice of law in all states is that the law of the stateof incorporation controls on issues relating to a corporation’s “internal affairs,” which includesresponsibilities of directors to shareholders.

D. Dodge v. Ford Motor Co. (Mich. 1919).1. Power of Court to Interfere in Declaring Dividend. It is a well-recognized principle of law that

the directors of a corporation, and they alone, have the power to declare a dividend of theearnings of the corporation, and to determine its amount. Courts of equity will notinterfere in the management of the directors unless it is clearly made to appear that they areguilty of fraud or misappropriation of the corporate funds, or refuse to declare a dividendwhen the corporation has a surplus of net profits which it can, without detriment to itsbusiness, divide among its stockholders, and when a refusal to do so would amount to suchan abuse of discretion as would constitute a fraud, or breach of that good faith which theyare bound to exercise towards the stockholders.

2. Purpose of Business Organization. A business corporation is organized and carried onprimarily for the profit of the stockholders. The powers of the directors are to beemployed for that end. The discretion of directors is to be exercised in the choice ofmeans to attain that end, and does not extend to a change in the end itself, to thereduction of profits, or to the nondistribution of profits among stockholders in order todevote them to other purposes.

3. Within Business Judgement. We are not, however, persuaded that we should interfere withthe proposed expansion of the business of the Ford Motor Co. In the view of the fact thatthe selling price of products may be increased at any time, the ultimate results of the largerbusiness cannot be certainly estimated. The judges are not business experts. It isrecognized that plans must often be made for a long future, for expected competition, for acontinuing as well as an immediately profitable venture. The experience of the FordMotor Co. is evidence of capable management of its affairs.

E. Shlensky v. Wrigley (Ill. 1968).1. It appears to us that the effect on the surrounding neighborhood might well be considered

by a director who was considering the patrons who would or would not attend the gamesif the park were in a poor neighborhood.

2. The response which courts make to such applications is that it is not their function toresolve for corporations questions of policy and business management. The directors arechose to pass upon such questions and their judgment unless shown to be tainted with fraud isaccepted as final. The judgment of the directors of corporations enjoys the benefit of apresumption that it was formed in good faith and was designed to promote the bestinterests of the corporation.

CHAPTER FOUR: THE LIMITED LIABILITY COMPANY

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I. FormationA. History and Law of Limited Liability Companies

1. Recently Created Form of Bus. Org. Before 1988, the world of unincorporated business31

organizations had two main players: ordinary general partnership and ordinary limitedpartnerships.a. Limited Liability Company. The first LLC statute was enacted in Wyoming. The

limited liability company is an alternative form of business organization thatcombines certain features of the corporate form with others more closelyresembling general partnerships.

2. The Players. In an LLC the investors are called "members." Like the traditionalcorporation, the LCC provides a liability shield for its members. It allows somewhat moreflexibility than the corporation in developing rules for management and control.a. Member-Managed/Manager-Managed. Most LLC statutes dichotomize governance

between “member-managed” LLCs and “manager-managed” LLCs.(1) Governance in a member-managed LLC resembles governance in a

general partnership. Governance in a manager-managed LLC resemblesgovernance in a limited partnership.32

b. Single-Member LLC . LLCs can be single-member LLCs (as can a corporation;partnerships, by definition, cannot).

3. Formalities a. Articles of Organization. The public filing of which will create the limited liability

company as a legal person.(1) Most LLC statutes require the articles to state whether the LCC is

member-managed or manager-managed, a characterization that hasimportant power-to-bind implications.33

(2) Arkansas’ default rule is that an LLC is member-managed.b. Operating Agreement. Like a partnership agreement in a general or limited

partnership, an LLC’s operating agreement serves as the foundational contractamong the entity’s owners.

4. Tax Treatmenta. Corporations. Corporate stockholders face “double taxation” on any dividends

they receive. (1) First, the corporation pays income tax on any profits it earns. Dividends

to shareholders are therefore made in “after-tax” dollars. Second,dividends are then taxed as they are received by the shareholders.

b. Other Entities. Partnerships, LLCs, Subchapter S Corporations are subject to34

In 1988, the IRS issued Revenue Procedure 88-76 which classified a Wyoming LLC as a partnership, and31

caused legislatures around the country to consider seriously the LLC phenomenon.

The resemblance is not complete. For example, managers in a manager-managed LLC are not required32

by statute to be members, although they usually are. In contrast, the managers of a limited partnership–i.e., thegeneral partners–are necessarily partners.

In a member-managed LLC, all members have the power to bind absent contrary agreement. In a33

manager-managed LLC, managers have the power to bind while the members do not.

The following requirements must be for a corporation to elect to be taxed as a partnership: (1) for most34

practical purposes, all shareholders must be either U.S. citizens or resident aliens; (2) the corporation cannot be acertain business type or structure, including foreign corporations, a bank or savings and loan association, or aninsurance company; (4) there can only be one class of stock; and (5) there can be no more than 100 individualshareholders, though certain tax-exempt entities such as employee stock ownership plans, pension plans, and charities

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“pass through” taxation–the business’ profits (whether distributed or not)allocated and taxable directly to the members.

5. Limited Liability. Because a limited liability company is “an entity distinct from itsmember,” its assets and obligations pertain legally to it and not to its members. As a result,absent extraordinary circumstances, an LLC’s members are not answerable qua membersfor the debts and other obligations of the LLC.

6. Permissible Purposes. At one time, most if not all LLC statutes required an LLC have abusiness purpose , but the modern trend is to permit an LLC to have any lawful purpose. 35

“Any lawful purpose” language also permits an LLC to be organized for nonprofitpurposes.

7. Various LLC Actsa. ABA Model Prototype LLC Act, adopted by Arkansas has many gaps and

ambiguities. The ABA has since promulgated a New Prototype Act.b. Uniform Limited Liability Company Act (“ULLCA”), was only adopted by eight

states.c. Revised Uniform Limited Liability Company Act (“RULLCA”) was approved in

2006.(1) Arkansas Adoption? RULLCA was recently recommended by the

Arkansas Bar Associations’ Committee on Uniform State Laws to beincluded in the legislative bar packet. The Board of Governors deniedthis request. It is likely that in the future it will be adopted.

B. Water, Waste & Land, Inc. d/b/a Westec v. Lanham (Colo. 1998).1. Facts. Clark and Lanham were managers and members of the limited liability company

P.I.I. Clark contacted Westec about hiring it for eng. work for a dev. project known asTaco Cabana. Clark gave his business card, which included Lanham’s address that was alsolisted as the principal office and place of business in its art. of org., to representatives ofWestec. The letters P.I.I. appeared on the card but there was no indication as to what theacronym meant or that it was an LLC. An oral agreement was reached on the project andClark asked Westec to send a written proposal, which Westec did. Westec never receivedthe contract but received verbal authorization from Clark to begin work. Westeccompleted the work and billed Lanham. No payments were made.

2. The LLC has become a popular form of business organization because it offers member thelimited liability protection of a corporation, together with the single-tier tax treatment of apartnership along with considerable flexibility in management and financing.a. LLC Avoids Double Taxation. The ability to avoid two-levels of income taxation

[that is, a tax collected from a corporation on its income plus a tax collected fromthe shareholders on dividend distributions by the corporation from the remainingincome] is an especially attractive feature of organization as a limited liabilitycompany.

3. The district court’s analysis assumed that the LLC Act displaced certain common lawagency doctrines, at least insofar otherwise would be applicable to suits by third partiesseeking to hold the agents of a limited liability company liable for their personal actions asagents.a. We hold, however, that the statutory notice provision applies only where a third

party seeks to impose liability on an LLC’s members or managers simply due totheir status as members or managers of the LLC. Where a third party sues amanager or member of an LLC under an agency theory, the principles of agency

can be shareholders.

Partnerships, by definition, are formed for a business purpose (“association of two or more person to carry35

on as co-owners a business for profit).

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law apply notwithstanding the LCC Act’s statutory notice rules.4. Under the common law of agency, an agent is liable on a contract entered on behalf of a

principal if the principal is not fully disclosed. In other words, an agent who negotiates acontract with a third party can be sued, for any breach of the contract unless the agentdiscloses both the fact that he or she is acting on behalf of a principal and the identity ofthe principal.36

a. This somewhat counterintuitive proposition–that an agent is liable even when thethird party knows that the agent is acting on behalf of an unidentifiedprincipal–has been recognized as sound by the courts of this state, and it is wellestablished rule under the common law.

b. Whether a principal is partially or completely disclosed is a question of fact.c. We conclude, however, that the LLC Act’s notice provision was not intended to alter the

partially disclosed principal doctrine.(1) Section 7-80-208 states: “The fact that the articles of organization are on

file in the office of the secretary of state is notice that the limited liabilitycompany is a limited liability company and is notice of all other facts setforth therein which are required to be set forth in the articles oforganization.”(a) In order to relieve Lanham of liability, this provision would

have to be read to establish a conclusive presumption that athird party who deals with the agent of a limited liabilitycompany always has constructive notice of the existence of theagent’s principal. We are not persuaded that the statute canbear such an interpretation.37

i) Exaggerates Plain Meaning. The statute could be readto state that third parties who deal with a limitedliability company are always on constructive notice ofthe company’s limited liability status, without regardto whether any part of the company’s name or eventhe fact of its existence has been disclosed. However,an equally plausible interpretation of the words usedin the statute is that once the limited liabilitycompany’s name is known to the third party,constructive notice of the company’s limited liabilityhas been given, as well as the fact that managers andmembers will not be liable simply due to their status asmanagers or members.

ii) Invitation to Fraud. It would leave the agent of alimited liability company free to mislead third partiesinto the belief that the agent would bear personalfinancial responsibility under any contract.

“If both the existence and identity of the agent’s principal are fully disclosed to the other party, the agent36

does not become a party to any contract which he negotiates. But where the principal is partially disclosed (i.e., theexistence of a principal is known but his identity is not), it is usually inferred that the agent is a party to the contract.” Reuchlein and Gregory, The Law of Agency and Partnership § 118 (2d ed. 1990).

Other LLC Act provisions reinforce the conclusion that the legislature did not intend the notice language37

of § 7-80-208 to relieve the agent of a limited liability company of the duty to disclose its identity in order to avoidpersonal liability. For example, § 7-80-201(1) requires limited liability companies to use the words “Limited LiabilityCompany” or the initials “LLC” as part of their names, implying that the legislature intended to compel any entityseeking to claim the benefits of the LLC Act to identify itself clearly as a limited liability company.

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iii) Derogation of the Common Law. Statutes in derogationof the common law are to be strictly construed.

5. The “missing link” between the limited disclosure made by Clark and the protection ofthe notice statute was the failure to state that “P.I.I.,” the Company, stood for “PreferredIncome Investors, LLC.”

II. The Operating AgreementA. Elf Atochem North America, Inc. v. Jaffari (Del. 1999).

1. Facts. Elf manufactured solvent-based maskants to the aerospace and aviation industries. Jaffari was the president of Malek, Inc., which developed environmentally-friendlysolvent-based maskants. The EPA soon classified solvent-base maskants as hazardouschemicals and Elf began looking for alternatives. They found Malek. Elf approachedMalek and Jaffari, finding the offer attractive, caused Malek LLC to be formed inDelaware. The parties then entered into a series of agreements, of which Malek LLC38

was not a signatory of, which included an Exclusive Distributorship Agreement, that Jaffariwould manage Malek, and that Jaffari would be the CEO of Malek. Elf contributed $1million for a 30 percent interest, while Malek, Inc. contributed its rights to the maskant fora 70 percent interest. The Agreement also contained an arbitration clause and forumselection clause. In 1998, Elf sued Jaffari and Malek LLC, individually and derivativelyalleging breach of fiduciary duties, breach of contract, tortious interference withprospective business relations, and fraud. The Del. Court of Chancery dismissed citinglack of subject matter jurisdiction because of the Agreement’s arbitration clause.

2. The Limited Liability Company and Flexibility. The Delaware LCC Act was adopted inOctober 1992. The LCC is an attractive form of business entity because it combinescorporate-type limited liability with partnership-type flexibility and tax advantages. TheAct can be characterized as a “flexible statute” because it generally permits members toengage in private ordering with substantial freedom of contract to govern theirrelationship, provided they do not contravene any mandatory provisions of the Act.a. LLC Act Modeled on LP Act. The Delaware Act has been modeled on the popular

Delaware LP Act. In fact, its architecture and much of its wording is almostidentical to that of the Delaware LP Act. Under the Act, a member of an LLC istreated much like a limited partner under the LP Act. The police of freedom ofcontract underlies both the Act an the LP Act.

3. Basic Approach. The basic approach of the Delaware Act is to provide members with broaddiscretion in drafting the Agreement and to furnish default provisions when the members’agreement is silent. The Act is replete with fundamental provisions made subject tomodification in the Agreement (e.g., “unless otherwise provided in a limited liabilitycompany agreement . . .”).

4. Section 18-1101(b) of the Act, like the essentially identical Section 17-1101(c) of the LPAct, provides that “[i]t is the policy of [the Act] to give the maximum effect to theprinciple of freedom of contract and to the enforceability of limited liability companyagreements.”a. In General, Only Mandatory Provisions Trump Agreement. In general, the

commentators observe that only where the agreement is inconsistent withmandatory statutory provisions will the members’ agreement be invalidated. Such statutory provisions are likely to be those intended to protect third parties,not necessarily the contracting members.

5. Malek LLC Not a Signatory to Agreement? Section 18-101(7) defines the limited liabilitycompany as “any agreement, written or oral, of the member or members as to the affairs of

The certificate of formation is a relatively brief and formal document that is the first statutory step in38

creating the LLC as a separate legal entity. The certificate does no contain a comprehensive agreement among theparties, and the statute contemplates that the certificate of formation is to be complemented by the terms of theAgreement.

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a limited liability company and the conduct of its business.”a. The Act is a statute designed to permit members maximum flexibility in entering

into an agreement to govern their relationship. It is the members who are thereal parties in interest. The LLC is simply their joint business vehicle. This is thecontemplation of the statute in prescribing the outlines of a limited liabilitycompany agreement.

6. Derivative Nature of Suit Irrelevant. Although Elf correctly points out that Delaware lawallows for derivative suits against management of an LLC, Elf contracted away its right tobring such an action in Delaware an agreed instead to dispute resolution in California.39

a. The Agreement does not distinguish between direct and derivative claims. Theysimply state that the members may not initiate any claims outside of California.

7. Court of Chancery “Special Jurisdiction” Notwithstanding Agreement? Elf is correct thatDelaware statutes vest jurisdiction with the Court of Chancery in actions involvingremoval of managers and interpreting, applying or enforcing LLC agreements respectively. Such a grant of jurisdiction may have been constitutionally necessary if the claims do notfall within the traditional equity jurisdiction.a. Merely a Default Provision Modifiable By Agreement. Nevertheless, for the purpose

of designating a more convenient forum, we find no reason why the memberscannot alter the default jurisdictional provisions of the statute and contract awaytheir right to file suit in Delaware.

b. Conclusion is bolstered by the fact that Delaware recognizes a strong publicpolicy in favor of arbitration. Normally, doubts on the issue of whether aparticular issue is arbitrable will be resolved in favor of arbitration.

III. Piercing the “LLC” VeilA. Kaycee Land and Livestock v. Flahive (Wyo. 2002).

1. Facts. Flahive Oil & Gas was a Wyoming LLC, of which Roger Flahive was the manager,and possessed no assets at the time of litigation. Kaycee had entered into a contract withFlahive to use the surface of its real property. However, Kaycee alleged that the propertyhad been contaminated by Flahive and sought to pierce the veil of the LLC and holdRoger Flahive personally liable for the contamination.

2. Piercing is an Equitable Doctrine. We have long recognized that piercing is an equitabledoctrine. The concept developed through common law and is absent from the statutesgoverning corporate organization.

3. Corporation Act’s Language v. LLC Act’s Language. Section 17-16-622(b)–a provision fromthe Model Business Corporation Act–reads: “Unless otherwise provided in the articles ofincorporation, a shareholder of a corporation is not personally liable for the acts or debts ofthe corporation except that he may become personally liable by reason of his own acts orconduct.”a. The LCC statute reads “Neither the members of a limited liability company nor

the managers of a limited liability company managed by a manager are liableunder a judgment, decree or order of a court, or in any other manner, for a debt,obligation or liability of the limited liability company.” § 17-15-113.(1) However, we agree with the commentary that; “It is difficult to read

statutory § 17-15-113 as intended to preclude courts from deciding todisregard the veil of an improperly used LLC.” Gelb, Liabilities ofMembers and Managers of Wyoming Limited Liability Companies, 31 Land &Water L. Rev. 133 (1996).

(2) Wyoming’s statute is very short and establishes only minimalrequirements for creating and operating LLCS. It seems highly unlikely

Section 13.8 of the Agreement specifically provided that the parties (i.e., Elf) agreed to institute, “[n]o39

action at law or in equity based upon any claim arising out of or related to this Agreement” except as action tocompel arbitration or to enforce an arbitration award.

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that the Wyoming legislature gave any consideration to whether thecommon-law doctrine of piercing the veil should apply to the liabilitylimitation granted by that fledgling statute.(a) It is true that some other states have adopted specific legislation

extending the doctrine to LLCs while Wyoming has not. However, that situation seems more attributable to the fact thatWyoming was a pioneer in the LLC arena and states whichadopted LLC statutes much later had the benefit of years ofpractical experience during which this issue was likely raised.

(3) It stands to reason that, because it is an equitable doctrine, “[t]he paucityof statutory authority for LLC piercing should not be considered abarrier to its application.” Lack of explicit statutory language should notbe considered an indication of the legislature’s desire to make LLCmembers impermeable.

b. We can discern no reason, in either law or policy, to treat LLCs differently thanwe treat corporations. If the members and officers of an LLC fail to treat it as aseparate entity as contemplated by statute, they should not enjoy immunity fromindividual liability for the LLC’s acts that cause damage to third parties.

IV. Fiduciary ObligationA. McConnell v. Hunt Sports Enterprises (Oh. 1999).

1. Facts. Columbus Hockey Limited LLC (CHL), of which McConnell and Hunt wereinvestors, was formed to seek an NHL team in Columbus, OH. In order to secure afranchise, CHL sought public financing for an arena but taxpayers rejected a sales taxincrease. Nationwide Insurance then expressed a desire to build an arena and lease it. Alease proposal was extended but reject by Hunt. McConnell, however, stated that if Huntwould not agree, he would. Relying on this backup offer, the NHL expansion committeerecommended Columbus be awarded a team. Hunt and his allies still found the leaseunacceptable while McConnell and his allies accepted the lease and signed an agreement intheir own names. McConnell’s group filed suit asking for a declaratory judgment toestablish its right to the franchise without the inclusion of Hunt or CHL. A directedverdict was granted to McConnell.

2. The term “fiduciary relationship” has been defined as a relationship in which specialconfidence and trust is reposed in the integrity and fidelity of another, and there is aresulting position of superiority and influence acquired by virtue of this special trust.a. In the case at bar, a limited liability company is involved which, like a

partnership, involves a fiduciary relationship. Normally, the presence of such arelationship would preclude direct competition between members of thecompany. However, we have an operating agreement that by its very terms allowsmembers to compete with the business of the company.

3. Issue. Whether an Operating Agreement of an LLC May Limit or Define Scope ofFiduciary Duty?a. In becoming members of CHL, appellant and appellees agreed to abide by the

terms of the operating agreement, and such agreement specifically allowedcompetition with the company by its members. As such, the duties createdpursuant to such undertaking did not include a duty not to compete. Therefore,there was no duty on the part of appellees to refrain from subjecting appellant tothe injury complained of herein.

b. In so concluding, we are not stating that no act related to such obtaining could beconsidered a breach of fiduciary duty. In general terms, members of limitedliability companies owe one another the duty of utmost trust and loyalty. However, such general duty in this case must be considered in the context ofmembers’ ability, pursuant to operating agreement, to compete with thecompany.

4. Tortious Interference with a Business Relationship. Tortious interference with a business

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relationship occurs when a person, without a privilege to do so, induces or otherwisepurposely causes a third person not to enter into or continue a business relationship withanother.a. The evidence does not show that appellees induced or otherwise purposely

caused Nationwide and the NHL not to enter into or continue a businessrelationship with appellant. Indeed, the evidence shows McConnell stated hewould lease the arena and obtain the franchise only if appellant did not. It wasonly after appellant rejected the lease proposal on several occasions thatMcConnell stepped in.

5. Breach of Contract Claim Against Hunt for Unilateral Rejection/Failure to Negotiate in GoodFaith. There was no evidence at trial that appellant was the operating member of CHL. The operating agreement, which sets forth the entire agreement between the members ofCHL, does not name any person or entity the operating or managing member of CHL.a. Section 4.1(b) of the operating agreement requires at least a majority approval

prior to taking any action on behalf of CHL. Further, the approval of themembers as to any action on behalf of CHL must have been evidenced byminutes of a meeting properly notice and held or by an action in writing signedby the requisite number of members.

b. Section 4.4's provision, relating to liability only for wilful misconduct, are in thecontext of member carrying out their duties under the operating agreement. There was no duty on appellant’s part to unilaterally file the actions at issue.

B. K.C. Properties v. Lowell (Ark. 2008) 1. Simplified Facts. A and B set up a Limited Liability Company (LLC) called ABLLC to

construct and operate a water park. They sign an operating agreement. ABLLC is amanager-managed LLC, and B is the manager. A owns a 49% membership interest in theLLC, and B owns a 51% interest. B also owns Blackacre, the land that the parties intend toacquire for the LLC, on which the water park is to be built. Although ABLLC has nowritten contract to purchase Blackacre, the parties' intentions are undisputed. B, asmanager, acting on behalf of ABLLC, even makes a contract with a contractor owned byA to construct the water park on Blackacre. At the same time that these negotiations andtransactions between A and B are taking place, B is secretly negotiating to sell Blackacre toa third party for a higher price. And that is what she does, without informing A in advanceof her decision to do so. A responds by suing B for damages for breach of fiduciary duty.

2. § 4-32-402. Liability to Company; DutiesUnless otherwise provided in an operating agreement:

(1) A member or manager shall not be liable, responsible, or accountable in damages orotherwise to the limited liability company or to the members of the limited liability companyfor any action taken or failure to act on behalf of the limited liability company unless the actor omission constitutes gross negligence or willful misconduct; [and](2) Every member and manager must account to the limited liability company and hold astrustee for it any profit or benefit derived by that person without the consent of more thanone-half (1/2) by number of the disinterested managers or members, or other personsparticipating in the management of the business or affairs of the limited liability company,from any transaction connected with the conduct or winding up of the limited liabilitycompany or any use by the member or manager of its property, including, but not limitedto, confidential or proprietary information of the limited liability company or other mattersentrusted to the person as a result of his or her status as manager or member...

3. The court relied on subsection (1) of the statute to hold that K.C. Properties could not sueanyone except Ozark's other member, LIP, and Ozark's manager, PMS. The court thenobserved that neither LIP nor PMS sold the 34 acres to another party, and therefore“neither PMS nor LIP committed any act or failure to act constituting gross negligence orwillful misconduct for which they could be held liable under § 4-32-402(1).

4. Court Pinned Decision on Duty of Care. What is remarkable is that the court pinned itsrejection of the breach of fiduciary duty claim solely on subsection (1) of Arkansas Code

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Annotated section 4-32-402. Subsection (1) of the statute addresses only the fiduciary dutyof care.a. Court Should Have Looked to the Duty of Loyalty. As is evident from the fact that

they were on both the buy side and the sell side of the planned transaction in thiscase, the individual defendants were engaged in self-interested behavior. Therefore, it is the other principal fiduciary duty—the duty of loyalty—that wasat issue. The duty of loyalty is addressed by subsection (2) of Arkansas CodeAnnotated section 4-32-402, set out above. Again, quoting from the drafters ofthe Prototype Act, “Subsection [(2)], which is based on UPA § 21, sets forth theduty of loyalty of LLC managers and managing members—that is, the duty to actwithout being subject to an obvious conflict of interest . . . .”

b. Analogous to Limited Partnership Law. In In re USACafes, a Delaware court heldthat the directors of the corporate general partner owed some degree of fiduciaryduty directly to the limited partners. While the court did not define the limits ofthe directors' obligation, it concluded that “it surely entails the duty not to usecontrol over the partnership's property to advantage the corporate director at theexpense of the partnership.”

V. DissolutionA. New Horizons Supply Cooperative v. Haack (Wis. App. 1999)

1. Facts. Kickapoo Valley Freight, LLC was the “Patron” under a Cardtrol Agreement issuedby New Horizon’s predecessor. Kickapoo agreed to be responsible for all fuel purchasedwith the card. The agreement was signed by Haack with no indication of whether she wassigning individually or in a representative capacity. The account soon was in arrears andwhen contacted about payment, Haack said she would pay $100 per month but nopayment was ever received. Haack was contacted again but Haack inform New Horizonsthat Kickapoo had dissolved and that she was a partner and that Robert, her brother, hadmoved out of state and that she would begin payments. No payment was ever receivedand subsequent attempts to collect payment proved fruitless. Horizons instituted an actionto recover against Haack.

2. Members of LLCs Not Personally Liable. Wis. Stat. § 183.0304 provides that “a member ofmanager of a limited liability company is not personally liable for any debt, obligation orliability of the limited liability company.” a. May Borrow From Common Law Corporation Principles. Wis. Stat. § 183.0304(2)

provides: “Notwithstanding sub. (1) [which sets forth the limitation on memberliability], nothing in this chapter shall preclude a court from ignoring the limitedliability company entity under principles of common law of this state that aresimilar to those applicable to business corporations and shareholders in this stateand under circumstances that are not inconsistent with the purposes of thischapter.”

3. The court disagrees with the trial court’s comments that implied that it erroneouslydeemed Kickapoo Valley’s treatment as a partnership for tax purposes to be conclusive. There is little in the record, moreover, to support a conclusion that Haack “organized,controlled and conducted” company affairs to the extent that it had “no separate existencewhich she “used to evade an obligation, to gain an unjust advantage or to commit aninjustice.”a. Defendant Failed to Shield Herself After Dissolution. Rather we conclude that entry

of judgment against Haack on the claim was proper because she failed to establishthat she took appropriate steps to shield herself from liability for the company’sdebts following its dissolution and the distribution of its assets.(1) The record is devoid of any evidence showing that appropriate steps

were taken upon the dissolution of the company to shield its membersfrom liability for the entity’s obligations.(a) A dissolved limited liability company may “dispose of known

claims against it” by filing articles of dissolution, and then

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providing written notice to its known creditors containinginformation regarding the filing of claims. Wis. Stat. §183.0907.

(b) Wis. Stat. § 183.0909 provides that a claim not barred under §183.0907 or 183.0908 may be enforced under this sectionagainst any of the following:i) “If the dissolved limited liability company’s assets have

been distributed in liquidation, a member of thelimited liability company to the extent of themember’s proportionate share of the claim or to theextent of the assets of the limited liability companydistributed to the member in liquidation, whichever isless, but a member’s total liability for all claims underthis section may not exceed the total value of assetsdistributed to the member in liquidation.”

CHAPTER FIVE: THE DUTIES OF OFFICERS, DIRECTORS, AND OTHER INSIDERS

I. The Obligations of Control: Duty of CareA. Kamin v. American Express Company (N.Y. 1976).

1. Facts. The shareholders’ derivative action complaint alleges that in 1972, AmEx acquirednearly 2 million shares of DLJ for $30 million. It was alleged that the market value ofthose shares was only $4 million. In 1974, AmEx declared a special dividend to distributeshares of DLJ in kind. A sale of the DLJ shares on the market would sustain a capital lossof $25 million which would be an offset against taxable capital gains on other investments. The plaintiffs demanded that the directors rescind the distribution and take steps topreserve the capital loss. This was rejected by the Board of Directors.

2. Grounds for a Claim for Actionable Wrongdoing. In actions by stockholders, which assail theacts of their directors or trustees, courts will not interfere unless the powers have beenillegally or unconscientiously executed; or unless it be made to appear that the acts werefraudulent or collusive, and destructive of the rights of the stockholders. Mere errors ofjudgment are not sufficient as grounds for equity interference, for the powers of thoseentrusted with corporate managements are largely discretionary.

3. Business Judgment for Declaring Dividend. Courts will not interfere with such discretionunless it be first made to appear that the directors have acted or are about to act in badfaith and for a dishonest purpose. It is for directors to say, acting in good faith of course,when and to what extent dividends shall be declared. The statute confers upon thedirectors this power, and the minority stockholders are not in a position to question thisright, so long a the directors are acting in good faith.

4. Merely Alleging Better Course of Action Insufficient. A complaint must be dismissed if all thatis presented is a decision to pay dividends rather than pursuing some other course ofconduct. A complaint which alleges merely that some course of action other than thatpursued by the Board of Directors would have been more advantageous gives rise to nocognizable cause of action.a. The directors’ room rather than the courtroom is the appropriate forum for

thrashing out purely business questions which will have an impact on profits,market prices, competitive situations, or tax advantages.

5. The statute permits an action against directors for “the neglect of, or failure to perform, orother violation of his duties in the management and disposition of corporate assetscommitted to his charge.”a. Improper Decision Insufficient for Neglect. This does not mean that a director is

chargeable with ordinary negligence for having made an improper decision, orhaving acted imprudently. The “neglect” referred to in the statute is neglect ofduties (i.e., malfeasance or nonfeasance) and not misjudgment. To allege that adirector “negligently permitted the declaration and payment of a divided withoutalleging fraud, dishonesty or nonfeasance, is to state merely that a decision was

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take with which on disagrees.b. Courts will not interfere unless a clear case is made out of fraud, oppression,

arbitrary action, or breach of trust.(1) If the business judgment rule is overcome then the court will determine

if the decision was fair to the corporation.B. Smith v. Van Gorkom (Del. 1985).

1. The court recited a litany of errors by a board composed of five management directors andfive eminently qualified outside directors. According to the court, the directors had failedto inquire into Van Gorkom’s role in setting the merger’s terms; failed to review themerger documents; had not inquired into the fairness of the $55 price and the value of thecompany’s significant, but unused, investment tax credits; accepted without inquiry theview of the company’s chief financial officer (Romans) that the $55 price was within a fairrange; had not sought an outside opinion from an investment bank on the fairness of the$55 price; and acted at a two-hour meeting without prior notice and without there beingan emergency.

2. Under Delaware law, the business judgment rule is the offspring of the fundamentalprinciple that the business and affairs of a Delaware corporation are managed by or underits board of directors.a. The rule itself is a presumption that in making a business decision, the directors of

a corporation acted on an informed basis, in good faith and in the honest beliefthat the action taken was in the best interest of the company.(1) Thus, the party attacking a board decision as uninformed must rebut the

presumption that its business judgment was an informed one.b. The determination of whether a business judgment is an informed one turns on

whether the directors have informed themselves prior to making a businessdecision, of all material information reasonably available to them.(1) In the specified context of a proposed merger of domestic corporations,

a director has a duty, along with his fellow directors, to act in aninformed and deliberate manner in determining whether to approve anagreement of merger before submitting the proposal to the stockholders. Certainly in the merger context, a director may not abdicate that dutyby leaving to the shareholders alone the decision to approve ordisapprove the agreement.

C. Legislative Response to the Decision. Del. Gen. Corp. Law § 102(b)(7) was adopted after the VanGorkom decision and the so-called D&O liability insurance crisis. This new law allowed a provisionin a corporation’s articles of incorporation that limited directors’ liability :40

A provision eliminating or limiting the personal liability of a director to the corporation to itsstockholders for monetary damages for breach of fiduciary duty as a director, provided that suchprovision shall not eliminate or limit the liability of a director: (i) For any breach of the director’s dutyof loyalty to the corporation or its stockholders; (ii) For acts or omissions not in good faith or whichinvolve intentional misconduct or a knowing violation of law; (iii) Under § 174 of this title [relatingto payment of dividends]; or (iv) for any transaction from which the director derived an improperpersonal benefit

D. Francis v. United Jersey Bank1. Directors Generally Afforded Immunity. Individual liability of a corporate director for acts of

the corporation is a prickly problem. Generally, directors are accorded broad immunityand are not insurers of corporate activities. The problem is particular nettlesome when athird party asserts that a director, because of nonfeasance, is liable for losses caused by actsof insiders, who in this case were officers, directors, and shareholders,

Del. Gen. Corp. Law 102(b)(7) does not permit the reduction of liability for any breach of the duty of40

loyalty or for any acts or omissions not in good faith or which involve intentional misconduct or knowing violationsof the law.

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2. Duty, Breach, and Causation. Determination of the liability of Pritchard requires findingsthat she had a duty to the clients of Pritchard & Baird, that she breached that duty and thather breach was a proximate cause of their losses.

3. New Jersey Business Corporation Act makes it incumbent upon directors to “dischargetheir duties in good faith and with that degree of diligence, care and skill which ordinarilyprudent men would exercise under similar circumstances in like positions.”a. Degree of Care Dependent on Business Type. Courts have espoused the principle

that directors owed that degree of care that a business of ordinary prudencewould exercise in the management of his own affairs. In addition to requiringthat directors act honestly and in good faith, the New York courts recognizedthat the nature and extent of reasonable care depended upon the type ofcorporation, it size and its financial resources.

4. Director Must Be Knowledgeable. As a general rule, a director should acquire at least arudimentary understanding of the business of the corporation. Accordingly, a directorshould become familiar with the fundamentals of the business in which the corporation isengaged.a. Because directors are bound to exercise ordinary care, they cannot set up as a

defense lack of the knowledge needed to exercise the requisite degree of care.b. Directors are under a continuing obligation to keep informed about the activities

of the corporation.(1) May not shut their eyes to corporate misconduct and then claim that

because they did not see the misconduct, they did not have a duty tolook.

c. Directorial management does not require a detailed inspection of day-to-dayactivities, but rather a general monitoring of corporate affairs and policies. (1) Should maintain familiarity with the financial status of the corporation

by a regular review of financial statements.5. Immunity from Reliance in Good Faith. Generally, directors are immune from liability if, in

good faith:a. “They rely upon the opinion of counsel for the corporation or upon written

reports setting forth financial data concerning the corporation and prepared by anindependent public accountant or certified public accountant or firm of suchaccountants or reports of the corporation represented to them to be correct by thepresident, the officer of the corporation having charge of its books of account, orthe person presiding at a meeting of the board.:”

6. Duty to Object & Resign. Upon discovery of an illegal course of action, a director has aduty to object and, if the corporation does not correct the conduct, to resign.a. Sometimes more may be required, such as seeking advice of counsel or

preventing illegal conduct by co-directors. This may include threat of suit.7. Fiduciary Relationship. In general, the relationship of a corporate director to the

corporation and its stockholders is that of a fiduciary.a. While directors may own a fiduciary duty to creditors also, that obligation

generally has not been recognized in the absence of insolvency.8. Causation. Usually, a director can absolve himself from liability by informing the other

directors of the impropriety and voting for a proper course of action. Conversely, adirector who votes for or concurs in certain actions may be liable to the corporation forthe benefit of its creditors or shareholders, to the extent of any injuries suffered by suchpersons, as a result of any such action.a. A director who is present at a board meeting is presumed to concur in corporate

action taken at a meeting unless his dissent is entered in the minutes of themeeting or filed promptly after adjournment.

II. Duty of Loyalty

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A. Directors and Managers1. Bayer v. Beran (N.Y. 1944).

a. Facts. In 1942, Celanese began a radio advertising campaign costing about $1million a year. It was claimed that the advertising was really merely a vehicle tolaunch the career of Miss Jean Tennyson, in real life Mrs. Camille Dreyfus, wifeof the president of the company. Before ‘42 the company had never advertisedon radio. However, in 1937, the FTC promulgated new regulations requiringcelanese products to be designated and labeled rayon. Thus, the directors becameconcerned with how to distinguish their product on the market.

b. Business Judgment Rule. “Question of policy and management, expediency ofcontracts or action, adequacy of consideration, lawful appropriation of corporatefunds to advance corporate interests, are left solely to their honest and unselfishdecision, for their power therein are without limitation and free from restraint,and the exercise of them for the common and general interests of the corporationmay not be questioned, although the results show that what they did was unwiseand inexpedient.”(1) It is only in a most unusual and extraordinary case that directors are held

liable for negligence in the absence of fraud, or improper motive, orpersonal interest.

c. Business Judgment Rule Subject to Duty of Loyalty. The business judgment rule,however, yields to the rule of undivided loyalty. This great rule of law isdesigned to avoid the possibility of fraud and to avoid the temptation of self-interest. It is designed to obliterate all divided loyalties which may creep into afiduciary relation.(1) Such personal transactions of directors with their corporation, such

transactions as may tend to produce a conflict between self-interest andfiduciary obligation, are, when challenged, examined with the mostscrupulous care, and if there is any evidence of improvidence oroppression, any indication of unfairness or undue advantage, thetransactions will be voided.

(2) Their dealings with the corporation are subjected to rigorous scrutinyand where any of their contracts or engagements are challenged theburden is on the director not only to prove the good faith of thetransaction but also to show its inherent fairness from the viewpoint ofthe corporation and those interested therein.

d. Not Improper to Appoint Relative But Action Closely Scrutinized. Of course it is notimproper to appoint relative of officers or directors to responsible positions in acompany. But where a close relative of the chief executive officer of acorporation, and one of its dominant directors, takes a position closely associatedwith a new and expensive field of activity, the motives of the director are likelyto be questioned.(1) The board would be placed in a position where selfish, personal interests

might be in conflict with the duty owed to the corporation. That beingso, the entire transaction, if challenged in the courts, must be subjectedto the most rigorous scrutiny to determine whether the action of thedirectors was intended or calculated to subserve some outside purpose,regardless of the consequences to the company, and in a mannerinconsistent with its interests.(a) The evidence fails to show that the program was designed to

foster or subsidize the career of Miss Tennyson as an artist or tofurnish a vehicle for her talents. That her participation in theprogram may have enhanced her prestige as a singer is noground for subjecting the directors to liability, as long as theadvertising served a legitimate purpose and a useful corporate

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purpose and the company received the full benefit thereof.e. Directors Acting Separately Cannot Bind Corp. The general rule is that the directors

acting separately and not collectively as a board cannot bind the corporation. There are two reasons for this: First, that collective procedure is necessary inorder that action may be deliberately taken after an opportunity for discussion andan interchange of views. Second, that directors are agents of the stockholders andare given by law no power to act except as a board.(1) Liability may not, however, be imposed on directors because they failed

to approve the radio program by resolution at a board meeting.(a) Failure to Meet Formalities Not Fatal. The failure to observe the

formal requirements is by no means fatal. The directorate ofthis company is composed largely of its executive officers. It isa close, working directorate. Its members are in dailyassociation with one another and their full time is devoted tothe business of the company with which they have beenconnected for many years. This same informal practicefollowed in this transaction had been the customary procedureof the directors in acting on corporate projects of equal orgreater magnitude. While a greater degree of formality shouldundoubtedly be exercised in the future, it is only just and proper topoint out that these directors, with all their loose procedure, have donevery well for the corporation.

2. Benihana of Tokyo, Inc. v. Benihana, Inc. (Del. 2006).a. Facts. The Benihana Protective Trust (BOT) owned 50.9% of Common stock41

(1 vote per share/75% of directors) and 2% of Class A stock (1/10 vote pershare/25% of directors). In 2003, Aoki, founder of Benihana, married Keiko. Conflicts arose between Aoki and his children because of a change in his will thatgave his new wife control upon his death. Benihana’s president discussed thesituation with another director. Benihana was also undertaking a Constructionand Renovation Plan however capital was insufficient. A plan was formed toissue convertible preferred stock to provide funds and put the company in a42

better negotiating position. One of the directors, Abdo, was also a director ofBFC. Three other offers were obtained but were deemed inferior to BFC’s. BFC executed a Stock Purchase Agreement with Benihana.

b. Safe Harbor for Disclosed Relationships/Interests. Section 144 of the DelawareGeneral Corporation Law provides a safe harbor for interested transactions, likethis one, if “[t]he material facts as to the director’s relationship or interest and asto the contract or transaction are disclosed or are known to the board of directorsand the board in good faith authorizes the contract or transaction by theaffirmative votes of a majority of the disinterested directors.”(1) Board Knew of Abdo’s Interested Status. Thus, although no one ever said,

“Abdo negotiated this deal for BFC,” the directors understood that hewas BFC’s representative in the Transaction.

Common Stock: The default rule is that each share receives one (1) vote per share. Common stock receives41

dividends, shares are treated identically and are entitled to the residual ownership interest (liquidation rights are in thefollowing order: secured creditors, creditors, preferred stock, and finally common stock). Common stock can beissued in multiple classes.

Preferred Stock: Some preference over common stock with regards to dividends and liquidation rights. 42

Preferred stock can have conversion rights that give preferred shareholders the option to convert their preferred intoother stock of the corporation, usually common stock.

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c. Breach of Fiduciary Duty Trigger Entire Fairness Standard?(1) Director with conflict of interest cannot use confidential information for

himself or for others.(a) The record does not support BOT’s contention that Abdo used

any confidential information against Benihana. Abdo did notset the terms of the deal; he did not deceive the board; and hedid not dominate or control the other directors’ approval in theTransaction. In short, the record does not support the claimthat Abdo breached his duty of loyalty.

d. No Entrenchment . It is settled law that, “corporate action may not be taken for43

the sole or primary purpose of entrenchment.”(1) Here, however, the trial court found that the primary purpose of the

Transaction was to provide what the directors subjectively believed tobe the best financing vehicle available for securing the necessary fundsfor the agreed upon Construction and Renovation Plan for theBenihana restaurants.

B. Corporate Opportunities1. Broz v. Cellular Information Systems, Inc. (Del. 1996).

a. Facts. Broz was the president and sole stockholder of RFBC and also a directorof CIS. RFBC owned and operated FCC license area Michigan-4. In 1994,Mackinac sought to divest itself of Michigan-2. The license was offered toRFBC but not CIS because it had just emerged from a lengthy and contentiousinsolvency reorganization. Also, from 1992 on, CIS had divested itself of fifteenseparate cellular licenses, leaving it with only five, all outside the Midwest. Brozcontacted several CIS directors about his interest in Michigan-2 but all stated thatCIS would not be interested. CIS then entered agreement with PriCellular tosell CIS. PriCellular obtained an option to purchased Michigan-2 but Broz metthe a term of the option agreement and ultimately purchased the license. Ninedays after the sale, PriCellular closed its tender offer for CIS.

b. Guth v. Loft Corporate Opportunity Test. The doctrine of corporate opportunityrepresents but one species of the broad fiduciary duties assumed by a corporatedirector or officer. A corporate fiduciary agrees to place the interests of thecorporation before his or her own in appropriate circumstances. (1) “if there is presented to a corporate officer of director a business

opportunity which the corporation is (1) financially able to undertake, is,from its nature, (2) in the line of the corporation’s business (fundamentalknowledge) and is of practical advantage to it, is (3) one in which thecorporation has an interest or a reasonable expectancy , and, (4) byembracing the opportunity, the self-interest of the officer or director willbe brought into conflict with that of the corporation, the law will notpermit him to seize the opportunity himself.”

c. Mackinac did not offer the property to CIS. Broz became aware of theopportunity in his individual rather than his corporate capacity. This factualposture does not present many of the fundamental concerns undergirding the lawof corporate opportunity (e.g., misappropriation of the corporation’s proprietaryinformation). However, while this lessens to some extent the burden imposedupon Broz to show adherence to his fiduciary duties, it is not dispositive.

d. Factors. (1) CIS was not financially capable of exploiting the license opportunity;

A manager who uses the corporate governance machinery to protect his incumbency effectively diverts43

control from the shareholders to himself. Besides preventing shareholders from exercising their controlrights–whether by voting or selling to a new owner–management entrenchment undermines the disciplining effect onmanagement of a robust market in corporate control.

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(2) CIS was in the business of divesting itself of its cellular license holdingstherefore it is not clear that CIS had a cognizable interest or expectancy in thelicense; (3) Finally, the corporate opportunity doctrine is implicated only in cases where thefiduciary’s seizure of an opportunity results in a conflict between the fiduciary’s duties to thecorporation and the self-interest of the director is actualized by the exploitation of theopportunity.

e. Presentation to the Board Unnecessary. A director or officer must analyze thesituation ex ante to determine whether the opportunity is one rightfullybelonging to the corporation. If the director or officer believes, based on one ofthe factors articulated above, that the corporation is not entitled to theopportunity, then he may take it for himself. Of course, presenting the opportunityto the board creates a kind of “safe harbor” for the director, which removes the specter of apost hoc judicial determination the director or officer has improperly usurped a corporateopportunity. It is not the law of Delaware that presentation to the board is anecessary element to a finding that a corporate opportunity has not been usurped.

f. The right of a director or officers to engage in business affairs outside of his or herfiduciary capacity would be illusory if these individuals were required to considerevery potential, future occurrence in determining whether a particular businessstrategy would implicate fiduciary duty concerns.

2. In re eBay, Inc. Shareholders Litigation (Del. Ch. 2004).a. Facts. Omidyar and Skoll founded eBay in 1995. In 1998, Goldman Sachs was

the lead underwriter on an IPO of common stock. Shares of eBay stock becamevaluable and the price rose considerably. In 1999, a secondary offering was madewith Goldman Sachs again as the underwriter. Goldman Sachs “rewarded” thedefendants by allocating to them thousands of IPO shares at the initial offeringprice. The plaintiffs alleged that Goldman Sachs provided these allocations to theindividual defendants to show appreciation for eBay’s business and to enhanceGoldman Sachs’ chances of obtaining future eBay business.

b. Distinguishing Broz. First, no one disputes that eBay was financially able to exploitthe opportunities in question. Second, eBay was in the business of investing insecurities. Thus, investing was a “line of business” of eBay. Third, the factalleged in the complaint suggest that investing was integral to eBay’s cashmanagement strategies and a significant part of its business. Finally, it is noanswer to say, as do defendants, that IPOs are risky investments. It is undisputedthat eBay was never given an opportunity to turn down the IPO allocations astoo risky.

c. Not Simply a Case of Broker’s Investment Recommendations. This was not an instancewhere a broker offered advice to a director about an investment in a marketablesecurity. The conduct challenged here involved a large investment bank thatregularly did business with a company steering highly lucrative IPO allocations toselect insider directors and officers at that company, allegedly both to rewardthem for past business and to induce them to direct future business to thatinvestment bank. This is a far cry from the defendant’s characterization of theconduct in question as merely “a broker’s investment recommendations” to awealthy client.

d. Conflict of Interest. One can realistically characterize these IPO allocation as a formof commercial discount or rebate for past or future investment banking services. Viewed pragmatically, it is easy to understand how steering such commercialrebates to certain insider directors places those directors in an obvious conflictbetween their self-interest and the corporation’s interest.

e. Agent’s Duty to Account for Profits. An agent is under a duty to account for profitspersonally obtained in connection with transactions related to his or hercompany. Even if this conduct does not run afoul of the corporate opportunitydoctrine, it may still constitute a breach of the fiduciary duty of loyalty.

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(1) Thus, even if one does no consider Goldman Sachs’ IPO allocations tothese corporate insiders–allocations that generated millions of dollars inprofit–to be a corporate opportunity, the defendant directors werenevertheless not free to accept this consideration from a company,Goldman Sachs, that was doing significant business with eBay and thatarguably intended the consideration as an inducement to maintaining thebusiness relationship in the future.

3. Northeast Harbor Golf Club, Inc. v. Harris (Me. 1995).a. Guth v. Loft Line of Business Test.

(1) If there is presented to a corporate officer or director a businessopportunity which the corporation is financially able to undertake, is,from its nature, in the line of the corporation’s business and is ofpractical advantage to it, is one in which the corporation has an interestor a reasonable expectancy, and, by embracing the opportunity, the self-interest of the officer or director will be brought into conflict with thatof his corporation, the law will not permit him to seize the opportunityfor himself.

(2) Weaknesses. (1) The question whether a particular activity is within acorporation’s line of business is conceptually difficult to answer (See In reeBay, Inc. Shareholders’ Litigation); and (2) the Guth test includes as anelement the financial ability of the corporation to take advantage of theopportunity. Often, the injection of financial ability into the equationwill unduly favor the inside director or executive who has command ofthe facts relating to the finances of the corporation.

b. Fairness Test.(1) The basis of the doctrine rests on the unfairness in the particular

circumstances of a director, whose relation to the corporation isfiduciary, taking advantage of an opportunity for her personal profitwhen the interest of the corporation justly calls for protection. This callsfor application of ethical standards of what is fair and equitable ... inparticular sets of facts.

(2) Weaknesses. Provides little or no practical guidance to the corporateoffice or director seeking to measure her obligations.

c. Line of Business/Fairness Hybrid Test.(1) Two step analysis: (1) Determining whether a particular opportunity is

within the corporation’s line of business; and (2) Scrutinizing theequitable consideration existing prior to, at the time of, and followingthe officer’s acquisition.

(2) Weaknesses. Merely piles the uncertainty and vagueness of the fairnesstest on top of the weaknesses in the line of business test.

d. ALI Approach.(1) The ALI Principles take a disclosure-oriented approach that mandates

informed corporate rejection before a manager can take a “corporateopportunity.” Under this approach, (1) the manager must have offeredthe opportunity to the corporation and disclosed his conflicting interest,and (2) the board or shareholder must have rejected it. ALI § 505(a).

(2) ALI § 505(b). Definition of a Corporate Opportunity. For purposes ofthis Section, a corporate opportunity is:(1) Any opportunity to engage in a business activity of which a director or seniorexecutive becomes aware, either:(A) In connection with the performance of functions as a director or seniorexecutive, or under circumstances that should reasonably lead the director or seniorexecutive to believe that the person offering the opportunity expects it to be offeredto the corporation; or

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(B) Through the use of corporate information or property, if the resultingopportunity is one that the director or senior executive should reasonably beexpected to believe would be of interest to the corporation; or(2) Any opportunity to engage in a business activity of which a senior executivebecomes aware and knows is closely related to a business in which the corporationis engaged or expects to engage.

C. Dominant Shareholders1. Sinclair Oil Corp. v. Levien (Del. 1971).

a. Facts. Sinclair was in the business of exploring for oil and of producing andmarketing crude oil and oil products. It owned about 97% of Sinven’s stock. Theplaintiff owned about 3,000 of 120,000 publicly held shares of Sinven. Sinclairnominated all of Sinven’s board of directors. These directors were, almostwithout exception, officers, directors, or employees in the Sinclair complex. Theplaintiff alleged that from 1960 through 1966, Sinven paid out excessive dividendand that Sinven was therefore prevented from industrial development. Thesedividends exceed earnings.

b. The chancellor held that because of Sinclair’s fiduciary duty and its control overSinven, its relationship with Sinven must meet the test of intrinsic fairness.(1) Intrinsic fairness. The standard of intrinsic fairness involves both a high

degree of fairness and a shift in the burden of proof. Under this standardthe burden is on Sinclair to prove, subject to careful judicial scrutiny,that its transactions with Sinven were objectively fair.

c. Sinclair argues that the transactions between it and Sinven should be tested, notby the test of intrinsic fairness with the accompanying shift of the burden ofproof, but by the business judgment rule.(1) Sinclair’s argument is misconceived.

(a) Intrinsic Fairness not Business Judgment Rule. When the situationinvolves a parent and a subsidiary, with the parent controllingthe transaction and fixing terms, the test of intrinsic fairnesswith its resulting shifting of the burden of proof, is applied.i) The basic situation for the application of the rule is

one in which the parent has received a benefit to theexclusion and at the expense of the subsidiary.

(b) Intrinsic Fairness Not Always Applied in Parent/Subsidiary. Aparent does indeed owe a fiduciary duty to its subsidiary whenthere are parent-subsidiary dealings. However, this alone willnot evoke the intrinsic fairness standard. This standard will beapplied when the fiduciary duty is accompanied by self-dealing–thesituation when a parent is on both sides of the transaction withits subsidiary.i) Self-dealing occurs when the parent, by virtue of its

domination of the subsidiary, cause the subsidiary toact in such a way that the parent receives somethingfrom the subsidiary to the exclusion of, and detrimentto, the minority stockholders of the subsidiary.

d. We do not accept the argument that the intrinsic fairness test can never be appliedto a dividend declaration by a dominated board, although a dividend declarationby a dominated board will not inevitably demand the application of the intrinsicfairness standard.(1) Business Judgment Rule Should Have Been Applied to Dividends. The

dividends resulted in great sums of money being transferred from Sinvento Sinclair. However, a proportionate share of this money was receivedby the minority shareholders of Sinven (fails exclusion requirement). Sinclair received nothing from Sinven to the exclusion of its minority

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stockholders. As such, these dividends were not self-dealing. Therefore,the business judgment standard should have been applied.(a) The dividend payment complied with the business judgment

standard. The motives for causing the declaration of dividendsare immaterial unless the plaintiff can show that the dividendpayments resulted from improper motives and amounted towaste.

(2) Intrinsic Fairness Standard Appropriate for Contract Breaches. Clearly,Sinclair’s act of contracting with its dominated subsidiary was self-dealing. Under the contract Sinclair received the products produced bySinven, and of course the minority shareholders of Sinven were not ableto share in the receipt of these products. If the contract was breached,then Sinclair received these products to the detriment of Sinven’sminority shareholders.(a) Although a parent need not bind itself by a contract with its

dominated subsidiary, Sinclair chose to operate in this manner. As Sinclair has received the benefits of this contract, so it mustcomply with the contractual duties.

(b) Under the intrinsic fairness standard, Sinclair must prove thatits causing Sinven not to enforce the contract was intrinsicallyfair to the minority shareholders of Sinven.

2. Zahn v. Transamerica Corp. (3d Cir. 1947).a. Facts. A corporation had two classes of common shares, class A and class B. The

class B shares held voting control. The class A shares, which were entitled totwice as much liquidation as class B shares, could be redeemed by the corporationat any time for $60. The controlling shareholder had the corporation redeem allof the minority's class A shares and then liquidate the corporation's assets, whichhad recently tripled in value. The result was that the controlling shareholderreceived the lion's share of the company's liquidation value.

b. The circumstances of the case at bar are sui generis and we can find no Kentuckydecision squarely in point. In our opinion, however, the law of Kentuckyimposes upon the directors of a corporation or upon those who are in charge ofits affairs by virtue of majority stock ownership or otherwise the same fiduciaryrelationship in respect to the corporation and to its stockholders as is imposedgenerally by the laws of Kentucky’s sister States or which was imposed by federallaw prior to Erie R. Co. v. Tompkins.(1) The Supreme Court in Southern Pacific Co. v. Bogert said: “The rule of

corporation law and of equity invoked is well settled and has been oftenapplied. The majority has the right to control; but when it does so, itoccupies a fiduciary relation toward the minority, as much so as thecorporation itself or its officers and directors.”

(2) We must also emphasize that there is a radical difference when astockholder is voting strictly as a stockholder and when voting as adirector; that when voting as a stockholder he may have the legal rightto vote with a view of his own benefits and to represent himself only;but that when he votes as a director he represents all the stockholders inthe capacity of a trustee for them and cannot use his officer as directorfor his personal benefit at the expense of the stockholders.

(3) We think that it is the settled law of Kentucky that directors may notdeclare or withhold the declaration of dividends for the purpose ofpersonal profit or, by analogy, take any corporate action for such apurpose.(a) The act of the board of directors in calling the Class A stock, an

act which could have been legally consummated by a

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disinterested board of directors, was here effected at thedirection of the principal Class B stockholder in order to profitit.

D. Ratification1. Fliegler v. Lawrence (Del. 1976).

a. Facts. One of the Defendant directors, acting in his individual capacity,purchased a lease option for antimony (metal) rights. He offered the rights toAgau but the directors agreed that Agau’s financial position would not allow thepurchase. The director then transferred the rights to a company formed for thespecific purpose of holding those rights. He then gave Agau a long-term optionto purchase the holding company. A few months later, Agau’s directors voted toexercise the option. A majority of shareholders voted the same way, but thedirectors also comprised a majority of shareholders. Plaintiff argued thatDefendant directors usurped a corporate opportunity for their own individualbenefit, and that the transaction was inherently unfair. Defendants responded thattheir voted was ratified by shareholders, thereby shifting the burden of proof toPlaintiff to prove that the transaction was fair, but they also offered proof that itwas fair.

b. Shareholder ratification of an “interested transaction,” although less thanunanimous, shifts the burden of proof to an objecting shareholder to demonstratethat the terms are so unequal as to amount to a gift or waste of corporate assets.(1) “The entire atmosphere is freshened and a new set of rules invoked

where formal approval has been given by a majority of independent,fully informed [share]holders.”

c. The purported ratification by the Agau shareholders would not affect the burdenof proof in this case because the majority of shares voted in favor of exercising theoption were cast by defendants in their capacity as Agau shareholders. Onlyabout one-third of the “disinterested” shareholders voted, and we cannot assumethat such non-voting shareholders either approved or disapproved.(1) Under these circumstances, we cannot say that “the entire atmosphere

has been freshened” and that departure from the objective fairness test ispermissible.

d. Defendants argue that the transaction here in question is protected by 8 Del.C. §144(a)(2) which, they contend, does not require that ratifying shareholders be“disinterested” or “independent”; nor, they argue, is there warrant for readingsuch a requirement into the statute.(1) We do not read the statute as providing the broad immunity for which

the defendants contend. It merely removes an “interested director”cloud when its terms are met and provides against invalidation of anagreement “solely” because such a director or officer is involved. Nothing in the statute sanctions unfairness to Agau or removes thetransaction from judicial scrutiny.

III. The Obligation of Good Faith» The process of giving content to good faith began with the Delaware Supreme Court’s decision in Cede & Co v.

Technicolor, Inc., (Del. 1993).“To rebut the rule, shareholder plaintiff assumes the burden of providing evidence that directors, inreaching their challenged decision, breach any one of the triads of their fiduciary duty–good faith,loyalty, or due care. If a shareholder plaintiff fails to meet this evidentiary burden, the businessjudgment rule attaches to protect corporate officers and directors and the decisions they make, and ourcourts will not second-guess these business judgments. If the rule is rebutted, the burden shifts to thedefendant directors, the proponents of the challenged transaction, to prove to the trier of fact the “entirefairness” of the transaction to the shareholder plaintiff.”

A. Compensation

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1. In re The Walt Disney Co. Derivative Litigation (Del. 2006).a. Claims Against Ovitz

(1) A de facto officer is one who actually assumes possession of an officeunder the claim and color of an election or appointment and who isactually discharging the duties of that office, but for some legal reasonlack de jure legal title to that office.

b. Due Care and Bad Faith as Separate Grounds(1) Our law presumed that “in making a business decision the directors of a

corporation acted on an informed basis, in good faith, and in the honestbelief that the action taken was in the best interests of the company.”(a) Those presumptions can be rebutted if the plaintiff shows that

the directors breached their fiduciary duty of care or of loyaltyor acted in bad faith. If that is shown, the burden then shifts tothe director defendants to demonstrate that the challenged actor transaction was entirely fair to the corporation and itsshareholders.

c. Full Disney Board Was Not Required to Consider and Approve OEA(1) The Delaware General Corporation Law expressly empowers a board of

directors to appoint committees and to delegate to them a broad rangeof responsibilities, which may include setting executive compensation. Nothing in the DGCL mandates that the entire board must make thosedecisions.

d. The Good Faith Determinations(1) At least three different categories of fiduciary behavior are candidates for

the “bad faith” pejorative label:(a) Bad Faith. “Subjective bad faith,” that is, fiduciary conduct

motivated by an actual intent to do harm. That such conductconstitutes classic, quintessential bad faith is a proposition sowell accepted in the liturgy of fiduciary law that it borders onaxiomatic. We need not dwell further on this category,because no such conduct is claimed to have occurred, or didoccur, in this case.

(b) Not Bad Faith/Rather, Breach of Duty of Care. Lack of duecare–that is, fiduciary action taken solely by reason of grossnegligence and without any malevolent intent. Both ourlegislative history and our common law jurisprudencedistinguish sharply between the duties to exercise due care andto act in good faith.

(c) Bad Faith. Intentional dereliction of duty, a conscious disregardfor one’s responsibilities. This falls between the first twocategories of (1) conduct motivated by subjective bad intentand (2) conduct resulting from gross negligence.i) Cases have arisen where corporate directors have no

conflicting self-interest in a decision, yet engage inconduct that is more culpable than simple inattentionor failure to be informed of all facts material to thedecision. To protect the interests of the corporationand its shareholders, fiduciary conduct of this kind,which does not involve disloyalty (as traditionallydefined) but it qualitatively more culpable that grossnegligence, should be proscribed. A vehicle is needed toaddress such violations doctrinally, and that doctrinal vehicleis the duty to act in good faith.

ii) A failure to act in good faith may be shown, for

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instance, where the fiduciary intentionally acts with apurpose other than that of advancing the best interestsof the corporation, where the fiduciary acts with theintent to violate applicable positive law, or where thefiduciary intentionally fails to act in the face of aknown duty to act, demonstrating a consciousdisregard for his duties.

e. Was Action By The New Board Required to Terminate Ovitz?(1) When corporate governing instruments are ambiguous, our case law

permits a court to determine their meaning by resorting well-establishedlegal rules of construction, which include the rules governing theinterpretation of contracts.(a) One such rule is that where a contract is ambiguous, the court

must look to extrinsic evidence to determine which of thereasonable readings the parties intended.

(2) Extrinsic evidence clearly supports the conclusion that the board and Eisnerunderstood that Eisner, as Board Chairman/CEO had concurrent power withthe board to terminate Ovitz as President.

f. The Waste Claim(1) Doctrine that a plaintiff who fails to rebut the business judgment rule

presumptions is not entitled to any remedy unless the transactionsconstituted waste.(a) To recover on a claim of corporate waste, the plaintiffs must

shoulder the burden of proving that the exchange was “so onesided that no business person or ordinary, sound judgmentcould conclude that the corporation has received adequateconsideration.”

(2) A claim of waste will arise only in the rare, “unconscionablecase where directors irrationally squander or give awaycorporate assets.” This onerous standard for waste is a corollaryof the proposition that where business judgment presumptionsare applicable, the board’s decisions will be upheld unless itcannot be “attributed to any rational business purpose.”

(3) The payment of a contractually obligated amount cannotconstitute waste, unless the contractual obligation is itselfwasteful.

B. Oversight1. Introduction

a. At the very least, however, a director must have a rudimentary understanding ofthe firm’s business and how it works, keep informed about the firm’s activities,engage in a general monitoring of corporate affairs, attend board meetingsregularly, and routinely review financial statements.

b. Beyond these obligations, however, the question remained as to whether boardsmust adopt rules and procedures to ensure that corporate officers and otheremployees do not engage in illegal or unlawful conduct, and must makereasonable efforts to monitor compliance with those rules and procedures.

2. Stone v. Ritter (Del. 2006).a. In Caremark, the Court of Chancery recognized that: “generally where a claim of

directorial liability for corporate loss is predicated upon ignorance of liabilitycreating activities within the corporation . . . only a sustained or systemic failureof the board to exercise oversight–such as an utter failure to attempt to assure areasonable information and reporting system exists–will establish the lack of goodfaith that is a necessary condition to liability.

b. Demand Futility. To excuse demand, “a court must determine whether or not the

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particularized factual allegations of a derivative stockholder complaint create areasonable doubt that, as of the time the complaint is filed, the board of directorscould have properly exercise its independent and disinterested business judgmentin responding to a demand.”

c. Evolution of Oversight Responsibility:(1) In Graham, the court held that “absent cause for suspicion there is no duty

upon the directors to install and operate a corporate system of espionageto ferret out wrongdoing which they have no reason to suspect exists.”

(2) Caremark narrowly construed the holding in Graham “as demanding forthe proposition that, absent grounds to suspect deception, neithercorporate boards nor senior officers can be charged with wrongdoingsimply for assuming the integrity of employees and the honesty of theirdealings on the company’s behalf.(a) “Generally where a claim of directorial liability for corporate

loss is predicted upon ignorance of liability creating activitieswithin the corporation, as in Graham or in this case, only asustained or systematic failure of the board to exerciseoversight–such as an utter failure to attempt to assure areasonable information and reporting system exists–willestablish the lack of good faith that is a necessary condition toliability.”

d. Good Faith. A failure to act in good faith requires conduct that is qualitativelydifferent from, and more culpable than, the conduct giving rise to a violation offiduciary duty of care (i.e., gross negligence).(1) The failure to act in good faith is not conduct that results, ipso facto, in

the direct imposition of fiduciary liability. The failure to act in goodfaith may result in liability because the requirement to act in good faith“is a subsidiary element,” i.e., a condition, “of the fundamental duty ofloyalty.” It follow that because a showing of bad faith conduct, in thesense described in Disney and Caremark, is essential to establish directoroversight liability, the fiduciary duty violated by the conduct is the dutyof loyalty.(a) Although good faith may be describe colloquially as part of a

“triad” of fiduciary duties that includes the duties of care andloyalty, the obligation to act in good faith does not establish anindependent fiduciary duty that stands on the same footing asthe duties of care and loyalty.44

(b) The fiduciary duty of loyalty is not limited to cases involving afinancial or other cognizable fiduciary conflict of interest. Italso encompasses where the fiduciary fails to act in good faith. As the Court of Chancery aptly put it in Guttman, “a directorcannot act loyally towards the corporation unless she acts in thegood faith belief that her actions are in the corporation’s bestinterests.”

(2) We hold that Caremark articulates the necessary conditions predicated for

The Arkansas Supreme Court has traditionally used language indicating that “good faith” is a standalone44

obligation. In practical terms, it probably does not make much difference as a violation of the obligation of good faithwill most likely also breach the duties of loyalty and due care.

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director oversight liability:45

(a) the directors utterly failed to implement any reporting orinformation systems or controls; or

(b) having implemented such a system or controls, consciouslyfailed to monitor or oversee its operations thus disablingthemselves from being informed of risks or problems requiringtheir attention.

IV. Securities Law OverviewA. Introduction

1. Dual Regulation. There is dual regulation at the federal and the state level. Both federaland state securities laws must be complied with.a. Federal Law

(1) Securities Act of 1933 (15 U.S.C. §§ 77a et seq.) The 1933 Act governsthe issuance of securities by business to raise capital.

(2) Securities Exchange Act of 1934 (15 U.S.C. §§ 87a et seq.) The 1934 Actregulates trading in securities and other regulatory matters affectingpublicly-held corporations.

b. State Law(1) Blue Sky Laws. Arkansas, like most states, has its own “blue sky” law,46

codified at Ark. Code Ann. §§ 23-42-101 et seq., and the ArkansasSecurities Commissioner has promulgated regulations.

B. What is a Security?1. Broad Definition. The statutory definitions of “security” under the federal acts are very

broad. See generally § 2(a)(1) of the 1933 Act which sets out a laundry list of both specificinstruments and general categories. The determination of whether a particular investmentinterest is a security is made on a case-by-case basis.a. For example, the definition includes “notes,” “stock,” “bond,” “evidence of

indebtedness,” “transferable share,” “fractional undivided interest in oil, gas, orother mineral rights,” “investment contract,” “certificate of interest orparticipation in any profit-sharing agreement,” “or, in general, any interest orinstrument commonly known as a ‘security.”’

2. Traditional Corporate Stock. Whether common or preferred, whether voting or nonvoting,whether of a publicly held or a closely held corporation -- is certain to be a security underfederal law. Landreth Timber Co. v. Landreth, 471 U.S. 681 (1985).

3. Promissory Notes. A promissory note may or may not be a security. In Reves v. Ernst &Young, 494 U.S. 56 (1990), the U.S. Supreme Court adopted the so-called "familyresemblance" test used by the Second Circuit. This test seeks to distinguish between notesthat are given by businesses to raise capital for investment (a security) and those that aregiven in connection with consumer transactions or given by businesses in exchange forshort-term loans to finance current operations (not a security).

4. Investment Contracts. The federal statutory definition of "security" includes so-called"investment contracts." This category is, in substance, a catch-all category that bringswithin the definition of "security" a variety of investment interests, including partnershipinterests; franchise, distributorship, and licensing arrangements; and sales of property, bothpersonal and real, coupled with management or development agreements.

In either case, imposition of liability requires a showing that the directors knew that they were not45

discharging their fiduciary obligations. Where directors fail to act in the face of a known duty to act, they breachtheir duty of loyalty by failing to discharge their fiduciary obligation in good faith.

So named because they were aimed at promoters who “would sell building lots in the blue sky in fee46

simple.”

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a. Howey Test. Federal courts apply the "Howey Test" to determine whether aparticular investment interest is an "investment contract" subject to regulation bythe federal securities laws. In SEC v. W.J. Howey Co., 328 U.S. 293, 298-99(1946), the United States Supreme Court announced: (1) “An investment contract for purposes of the Securities Act means a

contract, transaction or scheme whereby a person (1) invests his money(2) in a common enterprise and (3) is led to expect profits (4) solelyfrom the efforts of the promoter or a third party.”

(2) Applying this test, the Supreme Court held that the offer of small plotsof land in orange groves in Florida to vacationers from New England,coupled with the offer of a management contract under which anaffiliate of the vendor would cultivate and tend the grove in which theplot was located, harvest and market the fruit from the entire grove, andremit a share of the profits to the various owners was the offer of an"investment contract" under the 1933 Act.

5. Passive Investments. Subsequent cases have established that a passive investment, whatever itis called, is very likely to be a security. a. Limited Partnership Interests. For example, most limited partnership interests are

usually held to be securities, because in most limited partnerships the limitedpartners have very little management power over the business of the partnership.

b. Race Horse & Property Syndications, Etc. Investments in race horse or propertysyndications are likely to be securities. Chinchilla and earthworm raising ventureshave been held to be securities. Businesses using a multi-level distribution model,where the role of investors is primarily to attract other investors rather than to sella product, have been found to be issuers of securities. Ownership interests inLLCs may be securities, especially in manager-managed LLCs where themembers do not participate in the management of the LLC's business.

6. Under the Arkansas Securities Act. The statutory definition of “security” in the Arkansas Actis similar to those in the federal Acts. The important difference lies in how the Arkansascourts have interpreted the Arkansas Act.a. The Arkansas Supreme Court looks at various factors to determine whether a

given interest - whether it takes the form of corporate stock or some otherinterest– is a “security” subject to regulation under the Arkansas Act. It alsolooks to the so-called “risk capital” test, a test that some state courts use instead ofthe Howey test.(1) Risk Capital Test. The Arkansas courts have expressed the risk capital

test in terms of five elements: (a) The investment of money or money'sworth; (b) in a venture; (c) the expectation of some benefit to theinvestor as a result of the investment; (d) the contribution towards therisk capital of the venture; and (e) the absence of direct control over theinvestment or policy. Carder v. Burrow, 327 Ark. 545, 549, 940 S.W.2d429, 431 (1997). (a) Different Results from Federal Law. Applying this test to classify

various investment interests as securities or not securities, theArkansas Supreme Court has sometimes reached conclusionsopposite to the conclusions that a federal court would probablyhave reached applying federal law. See, e.g., Cook v. Wills, 305Ark. 442, 447, 808 S.W.2d 758, 761 (1991)(corporate stocknot a security); Casali v. Schultz, 292 Ark. 602, 732 S.W.2d836 (1987)(general partnership interest a security).

C. Exemption from 1933 Act Registration1. In General. When businesses seek to raise capital by issuing securities, the securities laws

require that the offering be “registered” with the appropriate governmental authoritybefore the securities are marketed

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a. Exempt Securities/Exempt Transactions. Because of the expense and the restrictions,businesses often seek an exemption from the registration requirements. There aretwo types of exemptions: exempt securities and exempt transactions. Exemptsecurities are listed in section 3 of the 1933 Act. (1) Examples. Probably the most familiar example of an exempt security is

the municipal bond. “Church bonds” are another example. Exemptsecurities are exempt from the registration requirements of the 1933 Act,but they are not exempt from the antifraud laws.

2. Section 4(2) Exemption. The private placement exemption is founded on Section 4(2) ofthe 1933 Act, which says that the registration requirements of the Act “shall not apply to .. . transactions by an issuer not involving any public offering.” The seminal caseinterpreting Section 4(2) is SEC v. Ralston Purina Co., 346 U.S. 119 (1953).a. Fend for Themselves. The Court reasoned that the Section 4(2) private placement

exemption must be interpreted in light of the purposes of the 1933 Act. Thepurpose of the registration requirement of the Act is “to protect investors bypromoting full disclosure of information thought necessary to informedinvestment decisions.” Therefore, the Section 4(2) exemption should be limitedto transactions in which the offerees do not need the protection of registration --in other words, those who are “able to fend for themselves” because they alreadyhave access to the kind of information that registration would disclose and theability to understand that information and its significance to an investmentdecision. By way of illustration, the Court referred to “executive personnel whobecause of their position have access to the same kind of information that the actwould make available in the form of a registration statement.”

b. Automatic Exemption. The Section 4(2) exemption is automatic; it does notrequire any filing with the SEC.

3. Regulation D . Section 3(b) of the 1933 Act gives the SEC authority to exempt byregulation offerings of $5 million or less (“limited offerings”). The SEC has promulgatedtwo important regulations under this authority, Regulation A and Regulation D. \a. Accredited Investor. One of the key concepts in Regulation D is the “accredited47

investor.” Generally speaking, an accredited investor is a person (or entity) thatbecause of wealth or position is conclusively deemed to be able to "fend forhimself." (1) Under Rule 506, an issuer can sell an unlimited dollar amount of

securities to an unlimited number of accredited investors and to 35 orfewer non-accredited investors who nonetheless are sophisticatedenough (either alone or with the assistance of a “purchaserrepresentative") to “fend for themselves.”

4. Intrastate Offering Exemption. The so-called “intrastate offering” exemption is established inSection 3(a)(11) of the 1933 Act and Rule 147 promulgated thereunder. a. Single State. To qualify for this exemption, the security must be part of an issue

that is offered and sold only to persons resident within a single state. b. Issuer Resident/Incorporated In State. In addition, the issuer must be a resident of

(or incorporated in) that state and doing a substantial part of its business in thatstate.

c. Nine Months Resale Restriction. Finally, the issuer must take precautions to makesure that the securities are not resold to non-residents of the state until nine ormore months have passed.

Accredited investors include banks, insurance companies, other corporations with total assets in excess of47

$5 million, directors or executive officers of the issuer, and individuals who have a net worth over $1 million or whohave an income of $200,000 in the previous two years (or $300,000 jointly with his or her spouse) and whoreasonably expect to reach the same income in the current year.

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5. Resales. Technically speaking, the registration requirements of the 1933 Act potentiallyapply to resales of securities as well as to primary offerings by issuers. Exemptions existwhich remove most resales from the reach of the registration provisions, but trouble canarise if a “control person” of the issuer sells large amounts of securities publicly.

D. Regulation of Reporting Companies by the 1934 Act1. Companies Required to Register. The companies that have to register under the 1934 Act are

(1) those whose securities are traded on a national securities exchange (e.g., the New YorkStock Exchange), (2) those whose total assets are $10,000,000 or more and who have 500or more shareholders, and (3) those companies that have issued securities under a 1933 Actregistration statement (although a small company can discontinue 1934 Act registration andreporting after the first year). Also, a company can voluntarily elect to register under the1934 Act and thereby become subject to its provisions.

2. Reporting Companies. Companies subject to the 1934 Act are often called “reportingcompanies” because they are required to file periodic reports setting forth their financialand general business condition.

E. Insider Trading1. Definition. “Insider trading” means buying or selling securities (almost always stock) on the

basis of material, non-public information. 2. SEC’s Advocation for Blanket Rule. The SEC has always advocated for a rule that would

prohibit anyone in possession of inside information from buying or selling stock on thebasis of it. a. Supreme Court Rejection/Common-Law Rule of Deceit. The Supreme Court has, for

Rule 10b-5 purposes, rejected this view. Instead, the Court has approached theproblem of insider trading as a specific application of the common-law rule ofdeceit. (1) Common-Law. Remember that under the common law, a person is

allowed to buy or sell property on the basis of information that he hasthat is unknown to the other party to the transaction. The exception iswhere the person has a "duty to disclose" that information to the otherparty. One source of a duty to disclose is where there is a fiduciaryrelationship or other special relationship of trust and confidence betweenthe parties. So, for example, an attorney cannot enter into a businesstransaction with a client without making full disclosure to the client ofall material information relating to that transaction that the attorney has.

V. Inside InformationA. Goodwin v. Agassiz (Mass. 1933).

1. Facts. Defendants purchased from plaintiff, through brokers, 700 shares of Cliff MiningCompany. Agassiz was president and director and McNaughton was a director andgeneral manager of the company. They had certain knowledge, material to the value ofthe stock, that the plaintiff did not possess. Exploration in 1925 of the property of CliffMining Company proved unsuccessful. However, an experienced geologist formulated atheory as to the possible existence of copper deposits in 1926. The defendants decided totest the theory but agreed that if the information became known the price of CliffMining’s stock would soar. The plaintiff learned of the failed exploration through anarticle and sold his stock through brokers. The plaintiff didn’t know that the purchase ofhis stock was made for the defendants and they did not know his stock was being boughtfor them. There was no communication between them

2. The directors of a commercial corporation stand in relation of trust to the corporation andare bound to exercise the strictest good faith in respect to its property and business.a. The contention that directors also occupy the position of trustee toward

individual stockholders in the corporation is plainly contrary to repeated decisionsof this court and cannot be supported.

3. While the general principle is as stated, circumstances may exist requiring that transactionsbetween a director and a stockholder as to stock in the corporation be set aside.

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a. The knowledge naturally in the possession of a director as to the condition of acorporation places upon him a peculiar obligation to observe every requirementof fair dealing when directly buying or selling its stock.(1) Mere silence does not usually amount to a breach of duty, but parties

may stand in such relation to each other that an equitable responsibilityarises to communicate facts.

(2) An honest director would be in a difficult position if he could neitherbuy nor sell on the stock exchange shares of stock of his corporationwithout first seeking out the other actual ultimate party to thetransaction and disclosing to him everything which a court or jury mightlater find that he then knew affecting the real or speculative value forsuch shares.(a) Business of that nature is a matter to be governed by practical

rules. Fiduciary obligations of directors ought not to be madeso onerous that men of experience and ability will be deterredfrom accepting such office.

(b) On the other hand, directors cannot rightly be allowed toindulge with impunity in practices which do violence toprevailing standards of upright business men.i) Closely Scrutinized. Therefore, where a director

personally seeks a stockholder for the purpose ofbuying his shares without making disclosure ofmaterial facts within his peculiar knowledge and notwithin reach of the stockholder, the transaction willbe closely scrutinized and relief may be granted inappropriate instances.

4. The Geologist’s Theory. At the annual stockholders meeting, no reference was made to thetheory. It was then at most a hope, possibly an expectation. Whether the theory wassound or fallacious, no one knew, and so far as appears has never been demonstrated. TheCliff Mining Company was not harmed by the nondisclosure. There would have been noadvantage to it, so far as appears, from a disclosure.

5. The Purchase. The identity of the buyers and seller of the stock in question in fact was notknown to the parties and perhaps could not readily have been ascertained. The defendantscaused the shares to be bought through brokers on the stock exchange. They said nothingto anybody as to the reasons actuating them. The plaintiff was no novice. He was amember of the Boston Stock Exchange and had kept a record of sales of Cliff MiningCompany stock. He acted upon his own judgment in selling his stock. He made noinquiries of the defendant or of other officers of the company.

B. Securities and Exchange Commission v. Texas Gulf Sulphur Co. (2d. Cir. 1969).1. Facts. TGS began exploratory drilling in Canada. Mollison, VP and a mining engineer,

supervised the project. Clayton, an electrical engineer was also on-site. Stephens, TGSPresident, ordered the drilling results be kept secret to prevent a rise in land prices. TGSemployees began buying up stock and options. Rumors of a rich strike spread and TGSreleased a misleading press release (April 12 ) with regards to the size of operations andth

results to quell them. Disclosure of the large ore strike was soon made (April 16 ). th

Between the time of the two releases, TGS executives and directors ordered more stock. Various prices of the stock over the relevant period: Pp. 474-75.

2. Rule 10b-5, 17 C.F.R. 240.10b-5, on which this action is predicated, provides:It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentalityof interstate commerce, or of the mails or of any facility of any national securities exchange,

(a) To employ any device, scheme, or artifice to defraud,(b) To make any untrue statement of a material fact or to omit to state a material factnecessary in order to make the statements made, in the light of the circumstances underwhich they were made, not misleading, or

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(c) To engage in any act, practice, or course of business which operates or would operate as afraud or deceit upon any person, in connection with the purchase or sale of any security.

a. Purpose of the Rule. Rule 10b-5 is based in policy on the justifiable expectation ofthe securities marketplace that all investors trading on impersonal exchanges haverelatively equal access to material information.

b. Essence of the Rule. The essence of the Rule is that anyone who, trading for hisown account in the securities of a corporation, has “access, directly or indirectly,to information intended to be available only for a corporate purpose and not forthe personal benefit of anyone” may not take “advantage of such informationknowing it is unavailable to those with whom he is dealing.” i.e., the investingpublic.

c. Insiders, as directors or management officers are, of course, by this Rule,precluded from so unfairly dealing, but the Rule is also applicable to onepossessing the information who may not be strictly termed an “insider” withinthe meaning of Sec. 16(b) of the Act.(1) Thus, anyone in possession of material inside information must either

disclose it to the investing public, or, if he is disabled from disclosing itin order to protect a corporate confidence, or he chooses not to do so,must abstain from trading in or recommending the securities concernedwhile such inside information remains undisclosed.

d. An insider is not, of course, always foreclosed from investing in his own companymerely because he may be more familiar with company operations than areoutside investors.(1) An insider’s duty to disclose information or his duty to abstain from

dealing in his company’s securities arises only in those situations whichare essentially extraordinary in nature and which are reasonably certainto have a substantial effect on the market price of the security if theextraordinary situation is disclosed.

(2) Nor is an insider obligated to confer upon outside investors the benefitof his superior financial or other expert analysis by disclosing hiseducated guesses or predictions.

e. The basic test of materiality is whether a reasonable man would attach importancein determining his choice of action in the transaction in question. This, ofcourse, encompasses any fact which in reasonable and objective contemplationmight affect the value of the corporation’s stock or securities.(1) Such a fact is a material fact and must be effectively disclosed to the

investing public prior to the commencement of insider trading in thecorporation’s securities.(a) Material facts include not only information disclosing the

earnings and distributions of a company but also those factswhich affect the probable future of the company and thosewhich may affect the desire of investors to buy, sell, or hold thecompany’s securities.

(2) In each case then, whether facts are material within Rule 10b-5 whenthe facts relate to a particular event and are undisclosed by those personswho are knowledgeable thereof will depend at any given time upon abalancing of both the indicated probability that the event will occur andthe anticipated magnitude of the event in light of the totality of thecompany activity.

f. The timing of a disclosure is a matter for the business judgment of the corporateofficers entrusted with the management of the corporation within the affirmativedisclosure requirements promulgated by the exchanges and by the SEC.(1) Where a corporate purpose is thus served by withholding the news of a

material fact, those persons who are thus quite properly true to their

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corporate trust must not during the period of non-disclosure dealpersonally in the corporation’s securities or give to outsiders confidentialinformation not generally available to all the corporations’ stockholdersand to the public at large.

g. Our decision to expand the limited protection afforded outside investors by thetrial court’s narrow definition of materiality is not at all shaken by fears that theelimination of insider trading benefits will deplete the ranks of capable corporatemanagers by taking away an incentive to accept such employment.(1) Such benefits, in essence, are forms of secret corporate compensation

derived at the expense of the uninformed investing public and not at theexpense of the corporation which receives the sole benefit from insiderincentive. Moreover, adequate incentives for corporate officers may beprovided by properly administered stock options and employee purchaseplans of which there are many in existence.

h. The core of Rule 10b-5 is the implementation of the Congressional purpose thatall investors should have equal access to the rewards of participation in securitiestransactions. It was the intent of Congress that all members of the investingpublic should be subject to identical market risks–which markets risks include, ofcourse, the risk that one’s evaluative capacity or one’s capital available to put atrisk may exceed another’s capacity or capital.

i. It seems clear from the legislative purpose Congress expressed in the Act, and thelegislative history of Section 10(b) that Congress when it used the phrase “inconnection with the purchase or sale of any security” intended only that thedevice employed, whatever it might be, be of a sort that would cause reasonableinvestors to rely thereon, and, in connection therewith, so relying, cause them topurchase or sell a corporation’s securities.(1) There is no indication the Congress intended that the corporations or

persons responsible for the issuance of a misleading statement would notviolate the section unless they engaged in related securities transactionsor otherwise acted with wrongful motives; indeed, the obvious purposesof the Act to protect to investing public and to secure fair dealing in thesecurities markets would be seriously undermined by applying such agloss onto the legislative language.

C. Dirks v. Securities & Exchange Commission (S. Ct. 1983).1. Facts. Dirks was an officer of a N.Y. broker-dealer firm specializing in investment analysis

of insurance company securities. Dirks caught wind of a massive fraud at Equity Fundingof America and investigated. Senior management denied any wrongdoing while otheremployee corroborated the allegations. Neither Dirks nor his firm owned any Equitystock but Dirks discussed his findings with a number of clients and investors who sold theirstock for more than $16 million. Dirks urged the Journal to publish a story about thefraud, but they declined citing possible liability for libel. California insurance agency sooninvestigated and uncovered the fraud. The SEC then filed a complaint against Equity. Then, the SEC found that Dirks had aided and abetted violations of Rule 10b-5 byrepeating the allegations of fraud to investors who sold their stock.

2. In the seminal case of In re Cady, Roberts & Co., the SEC recognized that the common lawin some jurisdictions imposes on corporate insiders, particularly officers, directors orcontrolling stockholder an affirmative duty of disclosure when dealing in securities.a. The SEC found that no only did breach of this common-law duty establish the

elements of a Rule 10b-5 violation, but that individuals other than corporateinsiders could be obligated either to disclose material nonpublic informationbefore trading or to abstain from trading altogether.

3. In Chiarella, we accepted the two elements set out in Cady Roberts for establishing a Rule10b-5 violation:a. The existence of a relationship affording access to inside information intended to

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be available only for a corporate purpose, andb. The unfairness of allowing a corporate insider to take advantage of that

information by trading without disclosure.4. In Chiarella, the Court held that there is no general duty to disclose before trading on

material nonpublic information, and held that a duty to disclose under §10(b) does notarise from the mere possession of nonpublic market information. Such a duty arises ratherfrom the existence of a fiduciary relationship.a. Not all breaches of fiduciary duty in connection with a securities transaction,

however, come within the ambit of Rule 10b-5. There must also bemanipulation or deception. In any inside-trading case this fraud derives from theinherent fairness involved where one takes advantage of information intended tobe available only for a corporate purpose and not for the personal benefit ofanyone.(1) Thus, an insider will be liable under Rule 10b-5 for inside trading only

where he fails to disclose material nonpublic information before tradingon it and thus makes secret profits.

5. We were explicit in Chiarella in saying that there can be no duty to disclose when theperson who traded on inside information was not the corporation’s agent, was not afiduciary, or was not a person in whom the sellers of the securities had placed their trustand confidence.a. Not to require a fiduciary relationship, the Court recognized, would depart

radically from the established doctrine that duty arises from a specific relationshipbetween two parties and would amount to recognizing a general duty between allparticipants in market transactions to forgo actions based on material, nonpublicinformation.

b. This requirement of a specific relationship between the shareholders and theindividual trading on inside information has created analytical difficulties for theSEC and courts in policing tippees who trade on inside information(1) Unlike insiders who have independent fiduciary duties to both the

corporation and its shareholders, the typical tippee has no suchrelationships.

6. The SEC’s position is that a tippee “inherits” the Cady Roberts obligation to shareholderswhenever he receives inside information from an insider.a. This view differs little from the view that the Court rejected in Chiarella. In that

case, the Court of Appeals agreed with the SEC and affirmed Chiarella’sconviction, holding that “anyone–corporate insider or not–who regularly receivesmaterial non-public information may not use that information to trade insecurities without incurring an affirmative duty to disclose.” Here the SECmaintains that anyone who knowingly receives nonpublic material informationfrom an insider has a fiduciary duty to disclose before trading.

b. Imposing a duty to disclose or abstain solely because a person knowingly receivesmaterial nonpublic information from an insider and trades on it could have aninhibiting influence on the role of market analysts, which the SEC itselfrecognizes is necessary to the preservation of a healthy market.

7. The conclusion that recipients of inside information do not invariably acquire a duty todisclose or abstain does not mean that such tippees always are free to trade on thatinformation. The need for a ban on some tippee trading is clear.a. Not only are insiders forbidden by their fiduciary relationship from personal using

undisclosed information to their advantage, they also may not give suchinformation to an outsider for the same improper purpose of exploiting theinformation for their personal gain.

b. Similarly, the transactions of those who knowingly participate with the fiduciaryin such a breach are forbidden as transactions on behalf of the trustee himself.

c. Thus, the tippee’s duty to disclose or abstain is derivative from that of the

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insider’s duty. As the Court noted in Chiarella, the tippee’s obligation has beenviewed as arising from his role as a participant after the fact in the insider’s breachof a fiduciary duty.

d. Thus, some tippees must assume an insider’s duty to the shareholder not becausethey receive inside information, but rather because it has been made available tothem improperly.(1) For Rule 10b-5 purposes, the insider’s disclosure is improper only

where it would violate his Cady Roberts duty. Thus, a tippee assumes afiduciary duty to the shareholders of a corporation not to trade onmaterial nonpublic information only when the insider has breached hisfiduciary duty to the shareholders by disclosing the information to thetippee and the tippee knows or should know that there has been abreach.(a) In determining whether a tippee is under an obligation to

disclose or abstain, it is thus necessary to determine whether theinsider’s “tip” constituted a breach of the insider’s fiduciaryduty. All disclosures of confidential corporate information arenot inconsistent with the duty insiders owe to shareholders.i) Whether disclosure is a breach of duty depends in

large part on the purpose of the disclosure. The test iswhether the insider will personally benefit, directly orindirectly, from his disclosure. Absent some personalgain, there has been no breach of duty tostockholders. And absent a breach by the insider,there is no derivative breach.

D. The SEC & Selective Disclosure. The SEC recently concluded that selective disclosure to analystsundermined public confidence in the integrity of the stock markets.1. Regulation FD . In 2000, the SEC adopted Regulation FD to create a non-insider trading-

based mechanism for restricting selective disclosure. If someone acting on behalf of apublic corporation discloses material nonpublic information to securities marketprofessional or holders of the issuer’s securities who may well trade on the basis of theinformation, the issuer must also disclose that information to the public.a. Intentional Disclosures. Where the disclosure is intentional, the issuer must

simultaneously disclose the information in a manner designed to convey it to thegeneral public.

b. Non-Intentional Disclosures. Where the disclosure was not intentional, as where acorporate officer “let something slip,” the issuer must make public disclosure“promptly” after a senior officer learns of the disclosure.

E. United States v. O’Hagan (S. Ct. 1997).1. Facts. O’Hagan was a partner in a Minneapolis law firm, Dorsey & Whitney, that was

retained by Grand Met to represent it in a potential tender offer for the common stock ofPillsbury. On Oct. 4, 1998, Grand Met publicly announced its tender offer for Pillsburystock. However, back in Aug. of 1988, O’Hagan began purchasing call options ofPillsbury stock. By the end of September, he owned 2,500 options. When Grant Met48

announced its tender offer of Pillsbury, the price of Pillsbury stock rose and O’Hagan thensold his Pillsbury options and common stock, making a $4.3 million profit. The SECinitiated an investigation that resulted in a 57-count indictment. A jury convictedO’Hagan on all counts and he was sentenced to 41-months imprisonment. A dividedCourt of Appeals reversed, holding that liability under § 10(b) and Rule 10b-5 could notbe grounded on the misappropriation theory of securities fraud on which the prosecution

Each option gave him the right to purchase 100 shares of Pillsbury stock by a specified date in September48

1988.

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relied and that Rule 14e-3(a)–which prohibits trading while in possession of material,nonpublic information relating to a tender offer–exceeds the SEC’s § 14(e) rulemakingauthority because the rule contains no breach of fiduciary duty requirement.

2. Under the “traditional” or “classical theory” of insider trading liability, § 10(b) and Rule10b-5 are violated when a corporate insider trades the securities of his corporation on thebasis of material, nonpublic information. Trading on such information qualifies as a“deceptive device” under § 10(b), the Court has affirmed, because “a relationship of trustand confidence exists between the shareholders of a corporation and those insiders whohave obtained confidential information by reason of their position with that corporation.a. The classical theory applies not only to officers, directors, and other permanent

insiders of a corporation, but also to attorneys, accountants, consultants, andothers who temporarily become fiduciaries of a corporation.

3. The “misappropriation theory” holds that a person commits fraud in connection with asecurities transaction, and thereby violates § 10(b) and Rule 10b-5 when hemisappropriates confidential information for securities trading purposes, in breach of a dutyowed to the source of the information.a. Under this theory, a fiduciary’s undisclosed, self-serving use of a principal’s

information to purchase or sell securities, in breach of a duty of loyalty andconfidentiality, defrauds the principal of the exclusive use of that information. Inlieu of premising liability on a fiduciary relationship between company insiderand purchaser or seller of the company’s stock, the misappropriation theorypremises liability on a fiduciary-turned-trader’s deception of those who entrustedhim with access to confidential information.

4. The two theories are complementary, each addressing efforts to capitalize on nonpublicinformation through the purchase or sale of securities.a. The classical theory targets a corporate insider’s breach of duty to shareholders

with whom the insider transacts.b. The misappropriation theory outlaws trading on the basis of nonpublic

information by a corporate “outside” in breach of a duty owed not to a tradingparty, but to the source of information.(1) The misappropriation theory is thus designed to protect the integrity of

the securities markets against abuses by outsiders to a corporation whohave access to confidential information that will affect the corporation’ssecurity price when revealed, but who owe not fiduciary or other dutyto that corporation’s shareholders.49

5. The Court agrees with the Government that misappropriation, as just defined, satisfies §10(b)’s requirement that chargeable conduct involve a “deceptive device or contrivance”use “in connection with” the purchase or sale of securities.a. Misappropriators deal in deception. A fiduciary who pretends loyalty to the

principal while secretly converting the principal’s information for personal gaindupes of defrauds the principal.

b. Full disclosure forecloses liability under the misappropriation theory: Because thedeception essential to the misappropriation theory involves feigning fidelity to thesource of information, if the fiduciary discloses to the source that he plans to tradeon the nonpublic information, there is no “deceptive device” and thus no § 10(b)violation–although the fiduciary-turned-trader may remain liable under state lawfor breach of a duty of loyalty.

6. The element that the misappropriator’s deceptive use of information be “in connectionwith the purchase or sale of a security is also satisfied because the fiduciary’s fraud isconsummated, not when the fiduciary gains the confidential information, but when,

The Government could not have prosecuted O’Hagan under the classical theory, for O’Hagan was no an49

“insider” of Pillsbury, the corporation in whose stock he traded.

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without disclosure to his principal, he uses the information to purchase or sell securities.a. The securities transaction and the breach of duty thus coincide. This is so even

though the person or entity defrauded is not the other party to the trade, but is,instead, the source of the nonpublic information.

b. A misappropriator who trades on the basis of material, nonpublic information, inshort, gains his advantageous market position through deception; he deceives thesource of the information and simultaneous harms members of the investingpublic.

F. Supreme Court’s Previous Consideration of Misappropriation Theory. The Supreme Court in Carpenter v.United States (1987), affirmed R. Foster Winans’ convictions on all counts, though the securitiesfraud count was affirmed only by an evenly divided court (4-4). Winans published the Wall StreetJournal’s “Heard on the Street” column which provided investing advice and information. Thecolumn had a short-lived effect on the price of stocks it covered. Though it was the Journal’spolicy to keep the contents of the column confidential before publication, Winans disclosed thecontents of his columns to several friends who then traded the affected stocks.

G. Rule 10b5-2. Rule 10b5-2 provides “a non-exclusive list of three situations in which a person has aduty of trust or confidence for purposes of the ‘misappropriation’ theory.”1. First, such a duty exists whenever someone agrees to maintain information in confidence. 2. Second, such a duty exists between two people who have a pattern or practice of sharing

confidences such that the recipient of the information knows or reasonable should knowthat the speaker expects the recipient to maintain the information’s confidentiality.

3. Third, such a duty exists when someone receives or obtains material nonpublicinformation from a spouse, parent, child, or sibling.

VI. Short-Swing ProfitsA. Reliance Electric Co. v. Emerson Electric Co. (S. Ct. 1972).

1. Section 16(b) of the Securities Act of 1934 provides, among other things, that acorporation may recover for itself the profits realized by an owner of more than 10% of itsshares from a purchase and sale of its stock within any six-month period, provided that theowner held more than 10% “both at the time of the purchase and sale.”

2. The history and purpose of § 16(b) have been exhaustively reviewed by federal courts onseveral occasions since its enactment in 1934.a. Those courts have recognized that the only method Congress deemed effective to

curb the evils of insider trading was a flat rule taking the profits out of a class oftransactions in which the possibility of abuse was believed to be intolerably great.

b. Congress did not reach every transaction in which an investor actually relies oninside information. A person avoids liability is he does not meet the statutorydefinition of an “insider,” or if he sells more than six months after purchase.

3. Among the “objective standards” contained in § 16(b) is the requirement that a 10%owner be such “both at the time of the purchase and sale ... of the security involved.”a. Read literally, this language clearly contemplates that a statutory insider might sell

enough shares to bring his holdings below 10%, and later–but still within sixmonths–sell additional shares free from liability under the statute.(1) Indeed, commentators on the securities law have recommended this

exact procedure for a 10% owner who, like Emerson, wishes to disposeof his holders within six months of their purchase.

B. Foremost-McKesson, Inc. v. Provident Securities Company (S. Ct. 1976).1. Issue. Whether a person purchasing securities that put his holdings above the 10% level is a

beneficial owner “at the time of the purchase” so that he must account for profits realizedon a sale of those securities within six months.

2. Section 16(b) provides that a corporation may capture for itself the profits realized on apurchase and sale, or sale and purchase, of its securities within six months by a director,officer, or beneficial owner.

3. Section 16(b)’s last sentence, however, provides that it “shall not be construed to cover anytransaction where such beneficial owner was not such both at the time of the purchase and

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sale, or the sale and purchase, of the security involved...”4. The legislative record reveals that the drafters focused directly on the fact that the original

draft of the bill that became § 16(b) covered a short-term purchase-sale sequence by abeneficial owner only if his status existed before the purchase, and no concern wasexpressed about the wisdom of this requirement.a. But the explicit requirement was omitted from the operative language when it

was restructured to cover sale-repurchase sequences. b. In the same draft, however, the exemptive provision was added to the section.

(1) On this record, we are persuaded that the exemptive provision wasintended to preserve the requirement of beneficial ownership before thepurchase. We hold that in a purchase-sale sequence, a beneficial ownermust account for profits only if he was a beneficial owner “before thepurchase.”

CHAPTER SIX: PROBLEMS OF CONTROL

I. Proxy Fights*A. Strategic Use of Proxies*B. Reimbursement of Costs*C. Private Actions for Proxy Rule Violations*D. Shareholder Proposals*E. Shareholder Inspection Rights*

II. Shareholder Voting Control*III. Control in Closely Held Corporations

A. Voting1. Straight Voting. In straight voting, each share may be voted for as many candidates as there

are slots on the board, but no share may be voted more than once for any given candidate. Directors are elected by a plurality (not necessarily majority) of the votes cast.

2. Cumulative Voting. Cumulative voting entitles a shareholder to cumulate or aggregate hisvotes in favor of fewer candidates than there are slots available, including in the extremecase aggregating all of his votes for just one candidate. The consequences are that aminority shareholder is far more likely to be able to obtain at least one seat on the board.a. Mandatory/Permissive Cumulative Voting. Corporations formed after January 1,

1987 are governed by the ‘87 Act while those formed before are governed by the‘65 Act, under which cumulative voting is required.(1) A corporation governed under the ‘65 Act can elect to be governed by

the ‘87 Act.b. Removal of Directors. In most states, shareholders have the right to remove a

director without cause at any time during his term. Consequently, because theright of cumulative voting would be completely nullified if an election to removewere done by a straight “yes or no” vote at which the majority of votes castdetermined the result, most states have a special provision to prevent this result.(1) Under MBCA § 8.08(c), if a corporation has cumulative voting, the

director cannot be removed if the number of votes cast against hisremoval would have been enough to elect him.

3. Staggered Board. Only a minority of the board will stand for election in any given year. The rationale given is that there will be a continuity of experience on the board. It is alsoused as a takeover defense mechanism.

B. The Statutory Norm. “The business of a corporation shall be managed by its board of directors.” Traditionally, powers have been allocated among the shareholders, the directors and the officers of acorporation in a particular way. Even today, most statutes assume that this allocation of powers willbe followed. 1. Shareholders. The shareholders act principally through two mechanism: (1) electing a

removing directors; and (2) approving or disapproving fundamental or non-ordinary changes (e.g.,mergers).

2. Directors. The directors “manage” the corporation’s business. That is, they formulate

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policy, and appoint officers to carry out that policy.3. Officers. The corporation’s officers administer the day-to-day affairs of the corporation,

under the supervision of the board.4. Inappropriate for Large or Closely-Held Corporations. For very large or very small

corporations, this statutory scheme does not reflect reality.a. A small corporation generally does not have its affairs managed by the board of

directors–the shareholders usually exercise control directly (they may happen alsoto be directors, but they usually do not act as a body of directors, and thecontrolling shareholders often disregard any non-shareholder directors).

b. A very large publicly-held company is really run by its officers, and the board ofdirectors frequently serves as little more than a “rubber-stamp” to approvedecisions made by officers.

C. Shareholder Vote Pooling Agreement. An agreement in which two or more shareholders agree to votetogether as a unit on certain or all matters.1. Disagreement. What if the shareholders disagree? Arbitration? How do you enforce the

decision? Proxies? To make irrevocable, the proxy must say that it is irrevocable and itmust be coupled with an interest.

2. MBCA § 7.32 validates shareholder agreements no matter how far they stray from thestatutory norm (non-public corporations).a. Can eliminate the board of directors altogether.b. Shareholder Agreement. The shareholder must agree. Notice to new shareholders

is given on the stock certificate. D. Ringling Bros.-Barnum & Bailey Combined Shows v. Ringling (Del. Sup. Ct. 1947).

1. Facts. The corporation had 1000 shares outstanding (315 by petitioner Edith, 315 bydefendant Aubrey and 370 by defendant John. Edith alleged that Aubrey was bound tovote her share for an adjournment of the meeting, or in the alternative, for a certain slateof directors. The agreement was entered into in 1941. First, the agreement provided thateach party “will consult and confer with the other and the parties will act jointly inexercising such voting rights in accordance with such agreement as they may reach withrespect to any matter calling for the exercise of such voting rights.” Second, in the eventthat the parties disagreed, the disagreement was to be submitted to arbitration to Mr. Looso Washington, D.C. The arbitrator’s decision was to be binding. Finally, the agreementwas to be in effect for a period of ten years unless terminated earlier by mutual agreement. A disagreement arose before the ‘46 meeting between Mr. Haley (acting on behalf ofAubrey) and Edith. Edith demanded that Mr. Koos arbitrate the dispute. He concludedthat both parties vote to adjourn for 60 days. Mr. Haley opposed the motion to adjourn. The chairman concluded that the motion carried but proceeded with the election of thedirectors, regardless.

2. Issue. Should the agreement be interpreted as attempting to empower the arbitrator tocarry his directions into effect?a. Certainly there is no express delegation or grant of power to do so, either by

authorizing him to vote the shares or to compel either party to vote them inaccordance with his directions.

b. The agreement expresses no other function of the arbitrator than that of decidingquestion in disagreement which prevent the effectuation of the purpose “to actjointly.” The power to enforce a decision does not seem a necessary or usual incident ofsuch a function.(1) Mr. Loos is not a party to the agreement. It does not contemplate the

transfer of any shares or interest in shares to him, or that he shouldundertake any duties which the parties might compel him to perform. The parties provided that they might designed any other individual toact instead of Mr. Loos. The agreement doesn’t attempt to make thearbitrator a trustee of an express trust. Whether the parties accept orreject his decision is no concern of his, so far as the agreement or

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surrounding circumstances reveal.(2) We think the parties sought to bind each other, but to be bound only to

each other, and not to empower the arbitrator to enforce decisions hemight make.(a) From this conclusion, it follows necessarily that no decision of the

arbitrator could ever be enforced if both parties to the agreement wereunwilling that it be enforced, for the obvious reason that there would beno one to enforce it.

(3) The language in the agreement with respect to a decision of thearbitrator other than to provide that it “shall be binding upon theparties,” when considered in relation to its context and the situations towhich it is applicable, means that each party promised the other toexercise her own voting rights in accordance with the arbitrator’sdecision.(a) The agreement is silent about any exercise of the voting rights

of one party by the other. There is nothing to justify implyinga delegation of the power in the absence of some indicationthat the parties bargained for that means. We do not findenough in the agreement or in the circumstances to justify aconstruction that either party was empowered to exercisevoting right of the other.

(4) Separating the Voting Right of Stock From Ownership. The defendantscontend that there is an established doctrine “that there can be noagreement, or any device whatsoever, by which the voting power ofstock of a Delaware corporation may be irrevocably separated fromownership of the stock, except by an agreement which complied with[statute].”(a) The defendants’ sweeping formulation would impugn well-

recognized means by which a shareholder may effectivelyconfer his voting rights upon others while retaining variousother rights.

(b) Various forms of such pooling agreements, as they aresometimes called, have been held valid and have beendistinguished from voting trusts.

(c) Generally speaking, a shareholder may exercise wide liberalityof judgment in the matter of voting, and it is not objectionablethat his motive may be for personal profit, or determined bywhims or caprice, so long as he violates no duty owed to hisfellow shareholders.

(5) Voting Agreements Okay. The ownership of voting stock imposes nolegal duty at all. A group of shareholders, may, without impropriety,vote their respective shares so as to obtain advantages of concertedaction.(a) Provisions Regarding Deadlock Okay. Reasonable provisions for

cases of failure of the group to reach a determination because ofan even division in their ranks seem unobjectionable.

c. Right to Reject Votes. The Court of Chancery may, in a review of an election,reject votes of a registered shareholder where his voting of them is found to be inviolation of right of another person.(1) We have concluded that the election should not be declared invalid, but

that effect should be given to a rejection of the votes representing Mrs.Haley’s shares.

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E. McQuade v. Stoneham (N.Y. 1934).1. Although it has been held that an agreement among stockholders whereby it is attempted

to divest the directors of their power to discharge an unfaithful employee of thecorporation is illegal as against public policy, it must be equally true that the stockholdersmay not, by agreement among themselves, control the directors in the exercise of thejudgment vested in them by virtue of their office and to elect officers and fix salaries. Their motives may not be questioned so long as their acts are legal. The bad faith or theimproper motives of the parties does not change the rule. Directors may not byagreements entered into as stockholders abrogate their independent judgment.

2. Agreeing to Combine to Elect Directors. Stockholders may, of course, combine to electdirectors. That rule is well settled.a. Limitations on Power to Unite. The power to unite is, however, limited to the

election of directors and is not extended to contracts whereby limitations areplaced on the power of directors to manage the business of the corporation by theselection of agents at defined salaries.

3. Stoneham and McGraw were not trustees for McQuade as an individual. Their duty was50

to the corporation and its stockholders, to be exercised according to their unrestrictedlawful judgment. They were under no legal obligation to deal righteously with McQuadeif it was against public policy to do so.

4. The court holds that it is restrained by authority to hold that a contract is illegal and voidso far as it precludes the board of directors, at the risk of incurring legal liability, fromchanging officers, salaries, or policies or retaining individuals in office, except by consentof the contracting parties.51

5. Concurring Opinion. The agreement contemplated no restriction upon the powers of theboard of directors, and no dictation or interference by stockholders except in so far asconcerns the election and remuneration of officers and the adhesion by the corporation toestablished policies.a. It seems difficult to reconcile such a decision with the statements in the opinion

of Manson v. Curtis that “it is not illegal or against public policy for two or morestockholders owning the majority of the shares of stock to unite upon a course ofcorporate policy or action, or upon the officers whom they will elect,” and that“shareholders have the right to combine their interests and voting powers tosecure such control of the corporation and the adoption of and adhesion by it to aspecific policy and course of business.”

b. The directors have the power and the duty to act in accordance with their ownbest judgment so long as they remain directors. The majority stockholders cancompel no action by the directors, but at the expiration of the term of office ofthe directors the stockholders have the power to replace them with others whoseactions coincide with the judgment or desires of the holders of a majority of thestock.

F. Clark v. Dodge (N.Y. 1936).1. Issue. The only question which need be discussed is whether the contract is illegal as

against public policy within the decision in McQuade v. Stoneham.2. Statutory Norm. The business of a corporation shall be managed by its board of directors.’

Gen. Corp. Law § 27. a. That is the statutory norm. Are we committed by the McQuade case to the

“A trustee is held to something stricter than the morals of the marketplace.” Meinhard v. Salmon.50

The court also concludes, in the alternative, that the agreement was invalid because at the time of the51

contract, McQuade was also a city magistrate. A New York City criminal statute prohibited from holding otheremployment during his government service.

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doctrine that there may be no variation, however slight or innocuous, from thatnorm, where salaries or policies or the retention of individuals in office areconcerned?

b. Basis of McQuade Nebulous. Apart from its practical administrative convenience,the reasons upon which it is said to rest are more or less nebulous. Public policy,the intention of the Legislature, detriment to the corporation, are phrases whichin this connection mean little. Possible harm to bona fide purchasers of stock orto creditors or to stockholding minorities have more substance; but such harmsare absent in many instances.

c. No Harm in Agreements. If the enforcement of a particular contract damagesnobody-not even, in any perceptible degree, the public-one sees no reason forholding it illegal, even though it impinges slightly upon the broad provision of §27.

3. Directors as Sole Stockholders–Agreement Enforceable. Where the directors are the solestockholders, there seems to be no objection to enforcing an agreement among them tovote for certain people as officers. There is no direct decision to that effect in this court,yet there are strong indications that such a rule has long been recognized.

4. Agreement Did Not Sterilize the Board. Except for the broad dicta in the McQuade opinion,we think there can be no doubt that the agreement here in question was legal and that thecomplaint states a cause of action. There was no attempt to sterilize the board of directors,as in the Manson and McQuade cases.

5. McQuade Confined to Its Facts. If there was any invasion of the powers of the directorateunder that agreement, it is so slight as to be negligible; and certainly there is no damagesuffered by or threatened to anybody. The broad statements in the McQuade opinion,applicable to the facts there, should be confined to those facts.

G. Agreements Requiring Election of Directors. Agreements by which the shareholders simply commit toelecting themselves, or their representatives , as directors, are generally considered unobjectionable,and are now expressly validated in many jurisdictions. They do not interfere with the obligations ofthe director to exercise their sound judgment in managing the affairs of the corporation.1. Agreements Requiring Appointment of Particular Officers/Employees. The courts have had more

difficulty with shareholder agreements requiring the appointment of particular individualsas officers or employees of the corporation, since such agreements do deprive the directorsof one of their most important functions.

H. Voting Trust. Another device that can be used for control is the voting trust, a device specificallyauthorized by the corporation laws of most states. With a voting trust, shareholders who which toact in concert turn their shares over to a trustee. The trustee then votes all the shares, in accordancewith instructions in the document establishing the trust.1. The general requirements for creating a voting trust are as follows: (1) a written agreement,

signed by the trustees and the beneficiary; (2) property is conveyed into the trust, i.e., theshareholders transfer some or all of their shares to the trustee; (3) the books of thecorporation are changed to reflect that the trustees have the right to vote the stock; and (4)the voting trust issues certificates to the beneficiaries.a. Early Hostility. Early courts were hostile to voting trusts because they separated

shareholders’ voting power and economic ownership interests. Today, statutesspecifically authorize voting trusts in virtually all jurisdictions.(1) MBCA § 7.30 sets a maximum term for such a trust at ten years. This is

in contrast with the Delaware corporation law which does not contain asunset provision.

b. Why a Voting Trust? (1) Provides cohesion and certainty to management in largecompanies with a large number of shareholders; (2) Regulatory agencies wantassurance that control of the business isn’t transferred without consent; (3)Closely-held family corporations; (4) Creditors may insist as a condition ofmaking loan the power along with the power to appoint trustee.

2. Proxy. A written grant of authority that grants the right to vote stock.

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a. Generally Revocable. Generally, a proxy is revocable by the shareholder, even ifthe proxy itself recites that it is irrevocable.

b. Exception for Proxy Coupled with Interest. All states, however, recognize one majorexception to this general rule of revocability: a proxy is irrevocable if it meets tworequirements: (1) it states that it is irrevocable; and (2) it is coupled with aninterest.(1) Coupled with an Interest. The recipient of the proxy must have some

property interest in the shares, or at lease some other direct economicinterest in how the vote is cast.52

I. Special Statutes for Closely Held Corporations. Provisions vary widely from state to state. Generally,they allow certain corporations to elect (it’s voluntary) close corporation status (whereupon thecorporation is said to be a statutory close corporation).1. Ex. In Delaware, close corporation status may be elected by corporations with not more

than 30 shareholders.a. Del. Gen. Corp. Law § 351 provides, “The certificate of incorporation of a close

corporation may provide that the business of the corporation shall be managed bythe stockholders of the corporation rather than by a board of directors.”

J. Limited Liability Company. With an LLC, issues of control are largely left to individual choice,reflected in a document, drafted by (or for) the investors (the “members”) and called “regulations”or “operating agreement” or something of the sort.1. Member Managed (like a partnership) or Manager Managed (like a corporation).

K. Ramos v. Estrada (Cal. App. 1992).1. Cal. Corp. Code § 178 defines a proxy to be “a written authorization signed ... by a

shareholder ... giving another person power to vote with respect to shares of suchshareholder.”a. No Proxy Statement Created. No proxies are created by this agreement. The

agreement has the characteristics of a shareholders' voting agreement expresslyauthorized by § 706(a) for close corporations. Although the articles ofincorporation do not contain the talismanic statement that “This corporation is aclose corporation,” the arrangements of this corporation, and in particular thisvoting agreement, are strikingly similar to ones authorized by the Code for closecorporations.

2. Section 706(a) states, in pertinent part: “an agreement between two or more shareholdersof a close corporation, if in writing and signed by the parties thereto, may provide that inexercising any voting rights the shares held by them shall be voted as provided by theagreement, or as the parties may agree or as determined in accordance with a procedureagreed upon by them....”3. Even though this corporation does not qualify as a close corporation, this

agreement is valid and binding on the Estradas. §706(d) states: “This section shallnot invalidate any voting or other agreement among shareholders ... whichagreement ... is not otherwise illegal.”a. The Legislative Committee comment regarding § 706(d) states that

“[t]his subdivision is intended to preserve any agreements which wouldbe upheld under court decisions even though they do not comply with one ormore of the requirements of this section, including voting agreements of

MBCA § 7.22(d) gives a catalog of people who will be deemed to hold a suitable “interest”: (1) a pledgee52

(e.g., a holder pledges his share in return for a loan from bank, and gives bank, the pledgee, his proxy); (2) a personwho has purchased or agreed to purchase the shares; (3) a creditor of the corporation (e.g., creditor says he won’t give credit tocorporations unless the controlling shareholder gives creditor a proxy that’s irrevocable while the debt is outstanding;and a party to a voting agreement (e.g., A, B, and C are the shareholders in a closely-held corporation; they sign a votingagreement to vote their shares together, which impliedly gives the two shareholders in the majority on any ballot anirrevocable proxy to vote the shares of the third).

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corporations other than close corporations.”4. The agreement calls for enforcement by specific performance of its terms because the stock

is not readily marketable. Section 709(c) expressly permits enforcement of shareholdervoting agreements by such equitable remedies. It states, in pertinent part: “The court maydetermine the person entitled to the office of director or may order a new election to beheld or appointment to be made, may determine the validity, effectiveness andconstruction of voting agreements ... and the right of persons to vote and may direct suchother relief as may be just and proper.”

IV. Abuse of ControlA. Donahue v. Rodd Electrotype (Mass. 1975).

1. Facts. Plaintiff was a minority shareholder in a corporation who had inherited her sharesfrom her husband, an employee of the corporation. The corporation had previouslybought back shares from its majority stockholder at a high price. It refused to buy a similarportion of P’s shares back from her at anything close to that price, thus leaving her with alargely unmarketable interest.

2. Close Corporation. There is no single, generally accepted definition. Some commentatorsemphasize an ‘integration of ownership and management’ in which the stockholdersoccupy most management positions. Others focus on the number of stockholders and thenature of the market for the stock. In this view, close corporations have few stockholders;there is little market for corporate stock. The court accepts aspects of both definitions:a. The court deems a close corporation to be typified by: (1) a small number of

stockholders; (2) no ready market for the corporate stock; and (3) substantialmajority stockholder participation in management, directors and operations of thecorporation.

3. Close Corporation Similar to Partnership. As thus defined, the close corporation bears astriking resemblance to a partnership. Commentators and courts have noted that the closecorporation is often little more than an ‘incorporated’ or ‘chartered’ partnership. Thestockholders ‘clothe’ their partnership with the benefits peculiar to a corporation, limitedliability, perpetuity and the like.a. Relationship of Trust. Just as in a partnership, the relationship among the

stockholders must be one of trust, confidence and absolute loyalty if the enterpriseis to succeed. Disloyalty and self-seeking conduct on the part of any stockholderwill engender bickering, corporate stalemates, and perhaps, efforts to achievedissolution.

4. Although the corporate form provides the above-mentioned advantages for thestockholders (limited liability, perpetuity, and so forth), it also supplies an opportunity forthe majority stockholders to oppress or disadvantage minority stockholders.a. The minority can, of course, initiate suit against the majority and their directors.

Self-serving conduct by directors is proscribed by the director’s fiduciaryobligation to the corporation. However, in practice, the plaintiff will finddifficulty in challenging dividend or employment policies. Such policies areconsidered to be within the judgment of the directors.(1) Thus, when these types of ‘freeze-outs’ are attempted by the majority

stockholders, the minority stockholders, cut off from all corporation-related revenues, must either suffer their losses or seek a buyer for theirshares. Many minority stockholders will be unwilling or unable to waitfor an alteration in majority policy.(a) At this point, the true plight of the minority stockholder in a

close corporation becomes manifest. He cannot easily reclaimhis capital. In a large public corporation, the oppressed ordissident minority stockholder could sell his stock in order toextricate some of his invested capital. By definition, thismarket is not available for shares in the close corporation.

5. In a partnership, a partner who feels abused by his fellow partners may cause dissolution by

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his ‘express will at any time’ and recover his share of partnership assets and accumulatedprofits. By contrast, the stockholder in the close corporation or ‘incorporated partnership’may achieve dissolution and recovery of his share of the enterprise assets only bycompliance with the rigorous terms of the applicable chapter of the General Laws.a. The minority stockholders may be trapped in a disadvantageous situation. No

outsider would knowingly assume the position of the disadvantage minority. Theoutsider would have the same difficulties. This is the capstone of the majorityplan. Majority ‘freeze-out’ schemes which withhold dividends are designed tocompel the minority to relinquish stock at inadequate prices.

6. Close Corp. Stockholders Owe One Another Fid. Duty. Because of the fundamentalresemblance of the close corporation to the partnership, the trust and confidence which areessential to this scale and manner of enterprise, and the inherent danger to minorityinterests in the close corporation, the court holds that stockholders in the close corporationowe one another substantially the same fiduciary duty in the operation of the enterprisethat partners owe to one another.

7. Equal Opportunity in a Close Corporation. We hold that, in any case in which thecontrolling stockholders have exercised their power over the corporation to deny theminority such equal opportunity, the minority shall be entitled to appropriate relief.a. Remedy. (1) The judgment may require Rodd to remit $36,000 with interest at

the legal rate to Rodd Electrotype in exchange for forty-five shares of RoddElectrotype treasury stock or (2) The judgment may require Rodd Electrotype topurchase all of the plaintiff’s shares for $36,000 without interest.

B. Wilkes v. Springside Nursing Home, Inc. (Mass. 1976).1. Facts. Four men (Wilkes, Riche, Quinn, and Pipkin) each invested $1,000 and acquired

10 shares of a Mass. corp. called Springdale, which was incorp. for the purpose of runninga nursing home out of an old hospital. It was understood by the four parties, at the time ofincorp., that they would each participate in management of the corp. It was alsounderstood that they would receive money in equal amounts as long as each assumed hisresponsibility. The business became profitable. In ‘59, Pipkin sold his shares to Connor,president of F.N. Agr. Bank, due to illness. In ‘65, Quinn purchased a portion of thecorp. property. Wilkes apparently helped inflate the price and his and Quinn’s relationshipdeterioated. Wilkes was not given a salary when the board exercised its right to establishthem and not reelected as a director or officer at the ‘67 annual meeting. He was informedhis presence was not welcome. The master found that this exclusion was not due toneglect or misconduct but rather because of bad personal relationships.

2. In Donahue, we held that “stockholders in the corporation owe one another substantiallythe same fiduciary duty in the operation of the enterprise that partners own to oneanother.”a. As determined in previous decisions of this court, the standard of duty owed by

partners to one another is one of “utmost good faith and loyalty.”3. Thus, we concluded in Donahue, with regard to “their actions relative to the operations of

the enterprise and the effects of that operation on the rights and investments of otherstockholders, [s]tockholders in close corporations must discharge their management andstockholder responsibilities in conformity with this strict good faith standard. They maynot act out of avarice, expediency, or self-interest in derogation of their duty of loyalty tothe other stockholders and to the corporation.”a. Freeze-Outs. In the Donahue case we recognized that one peculiar aspect of close

corporations was the opportunity afforded to majority stockholders to oppress,disadvantage or “freeze out” minority stockholders.53

In Donahue itself, for example, the majority refused the minority an equal opportunity to sell a ratable53

number of shares to the corporation at the same price available to the minority. The net result of this refusal was thatthe minority could be forced to “sell out at less than fair value,” since there is by definition no ready market for

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(1) Deprivation of Corporate Offices & Employment. “Freeze outs” may beaccomplished by the use of other devices. One such device which hasproved to be particularly effective in accomplishing the purpose of themajority is to deprive minority stockholders of corporate offices and ofemployment with the corporation.(a) Courts Hesitant to Interfere with Corp. Internal Affairs. This

freeze-out technique has been successful because courts fairlyconsistently have been disinclined to interfere in those facets ofinternal corporate operations, such as the selection andretention or dismissal of officers, directors, and employees,which essentially involve management decisions subject to theprinciple of majority control.

(b) The denial or employment to the minority at the hands of themajority is especially pernicious in some instances. A guarantyof employment with the corporation may have been one of the“basic reasons why a minority owner has invested capital in thefirm.”

b. The Donahue decision acknowledged, as a “natural outgrowth” of the case law inthis Commonwealth, a strict obligation on the part of majority stockholders in aclose corporation to deal with the minority with the utmost good faith andloyalty.(1) Concern of Donahue Standard Tempering Legitimate Action. The court is

concerned that the untempered application of the strict good faithstandard enunciated in the Donahue case to cases such as this one willresult in the imposition of limitations on legitimate action by thecontrolling group in a close corporation which will unduly hamper itseffectiveness in managing the corporation in the best interests of allconcerned. (a) Selfish Ownership. The majority, concededly, have certain

rights to what has been termed selfish ownership in thecorporation which should be balanced against the concept oftheir fiduciary duty to the minority.

4. Balancing Test. Therefore, when minority stockholders in a close corporation bring suitagainst the majority alleging breach of the strict good faith duty owed to them by themajority, the court must carefully analyze the action taken by the controlling stockholdersin the individual case.a. Legitimate Business Purpose. Whether the controlling group can demonstrate a

legitimate business purpose for its action.(1) In making this determination, the court must acknowledge the fact that

the controlling group in a close corporation must have some room tomaneuver in establishing the business policy of the corporation. It musthave a large measure of discretion, for example, in declaring orwithholding dividends, deciding whether to merge or consolidate,establishing the salaries of corporate officers, dismissing directors with orwithout cause, and hiring and firing corporate employees.

b. Less Harmful Alternative? When an asserted business purpose is advanced, it isopen to the minority to demonstrate that the same legitimate objective couldhave been achieved through an alternative course of action less harmful to theminority’s interest.

minority stock in a close corporation.

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C. Ingle v. Glamore Motor Sales, Inc. (N.Y. 1989).1. Facts. In ‘64, Ingle sought to purchase an equity interest in Glamore but was instead

initially hired as a sales manager. In ‘67, Ingle and Glamore entered into a shareholders’agreement that provided that Ingle would purchase 22 shares of the 100 shares in the corp.and that Ingle would have an five-year option to purchase 18 more shares and thatGlamore would nominate and vote Ingle as a director and secretary. The agreement alsogave Glamore the right to purchase back the stock if Ingle ceased to be an employee for anyreason. In ‘82, 60 more shares were issued which were purchased by Glamore and his twosons. A third agreement was entered into with a repurchase provision stating that if anystockholder shall cease to be an employee of the Corp. for any reason, Glamore would have anoption to repurchase within 30 days. Ingle was voted out in ‘83 and fired. Glamorenotified Ingle that he was exercising his option.

2. A minority shareholder in a close corporation, by that status alone, who contractuallyagrees to the repurchase of his shares upon termination of his employment for any reason,acquires no right from the corporation or majority shareholders against at-will discharge. There is nothing in law, in the agreement, or in the relationship of the parties to warrantsuch a contradictory and judicial alteration of the employment relationship or the expressagreement.a. It is necessary to appreciate and keep distinct the duty a corporation owes to a

minority shareholder as a shareholder from any duty it might owe him as anemployee.(1) Under the established common-law rule–and without any reference to

the shareholders’ agreement–the corporation had the right to dischargeplaintiff at will.(a) In Murphy v. American Home Products Corp. the court concluded

that there is no implied obligation of good faith and fair dealingin an employment at will, as that would be incongruous to thelegally recognized jural relationship in that kind of employmentrelationship.

b. Divestiture of his status as a shareholder, by operation of the repurchase provision,is a contractually agreed to consequence flowing directly from the firing, not viceversa.

c. No duty of loyalty and good faith akin to that between partners, precludingtermination except for cause, arises among those operating a business in thecorporate form who “have only the rights, duties and obligations of stockholders”and not those of partners.

3. Dissent. The majority is incorrect in treating the case as one of a claimed breach of ahiring contract by the employer rather than an unfair squeeze-out of a minorityshareholder in a close corporation by the majority.a. The majority’s decision summarily rejects, without discussion, plaintiff’s

underlying theory which is rooted in his equitable rights as a minority shareholderand principal in a close corporation and the fiduciary duty of fair dealing owedhim by the majority shareholders–rights and duties which have been widelyrecognized in statutory and decisional law in this and other jurisdictions. Wilkesv. Springside Nursing Home (Mass. 1976).

b. The relationship of a minority shareholder to a close corporation, if fairly viewed,cannot possibly be equated with an ordinary hiring and, in the absence of acontract, regarded as nothing more than an employment at will.

D. Brodie v. Jordan (Mass. 2006).1. Brodie, Barbuto and Jordan each held one-third of the shares of the Malden. After Brodie

ceased participating in the day-to-day operations, disagreements between him and Barbutoand Jordan arose. His requests to be bought out were denied. In ‘92, Walter was votedout as president and replaced by Jordan. Walter died in ‘97 and his wife inherited hisshare. She attended an annual shareholder’s meeting, through counsel, at which she

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nominated herself for director. Jordan and Barbuto voted against her election. She alsoasked for a valuation of the company, which was denied.

2. “Stockholders in a close corporation own one another substantially the same fiduciary dutyin the operation of an enterprise that partners owe one another. That is, a duty of “utmostgood faith and loyalty.” Donahue v. Rodd Electrotype Co. Of New England. a. Majority shareholders in a close corporation violate this duty when they act to

“freeze-out” the minority. (1) Freeze Outs. The squeezers [those who employ the freeze-out

techniques] may refuse to declare dividends; they may drain off thecorporation's earnings in the form of exorbitant salaries and bonuses tothe majority shareholder-officers and perhaps to their relatives, or in theform of high rent by the corporation for property leased from majorityshareholders; they may deprive minority shareholders of corporateoffices and of employment by the company; they may cause thecorporation to sell its assets at an inadequate price to the majorityshareholders.(a) What these examples have in common is that, in each, the

majority frustrates the minority's reasonable expectations ofbenefit from their ownership of shares.

b. Shareholder’s Reasonable Expectations. We have previously analyzed freeze-outs interms of shareholders' “reasonable expectations” both explicitly and implicitly. SeeBodio v. Ellis Mass. 1987) (thwarting minority shareholder's “rightful expectation”as to control of close corporation was breach of fiduciary duty); Wilkes v.Springside Nursing Home, Inc. (Mass. 1976) (denying minority shareholdersemployment in corporation may “effectively frustrate [their] purposes in enteringon the corporate venture”). (1) A number of other jurisdictions, either by judicial decision or by statute,

also look to shareholders' “reasonable expectations” in determiningwhether to grant relief to an aggrieved minority shareholder in a closecorporation.

3. Remedy for Freezed Out Minority Shareholder. The proper remedy for a freeze-out is torestore the minority shareholder as nearly as possible to the position she would have beenin had there been no wrongdoing.a. If, for example, a minority shareholder had a reasonable expectation of

employment by the corporation and was terminated wrongfully, the remedy maybe reinstatement, back pay, or both.

b. Similarly, if a minority shareholder has a reasonable expectation of sharing incompany profits and has been denied this opportunity, she may be entitled toparticipate in the favorable results of operations to the extent that those resultshave been wrongly appropriated by the majority.

E. Smith v. Atlantic Properties, Inc. (Mass. App. 1981).1. Facts. Wolfson purchased property in ‘51 for $350,000 ($50,000 down and a note, payable

in 33 months, for the remainder). He offered a 1/4th interest in the property to Smith,Zimble, and Burke, who each paid $12,500. Smith, an attorney, organized Atlantic tooperate the property. Each of the four investors received 25 shares. The articles ofincorporation and by-laws included an 80% provision and had the effect of giving any oneof the investors a veto in corporate decisions. Atlantic, after selling some assets, retainedabout 28 acres. Atlantic showed a profit during subsequent years and the mortgage waspaid. Disagreements arose between Wolfson and the other stockholders as a group. Wolfson desired repairs to structures on the property, the other stockholders desireddividends. He exercise his veto power in spite of potential IRS penalties–which weresoon assessed in ‘62, ‘63, and ‘64. Further penalties were assessed in ‘65, ‘66, ‘67, and ‘68.

2. Donahue Rule. The court in Donahue relied on the resemblance of a close corporation to apartnership and held that stockholders in the close corporation owe one another

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substantially the same fiduciary duty in the operation of the enterprise that partners owe toone another. That standard, the court said, was the utmost duty of good faith and loyalty. The court went on to say that such stockholders may not act out of avarice, expediency, orself-interest in derogation of their duty of loyalty to the other stockholders and to thecorporation.

3. Majority Shareholders May Seek Protection. In the Donahue case, the court recognized thatcases may arise in which, in a close corporation, majority stockholders may ask protectionfrom a minority stockholder. a. Such an instance arises in the present case because Dr. Wolfson has been able to

exercise a veto concerning corporate action on dividends by the 80% provision(in Atlantic's articles or organization and by-laws) already quoted. The 80%provision may have substantially the effect of reversing the usual roles of themajority and the minority shareholders. The minority, under that provision,becomes an ad hoc controlling interest.

4. Whatever may have been the reason for Dr. Wolfson's refusal to declare dividends (andeven if in any particular year he may have gained slight, if any, tax advantage fromwithholding dividends) we think that he recklessly ran serious and unjustified risks ofprecisely the penalty taxes eventually assessed, risks which were inconsistent with anyreasonable interpretation of a duty of “utmost good faith and loyalty.

F. Nixon v. Blackwell (Del. 1993).54

1. The tools of good corporate practice are designed to give a purchasing minoritystockholder the opportunity to bargain for protection before parting with consideration. Itwould do violence to normal corporate practice and our corporation law to fashion an adhoc ruling which would result in a court-imposed stockholder buy-out for which theparties had not contracted.

2. It would be inappropriate judicial legislation for this Court to fashion a specialjudicially-created rule for minority investors when the entity does not fall within thosestatutes, or when there are no negotiated special provisions in the certificate ofincorporation, by-laws, or stockholder agreements.

G. Jordan v. Duff and Phelps, Inc. (7th Cir. 1988).1. Facts. Jordan began work at Duff in ‘77. By ‘83 he had purchased 188 of 20,100 shares

outstanding. The shares were purchased at book value and he was required to sign anagreement before purchase. The agreement provided that upon certain events, thecorporation would buy back the stock. A board resolution, however, provided anexception allowing the stock to be kept for five years after termination. Jordan, seeking amove because of family strife, inquired about transferring and was denied. Jordansubsequently took a job in Houston. He finished the year out at Duff, however, to havehis stock valued at the end of the year. A merger between Duff and SP was soonannounced however, after Jordan had received a check for his stock. His stock wouldhave been valued much higher under the merger. He refused to cash the check and askedfor his stock back. This was denied and he filed suit. The merger, nevertheless, fellthrough after the Fed disapproved. Jordan amended his complaint to ask for rescissionrather than damages.

2. Close corporations buying their own stock, like knowledgeable insiders of closely heldfirms buying from outsiders, have a fiduciary duty to disclose material facts. The “specialfacts” doctrine developed by several courts at the turn of the century is based on the

The equal opportunity rule is at odds with the premise that equity investments in the corporation are54

permanent and are not subject to easy withdrawal, as in a partnership. That is, parties often choose the corporate formbecause it assures the stability of corporate resources. Shareholders can withdraw their investment only by selling toanother investor. Based on this, some recent courts have refused to infer partnership-type duties in close corporationsof the theory that parties could have contracted for them and, absent an agreement, corporate principles apply. Nixonv. Blackwell is representative of this trend.

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principle that insiders in closely held firms may not buy stock from outsiders inperson-to-person transactions without informing them of new events that substantiallyaffect the value of the stock.a. Because the fiduciary duty is a standby or off-the-rack guess about what parties

would agree to if they dickered about the subject explicitly, parties may contractwith greater specificity for other arrangements. It is a violation of duty to stealfrom the corporate treasury; it is not a violation to write oneself a check that theboard has approved as a bonus.(1) No Agreement, Express or Implied, Regarding No Duty to Disclose. The

stock was designed to bind Duff & Phelps's employees loyalty to thefirm. The buy-sell agreement tied ownership to employment. TheAgreement did not ensure that employees disregard the value of thestock when deciding what to do, and neither did the usual practice atDuff & Phelps. So the possibility that a firm could negotiate around thefiduciary duty does not assist Duff & Phelps; it did not obtain such anagreement, express or implied.

(2) Employment at will is still a contractual relation, one in which aparticular duration (“at will”) is implied in the absence of a contraryexpression. The silence of the parties may make it necessary to implyother terms-those we are confident the parties would have bargained forif they had signed a written agreement. One term implied in everywritten contract and therefore, we suppose, every unwritten one, is thatneither party will try to take opportunistic advantage of the other. “Thefundamental function of contract law (and recognized as such at leastsince Hobbes's day) is to deter people from behaving opportunisticallytoward their contracting parties, in order to encourage the optimaltiming of economic activity and to make costly self-protective measuresunnecessary.”

3. Dissent. The mere existence of a fiduciary relationship between a corporation and itsshareholders does not require disclosure of material information to the shareholders. Afurther inquiry is necessary, and here must focus on the particulars of Jordan’s relationshipwith Duff and Phelps.a. Jordan’s deal with Duff and Phelps required him to surrender his stock at book

value if he left the company. It didn’t matter whether he quit or was fired,retired, or died; the agreement is explicit on these matters. The majorityhypothesizes about “implicit parts of the relations between Duff & Phelps and itsemployees. But those relations are totally defined by:(1) The absence of an employment contract, which made Jordan an

employee at will(2) The shareholder agreement, which has no “implicit parts” that bear on

Duff & Phelps’ duty to Jordan, and explicitly tie his rights as ashareholder to his status as an employee

(3) A provision in the stock purchase agreement between Jordan and Duff& Phelps that “nothing herein contained shall confer on the Employeeany right to be continued in the employment of the Corporation.”

V. Control, Duration, and Statutory DissolutionA. Dissolution

1. Voluntary. In a corporation, a minority shareholder cannot dissolve the corporation. Thisrequires a board proposal and majority shareholder approval. See MBCA § 14.02. 55

Articles of dissolution are then filed with the Secretary of State.2. Administrative. The corporation is dissolved for failure to pay its franchise taxes. The

Two-thirds is required in some jurisdictions.55

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corporation can, however, pay its back taxes and be reinstated (resurrected). See Ark.Code Ann. § 4-27-1420 et seq.

3. Judicial. Modern corporate statutes provide a minority shareholder anotheroption–involuntary dissolution. The minority shareholder can ask a court to dissolve acorporation, and she would receive a final disposition after the corporation’s assets areliquidated and its affairs are wound up. A court in its discretion may order involuntary56

dissolution if the shareholder shows one of the statutory grounds:a. Board Deadlock. The directors cannot agree and the shareholders have been

unable to break the impasse on the board–and the corporation’s business issuffering as a result (irreparable injury to the corporation threatened or suffered).

b. Misconduct. Those in control have acted in a way that is “illegal, oppressive, orfraudulent.” See MBCA § 14.30(2)(iv).(1) Oppressive. Most litigation is over the meaning of oppression.

(a) Unfairness.c. Shareholder Deadlock. The shareholders are deadlocked–that is, the shareholders

have been unable to elect new directors for a specified period, such as twoconsecutive meetings. See MBCA § 14.30(2)(iii)

(a) Arkansas courts have tied oppression to reasonable expectationsof the minority shareholder. Smith v. Leonard, 317 Ark. 182,876 S.W.2d 266 (1994).57

B. Alaska Plastics, Inc. V. Coppock (Alaska 1980).1. No Market For Close Corp. Shares. In a corporation with publicly traded stock, dissatisfied

shareholders can sell their stock on the market, recover their assets, and invest elsewhere.In a close corporation there is not likely to be a ready market for the corporation's shares.a. The corporation itself, or one of the other individual shareholders of the

corporation, who are likely to provide the only market, may not be interested inbuying out another shareholder. If they are interested, majority shareholders whocontrol operate policy are in a unique position to “squeeze out” a minorityshareholder at an unreasonably low price.

2. From a dissatisfied shareholder's point of view, the most successful remedy is likely to be arequirement that the corporation buy his or her shares at their fair value. Ordinarily, thereare four ways in which this can occur:a. Articles of Incorporation. First, there may be a provision in the articles of

incorporation or by-laws that provide for the purchase of shares by thecorporation, contingent upon the occurrence of some event, such as the death ofa shareholder or transfer of shares.

b. Involuntary Dissolution. Second, the shareholder may petition the court for

Therefore, shareholders are not entitled to dissolution even if they prove a ground to do so. Courts are56

reluctant to dissolve a corporation: (1) dissolution is the ultimate form of corporate punishment, and (2) courts fearthat corporations, if dissolved, will be sold piecemeal and become worthless.

Court considers "oppressive actions to refer to conduct that substantially defeats the 'reasonable57

expectations' held by minority shareholders in committing their capital to the particular enterprise. A shareholderwho reasonably expected that ownership would lead him or her to a job, a share of corporate earnings, a place incorporate management, or some other form of security, would be oppressed in a very real sense when others in thecorporation seek to defeat those expectations and there exists no effective means of salvaging the investment."

A court considering a claim of oppression "must investigate what the majority shareholders knew, or shouldhave known, to be the petitioner's expectations in entering the particular enterprise. Majority conduct should not bedeemed oppressive simply because the petitioner's subjective hopes and desires in joining the venture are not fulfilled. Disappointment alone should not necessarily be equated with oppression."

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involuntary dissolution of the corporation. c. Statutory Right of Appraisal. Third, upon some significant change in corporate

structure, such as a merger, the shareholder may demand a statutory right ofappraisal.

d. Equitable Remedy for Breach of Fid. Duty. Finally, in some circumstances, apurchase may be justified as an equitable remedy upon a finding of a breach of afiduciary duty between directors and shareholders and the corporation or othershareholders.

3. Dissolution/Liquidation. As to the second method, Alaska's corporation code provides ashareholder may bring an action to liquidate the assets of a corporation upon a showingthat “the acts of the directors or those in control of the corporation are illegal, oppressiveor fraudulent....” A shareholder may also seek liquidation when “corporate assets are beingmisapplied or wasted.” Upon a liquidation of assets all creditors and the cost of liquidationmust be paid and the remainder distributed among all the shareholders “according to theirrespective rights and interests.”a. Extreme Remedy. Liquidation is an extreme remedy. In a sense, forced

dissolution allows minority shareholder to exercise retaliatory oppression againstthe majority. Absent compelling circumstances, courts often are reluctant to orderinvoluntary dissolution. As a result, courts have recognized alternative remediesbased upon their inherent equitable powers.(1) Alternative Remedies. Among those alternative remedies:

(a) An order requiring the corporation or a majority of itsstockholders to purchase the stock of the minority shareholdersat a price to be determined according to a specified formula orat a price determined by the court to be a fair and reasonableprice.

4. Statutory Appraisal. Available under the Alaska Business Corporation Act in twocircumstances where there is some fundamental corporate change: (1) the remedy isavailable upon the merger or consolidation with another corporation; or (2) upon a sale ofsubstantially all of the corporation's assets.a. De Facto Merger. In some circumstances courts have found that a corporate

transaction so fundamentally changes the nature of the business that there is a “defacto” merger which triggers the same statutory appraisal remedy.

5. Breach of a Fiduciary Duty Triggers Equitable Remedy. The Massachusetts Supreme JudicialCourt, in Donahue v. Rodd Electrotype Co., concluded that shareholders in closely heldcorporations owe one another a fiduciary duty.58

a. The California Supreme Court concluded that a controlling group ofshareholders owes a similar duty to minority shareholders. In Jones v. H. F.Ahmanson & Co. (Cal. 1969), the court held that a controlling block of stockcould not be used to give the majority benefits that were not shared with theminority.

b. We believe that Donahue and Ahmanson correctly state the law applicable to therelationship between shareholders in closely held corporations, or between thoseholding a controlling block of stock, and minority shareholders. We do notbelieve, though, that the existence and breach of a fiduciary duty amongcorporate shareholders supports the appraisal remedy ordered by the trial court inthis case.

“Because of the fundamental resemblance of the close corporation to the partnership, the trust and58

confidence which are essential to this scale and manner of enterprise, and the inherent danger to minority interests inthe close corporation, we hold that stockholders in the close corporation owe one another substantially the samefiduciary duty in the operation of the enterprise that partners owe to one another. In our previous decisions, we havedefined the standard of duty owed by partners to one another as the ‘utmost good faith and loyalty.’ ” Donahue.

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6. Trial Court’s Remedy Inappropriate. We are not aware of any authority which would allow acourt to order specific performance on the basis of an unaccepted offer, particularly onterms totally different from those offered. Such a rule would place a court in the impossibleposition of making and enforcing contracts between unwilling parties.a. Appropriate Remedy–Equal Opportunity. Donahue and Ahmanson suggest the

appropriate form of a remedy, however. In Donahue the court stated that where acontrolling shareholder took advantage of a special benefit, the fiduciary dutyowed to the other shareholders required that the corporation offer such a benefitequally: “The rule of equal opportunity in stock purchases by close corporationprovide equal access to these benefits for all stockholders.”

7. Derivative Suit Claim/Business Judgment Rule. Judges are not business experts, a fact whichhas become expressed in the so-called “business judgment rule.” The essence of thatdoctrine is that courts are reluctant to substitute their judgment for that of the board ofdirectors unless the board’s decisions are unreasonable.a. Unfair Distribution of Corp. Funds Will Trump Bus. Judg. Rule. If a stockholder is

being unjustly deprived of dividends that should be his, a court of equity will notpermit management to cloak itself in the immunity of the business judgment rule. Thus, there is authority for concluding that an unfair distribution of corporatefunds would be a proper subject for a derivative suit.

C. Meiselman v. Meiselman (N.C. 1983).1. North Carolina statute allowed a court to order dissolution where such relief was

“reasonably necessary for the protection of the rights and interests of the complainingshareholder.” As an alternative, the court could order a buy-out of the complainingshareholder’s shares.

2. Reasonable Expectations. The Supreme Court held that, at least in cases involving closecorporations, the complaining shareholder need not establish oppressive or fraudulentconduct by the controlling shareholder or shareholders. Instead, “rights and interest,”under the statute include “reasonable expectations,” which include expectations that theminority shareholder will participate in the management of the business or be employed bythe company but limited to expectations embodied in understandings, express or implied,among the participants.

D. Note on Limited Liability Companies1. Under the Delaware Limited Liability Co. Act § 18-604:

[U]pon resignation any resigning member is entitled to receive any distribution to which such memberis entitled under a limited liability company agreement and, if not otherwise provided in a limitedliability company agreement, such member is entitled to receive, within a reasonable time afterresignation, the fair value of such member's limited liability company interest as of the date ofresignation based upon such member's right to share in distributions from the limited liabilitycompany.

2. Thus, while in a corporation the default rule generally will be one of no right ofdissolution or buyout, under the LLC default rule members are granted that right.

E. Haley v. Talcott (Del. Ch. 2004).1. Facts. Haley and Talcott were members of Greg Real Estate, LLC, which owned the land

that a second company, Delaware Seafood (a.k.a. Redfin Grill), occupied. Haley andTalcott chose to create and operate the Redfin Grill as an entity solely owned by Talcott. However, due to a series of contracts between the two, the relationship was more similarto a partnership than a typical employer/employee relationship. The business grew into aprofitable one. The two parties exercised an option to purchase the land on which thebusiness was situated and both signed personal guaranties for the mortgage. A rift evolvedbetween the two due to Haley’s expectance to receive a share in the Redfin Grill. Letterswere exchange, revolving around Haley’s alleged resignation. A stalemate ensued due toHaley’s mere 50% interest in the LLC. While the agreement contained a detailed exitmechanism, it did not express any details about releasing the party from the personalguaranty or whether the party could resort to judicial dissolution in lieu of the exit

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mechanism. Therefore, Haley sought judicial dissolution of the LLC.2. Section 18-802 provides in its entirety:

On application by or for a member or manager the Court of Chancery may decree dissolution of alimited liability company whenever it is not reasonably practicable to carry on the business inconformity with a limited liability company.a. Section 18-802 of the Delaware LLC Act plays a role for LLCs similar to the role

that § 273 of the Delaware General Corporation Law plays for joint venturecorporations with only two stockholders.59

(1) Section 273 essentially sets forth three pre-requisites for a judicial orderof dissolution: 1) the corporation must have two 50% stockholders; 2)those stockholders must be engaged in a joint venture; and 3) they mustbe unable to agree upon whether to discontinue the business or how todispose of its assets.

3. The Delaware LLC Act is grounded on principles of freedom of contract. For that reason,the presence of a reasonable exit mechanism bears on the propriety of ordering dissolutionunder § 18-802.a. When the agreement itself provides a fair opportunity for the dissenting member

who disfavors the inertial status quo to exit and receive the fair market value ofher interest, it is at least arguable that the limited liability company may stillproceed to operate practicably under its contractual charter because the charteritself provides an equitable way to break the impasse.(1) In In re Delaware Bay Surgical Services, the court declined to dissolve a

corporation under § 273 in part because a mechanism existed for therepurchase of the complaining members 50% interest. But this matterdiffers from Surgical Services:(a) The court in Surgical Services found that both parties clearly

intended, upon entering the contract, that if the parties endedtheir contractual relationship, the respondent would be the onepermitted to keep the company.

(b) By contrast, no such obvious priority of interest exists here. Haley and Talcott created the LLC together and while thedetailed exit provision provided in the formative LLCagreement allows either party to leave voluntarily, it providesno insight on who should retain the LLC if both parties wouldprefer to buy the other out, and neither party desires to leave.

(c) In this case, forcing Haley to exercise the contractual exitmechanism would not permit the LLC to proceed in apracticable way that accords with the LLC Agreement, butwould instead permit Talcott to penalize Haley without exprescontractual authorization.

The relevant portion of § 273(a) reads: If the stockholders of a corporation of this State, having only 259

stockholders each of which own 50% of the stock therein, shall be engaged in the prosecution of a joint venture and ifsuch stockholders shall be unable to agree upon the desirability of discontinuing such joint venture and disposing ofthe assets used in such venture, either stockholder may, unless otherwise provided in the certificate of incorporation ofthe corporation or in a written agreement between the stockholders, file with the Court of Chancery a petition statingthat it desires to discontinue such joint venture and to dispose of the assets used in such venture in accordance with aplan to be agreed upon by both stockholders or that, if no such plan shall be agreed upon by both stockholders, thecorporation be dissolved.

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F. Pedro v. Pedro (Minn. App. 1992).60

1. Closely Held Corp. Shareholders Analogous to Partners. The relationship among shareholdersin closely held corporations is analogous to that of partners. Shareholders in closely heldcorporations owe one another a fiduciary duty. In a fiduciary relationship “the law imposesupon them highest standards of integrity and good faith in their dealings with each other.”Owing a fiduciary duty includes dealing “openly, honestly and fairly with othershareholders.”

2. Inasmuch as appellants’ breaches of fiduciary duty forced the buyout, they cannot benefitfrom wrongful treatment of their fellow shareholder and must disgorge any such gain.a. Breach of Fiduciary Duty. Appellants claim no breach of fiduciary duty can exist

because there has been no diminution in the value of the corporation or the stockvalue of respondent's shares. In support of this assertion, appellants cite severalcases where actions by an officer or director did reduce the value of thecorporation, constituting a breach of fiduciary duty.(1) An action depleting a corporation's value is not the exclusive method of

breaching one's fiduciary duties. Moreover, loss in value of ashareholder's stock is not the only measure of damages.

3. Damages Calculation. Moreover, the measure of damages for the buyout was proper.a. If the fair value of the shares is greater than the purchase price for the buyout as

calculated from the formula in the SRA, the difference is the measure ofrespondent's damage resulting from having been forced to sell his shares in thecompany.

4. Lifetime Employment. Minnesota statute provides, “In determining whether to orderequitable relief, dissolution, or a buy-out, the court shall take into consideration the dutywhich all shareholders in a closely held corporation owe one another to act in an honest,fair and reasonable manner in the operation of the corporation and the reasonableexpectations of the shareholders as they exist at the inception and develop during thecourse of the shareholders' relationship with the corporation and with each other.”a. Employment Part of Reasonable Expectations. This section allows courts to look to

respondent's reasonable expectations when awarding damages. In addition to anownership interest, the reasonable expectations of such a shareholder are a job,salary, a significant place in management, and economic security for his family.

b. Double Recovery? Even appellants concede respondent has two separate interests,as owner and employee. Thus, allowing recovery for each interest is appropriateand will not be considered a double recovery.

G. Stuparich v. Harbor Furniture Mfg., Inc. (Cal. App. 2000).1. Issue. The issue is whether plaintiffs raised a triable issue of material fact as to whether

dissolution is “reasonably necessary” to protect their rights or interests.2. On this undisputed record, we cannot say that the trial court erred in finding as a matter of

law, that the drastic remedy of liquidation is not reasonably necessary for the protection ofthe rights or interests of the complaining shareholder or shareholders.

VI. Transfer of ControlA. Frandsen v. Jensen-Sundquist Agency, Inc. (7th Cir. 1986).

1. Merger Not a Sale. A sale of stock was never contemplated. The transaction originallycontemplated was a merger of Jensen-Sundquist into First Wisconsin. In a merger, as theword implies, the acquired firm disappears as a distinct legal entity. In effect, theshareholders of the merged firm yield up all of the assets of the firm, receiving either cashor securities in exchange, and the firm dissolves. In this case, the shareholders would have

The result in this case is curious because the court finds a breach of fiduciary duty to make up the60

difference between the SRA buyout price and the fair market value of the shares. The Minnesota statute, however,explicitly states that the court may order a buy-out of the shares of either party at “fair value” is “those in control haveacted fraudulently, illegally, or in a manner unfairly prejudicial toward one or more shareholders.”

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received cash. Their shares would have disappeared but not by sale, for in a merger theshares of the acquired firm are not bought, they are extinguished.a. The distinction between a sale or shares and a merger is such a familiar one in the

business world that it is unbelievable that so experienced a businessman asFrandsen would have overlooked it.

b. A sale of the majority bloc’s shares is not the same thing as a sale of either all orsome of the holding company’s assets. The sale of assets does not result insubstituting a new majority bloc, and that is the possibility at which the protectiveprovisions are aimed.

B. Zetlin v. Hanson Holdings, Inc. (N.Y. 1979).1. Premium Price for Majority Shares. Absent looting of corporate assets, conversion of a

corporate opportunity, fraud or other acts of bad faith, a controlling shareholder is free tosell, and a purchaser is free to buy, that controlling interest at a premium price.a. Premium Price is for Privilege of Controlling Corp. Certainly, minority shareholders

are entitled to protection against such abused by controlling shareholders. Theyare not entitled, however, to inhibit the legitimate interests of the otherstockholders. It is for this reason that control shares usually command a premiumprice. The premium is the added amount an investor is willing to pay for theprivilege of directly influencing the corporation’s affairs.

C. Perlman v. Feldmann (2d. Cir. 1955).1. Facts. Feldmann owned 32% of the shares of Newport Steel and sold his shares for $20 per

share–a two-thirds premium over the then-market price of $12. A minority shareholderbrought a derivative suit claiming Feldmann had sold a corporate asset, namely Newport’ssteel supplies, during the Korean War’s steel shortage, when steel prices were controlledand access to steel commanded a premium. Feldmann had invented a way to skirt theprice controls (known in the industry as the “Feldmann Plan”) by having buyers makeinterest-free advances to obtain supply commitments. The buyer (Wilport), a syndicate ofsteel end-users, wanted Newport’s steel supplies free of the Feldmann plan. The courtheld that Feldmann had breached a fiduciary duty to the corporation because his sale ofcontrol sacrificed the favorable cash flow generated by the Feldmann Plan.

2. Both as director and as dominant stockholder, Feldmann stood in a fiduciary relationshipto the corporation and to the minority stockholders as beneficiaries thereof.

3. It is true that this is not the ordinary case of breach of fiduciary duty. We have here nofraud, no misuse of confidential information, no outright looting of a helpless corporation.a. But on the other hand, we do not find compliance with that high standard which

we have just stated and which we and other courts have come to expect anddemand of corporate fiduciaries. The actions of defendants in siphoning off forpersonal gain corporate advantages to be derived from a favorable marketsituation do not betoken the necessary undivided loyalty owed by the fiduciary tohis principal.

b. We do not mean to suggest that a majority stockholder cannot dispose of hiscontrolling bloc to outsiders without having to account to his corporation forprofits or even never do this with impunity the buyer is an interested customer,actual or potential, for the corporation’s product. But when the sale necessarilyresults in a sacrifice of this element of corporate good will and consequentunusual profit to the fiduciary who has caused the sacrifice, he should account forhis gains.

c. So in a time of market shortage, where a call on a corporation’s productcommands an unusually large premium, in one form or another, we think itsound law that a fiduciary may not appropriate to himself the value of thispremium.

4. Dissent. Concededly, a majority or dominant shareholder is ordinarily privileged to sell hisstock at the best price obtainable from the purchaser. In so doing he acts on his ownbehalf, not as an agent of the corporation. If he knows or has reason to believe that the

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purchaser intends to exercise to the detriment of the corporation the power ofmanagement acquired by the purchase, such knowledge and reasonable suspicion willterminate the dominant shareholder’s privilege to sell and will create a duty not to transferthe power of management to the purchaser.

D. Essex Universal Corp. v. Yates (2d. Cir. 1962).1. Illegal to Sell Office Without Sufficient Stock. It is established beyond question under New

York law that it is illegal to sell corporate officer or management control by itself (that is,accompanied by no stock or insufficient stock to carry voting control). The same ruleapparently applies in all jurisdictions where the question has arisen.a. Rationale. The rationale of the rule is indisputable: persons enjoying management

control hold it on behalf of the corporation’s stockholders, and therefore may notregard it as their own personal property to dispose of as they wish.

2. There is no question of the right of a controlling shareholder under New York lawnormally to derive a premium from the sale of a controlling block of stock. In otherwords, there was no impropriety per se in the fact that Yates was to receive more per sharethan the generally prevailing market price for Republic stock.

3. Issue. Whether it is legal to give and receive payment for the immediate transfer ofmanagement control to one who has achieved majority share control but would nototherwise be able to convert that share control into operating control for some time.a. The easy and immediate transfer of corporate control to new interests is ordinarily

beneficial to the economy and it seems inevitable that such transactions would bediscouraged if the purchaser of a majority stock interest were require to waitsome period before his purchase of control could become effective. Conversely,it would greatly hamper the efforts of any existing majority group to dispose of itsinterest if it could not assure the purchaser of immediate control over corporationoperations.

b. If Essex was contracting to acquire what in reality would be equivalent toownership of a majority of stock, i.e., if it would as a practical certainty have beenguaranteed of the stock voting power to choose a majority of the directors ofRepublic in due course, there is no reason why the contract should not similarlybe legal. Whether Essex was thus to acquire the equivalent of majority stockcontrol would, if the issue is properly raised by the defendants, be a factual issueto be determined by the district court on remand.(1) Because 28.3 percent of the voting stock of a public held corporation is

usually tantamount to majority control, I would place the burden ofproof on this issue on Yates as the party attacking the legality of thetransaction.

4. Concurrence #1 (J. Clark). Prefer to avoid too precise instructions to the district court inthe hope that if the action again comes before us the record will be generally moreinstructive on this important issue than it is now (a case-by-case approach).

5. Concurrence #2 (J. Friendly). I have no doubt that many contracts, drawn by competentcounsel and responsible counsel, for the purchase of blocks of stock from interests thoughtto “control” a corporation although owning less than a majority, have containedprovisions like paragraph 6 of the contract sub judice. a. However, developments over the past decades seems to me to show that such a

clause violates basic principle of corporate democracy. To be sure, stockholderswho have allowed a set of directors to be placed in office, whether by their voteor their failure to vote, must recognize that death, incapacity or other hazard mayprevent a director from serving a full term, and that they will have no voice as tohis immediate successor.(1) But the stockholders are entitled to expect that, in that event, the

remaining directors will fill the vacancy in the exercise of their fiduciaryresponsibility. A mass seriatim resignation directed by a sellingstockholder, and the filling of vacancies by his henchman at the dictation

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of a purchaser and without any consideration of the character of thelatter’s nominees, are beyond what the stockholders contemplated orshould have expected to contemplate.

E. Classified Board. A classified board is one for which different classes of stock elect different sets ofdirectors. Contrast this with a staggered board, as was the one set out in the facts of Essex.

F. DeBaun v. First Western Bank and Trust Company (Cal App. 1975).1. Early Law. Early case law held that a controlling shareholder owed no duty to minority

shareholders or to the controlled corporation in the sale of his stock.a. Now Controlling Shareholder Must Exercise Good Faith & Fairness. Decisional law

has since recognized the fact of financial life that corporate control by ownershipof a majority of shares may be misused. Thus the applicable proposition now isthat in any transaction where the control of the corporation is material, thecontrolling majority shareholder must exercise good faith and fairness from theviewpoint of the corporation and those interested therein.

2. Duty of Good Faith Encompasses Recognizing Potential Looter. That duty of good faith andfairness encompasses an obligation of the controlling shareholder in possession of fact suchas to awaken suspicion and put a prudent man on his guard (that a potential buyer of hisshares may loot the corporation of its assets to pay for the shares purchased) to conduct areasonable adequate investigation (of the buyer).

CHAPTER SEVEN: MERGERS, ACQUISITIONS, AND TAKEOVERS

I. Mergers and Acquisitions61

A. The DeFacto Merger Doctrine1. Statutory Merger. A statutory merger is a combination accomplished by using a procedure

described in the state corporation laws (most of which are essentially the same in thisrespect). Under a statutory merger the terms of merger are spelled out in a documentcalled a merger agreement, drafted by the parties, which prescribes, among other things,the treatment of the shareholders or each corporation. Considerable flexibility is available.a. Approval Required. If the statutory merger procedure is used, approval by votes of

the boards of directors and shareholders of each of the two corporations isrequired.

b. Appraisal Right for Non-Approving Shareholders (Dissenter’s Rights). In addition,shareholders of each corporation who voted against the merger would have beenentitled to demand that they be paid in cash the fair value of their shares(determined by agreement or, failing agreement, by a judicial proceeding). Thisright to be paid off is called the “appraisal right.”

2. Practical Mergers. These acquisitions do not use the statutory procedure.a. Short Form Merger. Corp. A would offer its shares to Corp. B shareholders in

return for their shares of Corp. B. Corp. A would seek to acquire enough sharesto gain control of Corp. B (and the offer could be made contingent on thatoutcome). No votes of the shareholders and directors of Corp. B would berequired since the transaction would be between Corp. A and the individualstockholders of Corp. B. Neither would there be any appraisal rights. Once itgained sufficient control (typically 90%), Corp. A could use a special procedure, ashort form merger, to merge Corp. B into Corp. A.(1) Corp. A might also acquire the shares of Corp. B for cash. It might also

use a subsidiary to accomplish the acquisition. The common elementwould be a sale by the individual Corp. B shareholders for their shares,for share of Corp. A, or for cash.

b. Assets Acquisition. Corp. A buys all of the assets of Corp. B for stock (or for cash). Here, Corp. A would deal with Corp. B rather than with its shareholders.

See also Handout on Mergers and Acquisitions: Diagrams.61

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(1) One advantage of assets acquisition is that the acquiring corporation doesnot succeed to unforeseen liabilities of the acquire corporation as itwould under a statutory merger. (Known liabilities will be satisfied bythe seller or assumed by the buyer and taken into account in thepurchase price).(a) There is authority, however for holding an acquiring

corporation in an assets acquisition liable for product liabilitiesof the acquired corporation that did not arise until years afterthe asset transfer. See, e.g., Knapp v. North American RockwellCorp. (3d. Cir. 1974).

(2) Corp B will be left with nothing but shares of Corp. A. Ordinarily, itwould then liquidate and distribute the share to its shareholders. Corp.B would cease to exist.

3. Farris v. Glen Alden Corporation (Pa. 1958).62

a. Facts. Glen Alden acquired the assets of List in a stock-for-assets exchangeapproved by both companies’ boards and the List shareholders, but not the GlenAlden shareholders. The transaction doubles the assets of Glen Alden, increasedits debt sevenfold, and left its shareholders in a minority position. To

b. When use of the corporate form of business organization first became widespread,it was relatively easy for courts to define a “merger” or a “sale of assets” and tolabel a particular transaction as one or the other.(1) But prompted by the desire to avoid the impact of adverse, and to

obtain the benefits of favorable, government regulations, particularlyfederal tax laws, new accounting and legal techniques were developed bylawyers and accountants which interwove the elements characteristic ofeach, thereby creating hybrid forms of corporate amalgamation. Thus, itis no longer helpful to consider an individual transaction in the abstractand solely by reference to the various elements therein determinewhether it is a “merger” or a “sale.”

(2) Instead, to determine properly the nature of a corporate transaction, wemust refer not only to all the provisions of the agreement, but also to theconsequences of the transaction and to the purposes of the provisions ofcorporate law said to be applicable.

c. Appraisal Rights. Section 908(A) of the Penn. Bus. Corp. Law provides: “If anyshareholder of a domestic corporation which becomes a party to a plan or mergeror consolidation shall object to such plan of merger or consolidation, suchshareholder shall be entitled to ... [the fair value of his shares upon surrender ofthe share certificate or certificates representing his shares].”

d. Fundamental Change? Does the combination outlined in the present“reorganization” agreement so fundamentally change the corporate character ofGlen Alden and the interest of the plaintiff as a shareholder therein, that to refusehim the rights and remedies of a dissenting shareholder would in reality force himto give up his stock in one corporation and against his will accept shares inanother?(1) If so, the combination is a merger within the meaning of the corporation

Glen Alden was incorporated in Pennsylvania and List in Delaware. Delaware law at the time provided62

that a sale of substantially all of the assets of List required the approval of a majority of the List shareholders, but theList shareholders did not have appraisal rights. Under Pennsylvania law, if Glen Alden had sold it assets to List,approval by a majority of the Glen Alden shareholders would have been required and dissenting shareholders wouldhave had appraisal rights. Under present Delaware law, appraisal is not available in a merger if the shares relinquishedare “(i) listed in a national securities exchange or (ii) held of record by more than 2,000 stockholders,” and if theshares received have similar characteristics (e.g., voting and dividend rights). Del. Gen. Corp. Law § 262(b)(1).

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law.e. The amendments do not provide that a transaction between two corporations

which has the effect of a merger but which includes a transfer of assets forconsideration is to be exempt from the protective provisions of the statute. Theyprovide only that the shareholders of a corporation which acquires the propertyor purchases the assets of another corporation, without more, are not entitled to theright to dissent from the transaction.

4. Hariton v. Arco Electronics (Del. 1963).63

a. Equal Dignities. The sale-of-assets statute and the merger statute are independentof each other. They are, so to speak, of equal dignity, and the framers of areorganization plan may resort to either type of corporate mechanics to achievethe desired end. This is not an anomalous result in our corporation law.

B. Freeze-Out Mergers1. Tender Offers. A tender offer is a public offer made by a bidder to a target’s shareholders, in

which the bidder offers a substantial premium above market price for most or all of thetarget’s shares.a. Oversubscribed. More shareholder tender their stock than needed. The wanted

shares have to be purchased pro-rata.2. Authorized, Issued, & Outstanding. Shares are (1) authorized by the articles of incorporation;

(2) issued, meaning they have at some time been sold by the corporation to an investor; or(3) outstanding, meaning that the stock is currently owned by someone other than thecorporation.a. Authorized, Issued But Not Outstanding. “Treasury stock.”

3. Weinberger v. UOP, Inc. (Del. Sup. 1983).a. The plaintiff in a suit challenging a cash-out merger must allege specific acts of

fraud, misrepresentation, or other items of misconduct to demonstrate theunfairness of the merger terms to the minority.

b. The ultimate burden of proof is on the majority shareholder to show by apreponderance of the evidence that the transaction is fair. Nevertheless, it is firstthe burden of the plaintiff attacking the merger to demonstrate some basis forinvoking the fairness obligation. (1) However, where corporate action has been approved by an informed

vote of a majority of the minority shareholders, we conclude that theburden entirely shifts to the plaintiff to show that the transaction wasunfair to the minority.

(2) But in all this, the burden clearly remains on those relying on the vote toshow that they completely disclosed all material facts relevant to thetransaction.

c. In considering the nature of the remedy available under our law to minorityshareholders in a cash-out merger, we believe that it is, and hereafter should be,an appraisal under 8 Del.C. § 262 as hereinafter construed.

d. Complete Candor. In assessing this situation, the Court of Chancery was requiredto: examine what information defendants had and to measure it against what theygave to the minority stockholders, in a context in which “complete candor” isrequired. In other words, the limited function of the Court was to determinewhether defendants had disclosed all information in their possession germane tothe transaction in issue. And by “germane” we mean, for present purposes,information such as a reasonable shareholder would consider important in decidedwhether to sell or retain stock.

Most courts have rejected the de facto merger doctrine and have refused to imply merger-type protection63

for shareholders when the statute does not provide it. In fact, in many states where courts have used the de facto mergeranalysis, the legislature has later abolished the doctrine by statute.

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(1) Completeness, not adequacy, is both the norm and the mandate underpresent circumstances.

(2) This is merely stating in another way the long-existing principle ofDelaware law that these Signal designated directors on UOP’s board stillowed UOP and it shareholders and uncompromising duty of loyalty.

e. There is no “safe harbor” for such divided loyalties in Delaware. When directorsof a Delaware corporation are on both sides of a transaction, they are required todemonstrate their utmost good faith and the most scrupulous inherent fairness ofthe bargain.

f. The concept of fairness has two basic aspects: fair dealing and fair price.64

(1) Fair Dealing. The former embraces questions of when the transactionwas time, how it was initiated, structured, negotiated, disclosed to thedirectors, and how the approvals of the directors and the stockholderswere obtained.(a) Part of fair dealing is the obvious duty of candor required by

Lynch I. Moreover, one possessing superior knowledge maynot mislead any stockholder by use of corporate information towhich the latter is not privy.i) Delaware has long imposed this duty even upon

person who are not corporate officers or directors, butwho nonetheless are privy to matters of interest orsignificance to their company.

(2) Fair Price. The latter aspect of fairness relates to the economic andfinancial considerations of the proposed merger, including all relevantfactors: assets, market value, earnings, future prospects, and any otherelements that affect the intrinsic or inherent value of a company’s stock.(a) Delaware Block/Weighted Average Method. Elements of value,

i.e., assets, market price, earnings, etc., were assigned aparticular weight and the resulting amounts added to determinethe value per share. This procedure has been used for decades.i) However, to the extent that it excludes other

generally accepted techniques used in the financialcommunity and the court, it is now clearly outmoded. It is time we recognize this in appraisal and otherstock valuation proceedings and bring out law currenton the subject.

(b) More Liberal Approach. We believe that a more liberal approachmust include proof of value by any techniques or methodswhich are generally considered acceptable in the financialcommunity and otherwise admissible in court, subject only toour interpretation of 8 Del.C. § 262(h).65

i) Fair price obviously requires consideration of all

Not Bifurcated. The test for fairness is not a bifurcated on as between fair dealing and price. All aspects of64

the issue must be examined as a whole since the question is one of entire fairness. However, in a non-fraudulenttransaction we recognize that price may be the preponderant consideration outweighing other features of the merger. Here, the court addresses the two basic aspects of fairness separately because it finds error as to both.

The Court of Chancery “shall appraise the shares, determining their fair value exclusive of any element of65

value arising from the accomplishment or expectation of the merger, together with a fair rate of interest, if any, to bepaid upon the amount determined to be the fair value. In determining such fair value, the Court shall take intoaccount all relevant factors. (emphasis added).

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relevant factors involving the value of a company.(c) No Limitation On Other Relief. While a plaintiff’s monetary

remedy ordinarily should be confined to the more liberalizedappraisal proceeding herein established, we do not intend anylimitation on the historic powers of the Chancellor to grantsuch other relief as the facts of a particular case may dictate.i) The appraisal remedy we approve may not be

adequate in certain cases, particularly where fraud,misrepresentation, self-dealing, deliberate waste ofcorporate assets, or gross or palpable overreaching areinvolved.

g. No Business Purpose. In view of the fairness test which has long been applicable toparent-subsidiary mergers, the expanded appraisal remedy now available toshareholders, and the broad discretion of the Chancellor to fashion such relief asthe facts of a given case may dictate, we do not believe that any additionalmeaningful protection is afforded minority shareholders by the business purposerequirement. Accordingly, such requirement shall no longer be of any force oreffect.

4. Coggins v. New England Patriots Football Club, Inc. (Mass. 1986).a. In Singer v. Magnavox Co. (Del. 1977), the Delaware court established the so-

called “business-purpose” test, holding that controlling stockholders violates theirfiduciary duties when they “cause a merger to be made for the sole purpose ofeliminating a minority on a cash-out basis.”(1) In 1983, Delaware jettisoned the business-purpose test, satisfied that the

“fairness” test, long applicable to parent-subsidiary mergers, theexpanded appraisal remedy now available to stockholders, and the broaddiscretion of the Chancellor to fashion such relief as the facts of a givencase may dictate, provided sufficient protection to the frozen-outminority. Weinberger v. UOP, Inc. (Del. 1983).(a) Business Purpose Test Still Applicable in Mass. Unlike the

Delaware court, however, we believe that the “business-purpose” test is an additional useful means under our statutesand case law for examining a transaction in which a controllingstockholder eliminates the minority interest in a corporation. This concept of fair dealing is not limited to close corporationsbut applies to judicial review of cash freeze-out mergers.

b. A controlling stockholder who is also a director standing on both sides of thetransaction bears the burden of showing that the transaction does not violatefiduciary obligations. Judicial inquiry into a freeze-out merger in technicalcompliance with the statute may be appropriate, and the dissenting stockholdersare not limited to the statutory remedy of judicial appraisal where violations offiduciary duty are found.(1) Judicial scrutiny should begin with recognition of the basic principle that

the duty of a corporate director must be to further the legitimate goals ofthe corporation. The result of a freeze-out merger is the elimination ofpublic ownership in the corporation. The controlling faction increasesits equity from a majority to 100%, using corporate processes andcorporate assets.

(2) The corporate directors who benefit from this transfer of ownershipmust demonstrate how the legitimate goals of the corporation arefurthered. A director of a corporation violates his fiduciary duty whenhe uses the corporation for his or his family’s personal benefit in amanner detrimental to the corporation.(a) While we have recognized the right to “selfish ownership” in a

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corporation, such a right must be balanced against the conceptof the majority stockholder’s fiduciary obligation to theminority shareholders.

(3) Because the danger of abuse of fiduciary duty is especially great in afreeze-out merger, the court must be satisfied that the freeze-out was forthe advancement of a legitimate corporate purpose.

(4) If satisfied that elimination of public ownership is in furtherance of abusiness purpose, the court should then proceed to determine if thetransaction was fair by examining the totality of the circumstances.

c. The normally appropriate remedy for an impermissible freeze-out merger isrescission. (1) Because Massachusetts statutes do not bar a cash freeze-out, however,

numerous third parties relied in good faith on the outcome of themerger.

(2) The passage of time has made the 1976 position of the parties difficult, ifnot impossible, to restore.

(3) In these circumstances, the interests of the corporation and of theplaintiffs will be furthered best by limiting the plaintiffs’ remedy to anassessment of damages.

d. Rescissory damages must be determined based on the present value of thePatriots, that is, what the stockholders would have if the merger were rescinded.

C. De Facto Non-Merger*D. LLC Mergers

1. VGS, Inc. v. Castiel (Del. Ch. 2000).a. Castiel formed VGS, LLC for the purpose of pursuing a FCC license to build and

operate a satellite system. The LLC had only one member, VGS Holdings, Inc. Ellipso, Inc. joined as a second member, followed by Sahagen, LLC as a thirdmember. The units were distributed as follows: 660 units to Holdings, 26066

units to Sahagen and 120 units to Ellipso. Castiel had the power to appoint,remove, and replace 2 of the 3 members of the Board of Managers. Castielnamed himself and Tom Quinn. Sahagen named himself as the third member ofthe Board. Disagreements between Castiel and Sahagen soon arose about how tomanage the LLC. Sahagen convinced Quinn to oust Castiel and together theyacted by written consent to merge the LCC into VGS, Inc. The LCC ceased toexist and its assets and liabilities passed to VGS. The incorporators did not nameCastiel to the board of the corporation.67

b. Section 18-404(d) of the LCC Act states in pertinent part:Unless otherwise provided in a limited liability company agreement, on anymatter that is to be voted on by manager, the managers may take such actionwithout a meeting, without prior notice and without a vote if a consent orconsents in writing, setting forth the action so taken, shall be signed by themanagers having not less than the minimum number of votes that would benecessary to authorize such action at a meeting.

(1) Therefore, the LLC Act, read literally, does not require notice to Castiel

Castiel controlled both Holdings and Ellipso. Sahagen, LLC was controlled by Peter Sahagen, an66

aggressive venture capitalist.

On the same day as the merger, Sahagen executed a promissory note to the corporation in exchange for67

two million shares of stock. VGS also issued 1,269,200 shares of common stock to Holdings, 230,800 shares ofcommon stock to Ellipso, and 500,000 shares of common stock to Sahagen Satellite. Thus, Holdings and Ellipso wentfrom having a 75% interest in the LLC to having only a 37.5% interest in VGS.

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before Sahagen and Quinn could act by written consent. The LLCAgreement does not purport to modify the statute in this regard.

(2) Purpose of Written Consent. Section 18-404(d) has yet to be interpretedby this court or the Supreme Court. Nonetheless, it seems clear that thepurpose of permitting action by written consent without notice is toenable LLC managers to take quick, efficient action in situations where aminority of managers could not block or adversely affect the course setby the majority even if they were notified of the proposed action andobjected to it.(a) Not Intended to Clandestinely Deprive. The General Assembly

never intended to enable two managers to deprive,clandestinely and surreptitiously, a third manager representingthe majority interest in the LLC of an opportunity to protectthat interest by taking action that the third manager’s memberwould surely have opposed if he had knowledge of it.

(b) Action by Written Notice Only By Constant Majority. Applicationof equity requires construction of the statute to allow actionwithout notice only by a constant or fixed majority. It cannotapply to an illusory, will-of-the wisp majority which wouldimplode should notice be given.

c. Duty of Loyalty. Sahagen and Quinn each owed a duty of loyalty to the LLC, itsinvestors and Castiel, their fellow manager.(1) Agreement Doesn’t Rely on Equity Interest Voting. It may seem somewhat

incongruous, but this Agreement allows the action to merge, dissolve orchange to corporate status to be taken by simple majority vote of theboard of managers rather than rely upon the default position of thestatute which requires a majority vote of the equity interest.(a) However, Sahagen and Quinn Knew of Castiel’s Control Plan.

Instead, the drafters made the critical assumption, known to allthe players here, that the holder of the majority equity interesthas the right to appoint and remove two managers, ostensiblyguaranteeing control over a three-member board.

(b) When Sahagen and Quinn, fully recognizing that this wasCastiel’s protection against actions adverse to his majorityinterest, acted in secret, without notice, they failed to dischargetheir duty of loyalty to him in good faith.

d. Breach of Duty of Loyalty Abrogates Protection of Bus. Judgment Rule. It should beclear that the actions of Sahagen and Quinn, in their capacity as managersconstituted a breach of their duty of loyalty and that those actions do not,therefore, entitle them to the benefit or protection of the business judgment rule.

II. TakeoversA. Introduction

1. Cheff v. Mathes (Del. Ch. 1964).a. Purpose of Entrenchment. In an analogous field, courts have sustained the use of

proxy funds to inform stockholders of management’s views upon the policyquestions inherent in an election to a board of directors, but have not sanctionedthe use of corporate funds to advance the selfish desires of the directors toperpetuate themselves in office.

b. Maintain Proper Business Practices. Similarly, if the action of the board weremotivated by a sincere belief that the buying out of the dissident stockholder wasnecessary to maintain what the board believed to be proper business practices, theboard will not be held liable for such decision, even though hindsight indicatesthe decision was not the wisest course.

2. The court in Cheff essentially applies the business judgment rule.

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a. Reasonable Investigation/Plausible Business Purpose. Courts initially dealt with thetakeover dilemma by a judicial slight of hand. To ascertain whether anentrenchment motive lurked behind a takeover defense, courts adopted a processoriented standard. The courts accepted defensive action if the incumbent boardcould point to a “reasonable investigation” (preferably by outside directors) into aplausible business purpose for the defense–thus showing the absence of anentrenchment motive. Once this was done, the challenger bore the difficultburden of proving the board’s dominant motive was entrenchment.

3. Greenmail. During the ‘80s, the purchase by a corporation of a potential acquirer’s stock,at a premium over the market, came to be called “greenmail.”a. IRS Response. In 1987, the IRS enacted § 5881 which imposes a penalty tax of

50 percent on the gain from greenmail, which is defined as gain from the sale ofstock that was held for less than two years and sold to the corporation pursuant toan offer that “was not made on the same terms to all shareholders.”

B. Development1. Two-Tiered Front-Loaded Cash Tender Offer. Ex. P could offer to buy 51 percent of the

stock at $65 (the front end), and announce that will thereafter merge S Corp. into his ownfirm in a transaction that pays $55 cash per share for the remaining 49 percent of the stock(the back end).68

2. Unocal Corp. v. Mesa Petroleum Co. (Del. 1985).a. Issue. The validity of a corporation’s self-tender for its own shares which

excludes from participation a stockholder making a hostile tender offer for thecompany’s stock.

b. It is now well-established that in the acquisition of its shares a Delawarecorporation may deal selectively with its stockholders, provided the directors havenot acted out of a sole or primary purpose to entrench themselves in office. Cheffv. Mathes.(1) The only difference is that heretofore the approved transaction was the

payment of “greenmail” to a raider or dissident posing a threat to thecorporate enterprise. All other stockholders were denied such favoredtreatment, given Mesa’s past history of greenmail, its claims here arerather ironic.

c. Two-Part Analysis. When a board addressed a pending takeover bid it has anobligation to determine whether the offer is in the best interests of thecorporation and its shareholders.(1) Threat to Corporate Policy. There are certain caveats to a proper exercise

of this function. Because of the omnipresent specter that a board may beacting primarily in its own interests, rather than those of the corporationand its shareholders, there is an enhanced duty which calls for judicialexamination at the threshold before the protections of the businessjudgment rule may be conferred.(a) We must bear in mind the inherent danger in the purchase of

shares with corporate funds to remove a threat to corporatepolicy when a threat to control is involved. The directors areof necessity confronted with a conflict of interest, and anobjective decision is difficult.

(b) In the fact of this inherent conflict, directors must show thatthey had reasonable grounds for believing that a danger tocorporate policy and effectiveness existed because of another

Hence the term “cash-out merger.” The tender offer is “front-end loaded” because the front end offers a68

higher price ($65) than the back end ($55). A two-tiered offer can be “coercive” even if the front end is any-and-alloffer rather than an offer for 51 percent of the stock.

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person’s stock ownership.i) However, they satisfy that burden by good faith and

reasonable investigation.(2) Reasonable in Relation to Threat Posed. If a defensive measure is to come

within the ambit of the business judgment rule, it must be reasonable inrelation to the threat posed. This entails an analysis by the directors ofthe nature of the takeover bid and its effect on the corporate enterprise.(a) Examples of such concerns may include: inadequacy of the

price offered, nature and timing of the offer, questions ofillegality, the impact on “constituencies” other thanshareholders (i.e., creditors, customers, employees, and perhapseven the community generally), the risk of nonconsummation,and the quality of securities being offered in the exchange.

(b) While not a controlling factor, it also seems that a board mayreasonably consider the basic stockholder interests at stake,including those short term speculators, whose actions may havefueled the coercive aspect of the offer at the expense of thelong-term investor.

d. Fairness. The concept of fairness, while stated in the merger context, is alsorelevant in the area of tender offer law.

3. Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc. (Del. 1985.a. Business Judgment Rule. If the business judgment rule applies, there is a

presumption that in making a business decision the directors of a corporationacted on an informed basis, in good faith and in the honest belief that the actiontaken was in the best interests of the company.(1) However when a board implements anti-takeover measures there arises

the omnipresent specter that a board may be acting primarily in its owninterests, rather than those of the corporation and its shareholders.(a) This potential for conflict places on the directors the burden of

proving that they had reasonable grounds for believing therewas danger to corporate policy and effectiveness, a burdensatisfied by a showing of good faith and reasonableinvestigation. In addition, the directors must analyze thenature of the takeover and its effect on the corporation in orderto ensure balance–that the responsive action taken is reasonablein relation to the threat posed.i) The Rights Plan. Under the circumstances, it cannot

be said that the Rights Plan as employed wasunreasonable, considering the threat posed. Indeed,the Plan was a factor in causing Pantry Pride to raiseits bids from a low of $42 a share to an eventual highof $58. At the time of its adoption the Rights Planafforded a measure of protection consistent with thedirectors’ fiduciary duty in facing a takeover threatperceived as detrimental to corporate interests.

ii) Stock Exchange. The directors’ general broad powersto manage the business and affairs of the corporationare augmented by the specific authority conferredunder Delaware statute, permitting the company todeal in its own stock. However, when exercising thatpower in an effort to forestall a hostile takeover, theboard’s actions are strictly held to the fiduciarystandards outline in Unocal. a) These standards require the directors to

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determine the bests interests of thecorporation and its stockholders, and imposean enhanced duty to abjure any action that ismotivated by consideration other than agood faith concern for such interests.

b. When Pantry Pride increased its offers, it became apparent to all that the break-up of the company was inevitable. The significantly altered the board’sresponsibilities under the Unocal standards. It no longer faced threats to corporatepolicy and effectiveness, or to the stockholders’ interests, from a grosslyinadequate bid.(1) The directors’ role changed from defenders of the corporate bastion to

auctioneers charged with getting the best price for the stockholder at asale of the company.(a) Other Corporate Constituencies. Revlon argued that it acted in

good faith in protecting the noteholders because Unocal permitsconsideration of other corporate constituencies. Although suchconsiderations may be permissible, there are fundamentallimitations upon that prerogative. i) Considerations Inappropriate Where Active Bidding

Engaged. A board may have regard for variousconstituencies in discharging its responsibilities,provided there are rationally related benefits accruingto the stockholders. However, such concern for non-stockholder interests in inappropriate when an auctionamong active bidders is in progress, and the object isno longer to protect or maintain the corporateenterprise but to sell it to the highest bidder.

c. Lock-Ups. A lock-up is not per se illegal under Delaware law. Such option canentice other bidder to enter a contest for control of the corporation, creating anauction for the company and maximizing shareholders’ profit.(1) However, while those lock-ups which draw bidders into the battle

benefit shareholders, similar measures which end an active auction andforeclose further bidding operate to the shareholders’ detriment.

(2) The no-shop provision, like the lock-up provision, while not per seillegal, is impermissible under the Unocal standards when a board’sprimary duty becomes that of an auctioneer responsible for selling thecompany to the highest bidder.

d. Favoritism for a white knight to the total exclusion of a hostile bidder might bejustifiable when the latter’s offer adversely affects shareholder interest, but whenbidders make relatively similar offers, or dissolution of the company becomeinevitable, the directors cannot fulfill their enhanced Unocal duties by playingfavorites with the contending factions.(1) Market forces must be allowed to operate freely to bring the target’s

shareholders the best price available for their equity.

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45249374 Business Associations Fall 2010 Fendler Outline

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