Corporations Outline

CORPORATIONS – FALL 2007PROFESSOR ASHFORD

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AGENCY

I. General Informationa. Three types of problems usually involved in Agency problem

i. Is the problem between the agent and the principalii. Does the problem involve a third party trying to hold the principal to an agreement based on the agent’s conduct or on

an express agreementiii. Does it involve a third party trying to hold a principal liable for the agent’s torts?

b. General Analysis of Determining Liabilityi. Is there a principal/agent relationship?

ii. If agency relationship exists, what is the scope of the agent’s authority?1. Depending on the authority with which the agent acted, the agent’s liability on a contract will depend on the

status of the principal.2. If it is a tort claim, agent or principal liability will depend on the status of the principal and whether the agent

was acting within the scope of his employment.II. Relationships of the Principal and Agent

a. Who is an agent?i. Rest. Agency §1

1. Agency is the fiduciary relation which results from the manifestation of consent by one person to another that the other shall act on his behalf and subject to his control, and consent by the other to so act.

2. The one for whom the action is taken is the principal.3. The one who is to act is the agent.

ii. Burden of Proof: person asserting the existence of an principal/agent relationship has the burden of proving it based on the factual elements of the circumstances

b. Other legal relationshipsi. Rest. Agency §§ 2(1) & (2): Master/Servant

1. Master: principal who employs an agent to perform service in his affairs and who controls or has the right to control the physical conduct of the other.

2. Servant: agent who is employed by a master and whose physical conduct in the performance of the service is controlled or is subject to right of control by the masters.

ii. Rest. Agency §2(3): Independent Contractors1. a person who contracts with another to do something for him but who is not controlled by the other nor

subject to the other’s right to control with respect to his physical conduct in the performance of the undertaking.

2. whether an IC is an agent depends on the extent of the right to control exercised by the principaliii. Employer-Employee

1. employer has the right to control the physical conduct of the employee; all employees are agents, but not all agents are employees

iv. Independent Contractors in creditor-debtor relationships1. Rest. Agency §14 – A creditor may become liable as principal if the creditor assumes de facto control of his

debtor’s business. (Cargill)v. Franchises

1. In general, in franchise arrangements, the franchiser supplies the franchisee with brad/business identity and controls the distribution of its goods or services through a contract. The extent of the control of the contract is usually limited to achieve standardization.

2. In general, the franchisee has the right to profit and bears the risk of loss, and generally has control over the day-to-day operations.

3. When will principal/agency relationship effectuate: when the franchise agreement gives the franchiser too much control over the day-to-day operation of the business.

c. Creation of Agency Relationshipi. By express agreement

ii. By ratification: when the principal accepts the benefits or otherwise affirms the conduct of someone purporting to act for the principal, even though no actual agency agreement exists.

1. Rest. Agency §82: Ratificationiii. By estoppel: when a principal acts in such a way that a third person reasonably believes that someone is the principal’s

agent.1. Rest. Agency §8B. Estoppel—Change of Position

d. Duties of the Agent to the Principali. Rest. Agency §387: General Principle – Duty of Loyalty

1. Unless otherwise agreed, an agent is subject to a duty to his principal to act solely for the benefit of the principal in all matters connected with his agency

ii. Rest. Agency §13: Agent as Fiduciary1. an agent is a fiduciary with respect to matters within the scope of his agency

iii. Rest. Agency §376: General Rule – Duties of Agent to Principal1. The existence and extent of the duties of the agent to the principal are determined by the terms of the

agreement between the parties, interpreted in light of the circumstances under which it is made, except to the


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extent that fraud, duress, illegality or the incapacity of one or both of the parties to the agreement modifies it or deprives it of legal effect

iv. Rest. Agency §379: Duty of Care and Skill1. agent has duty to act with standard care and skill which is standard in the locality for the kind of work, and to

exercise any special skill that he hasv. Rest. Agency §380: Duty of Good Conduct

1. agent has duty to not conduct himself with such impropriety that he brings disrepute upon the principal or business; has duty not to act in a way as to make continued friendly relations with the principal impossible

vi. Rest. Agency §381: Duty to Give Information1. agent has duty to use reasonable efforts to give principal information relevant to affairs entrusted to him and

which, if the agent has notice, the principal would desire to have, which can be communicated without violating superior duty to a third person

vii. Rest. Agency §382: Duty to Keep and Render Accountsviii. Rest. Agency §383: Duty to Act Only as Authorized

ix. Rest. Agency §384: Duty Not to Attempt the Impossible or Impracticablex. Rest. Agency §385: Duty to Obey

xi. Rest. Agency §388: Duty to Account for Profits Arising out of Employmentxii. Rest. Agency §389: Acting as Adverse Party Without the Principal’s Consent

1. agent has duty not to deal with his principal as an adverse party in a transaction connected with his agency without the principal’s knowledge

xiii. Rest. Agency §390: Acting as Adverse Party With Principal’s Consent1. agent who acts on his own account in a transaction in which he is employed and with the knowledge of the

principal has a duty to deal fairly with the principal and to disclose to him all facts which the agent knows or should know would reasonably affect the principal’s judgment

xiv. Rest. Agency §391: Acting for Adverse Party Without Principal’s Consent1. agent has duty not to act on behalf of an adverse party

xv. Rest. Agency §392: Acting for Adverse Party With Principal’s Consent1. agent who, with knowledge of 2 principals, acts for both of them in a transaction between them has a duty to

act with fairness to each and to disclose to each all facts which he knows or should know would reaonsably affect the judgment of each in permitting such dual agency

xvi. Rest. Agency §393: Competition as to Subject Matter of Agency1. agent has duty not to compete with principal concerning the subject matter of his agency

xvii. Rest. Agency §395 & 396: Relating to Use or Disclosure of Confidential Information Acquired during Agency, and Duties extending After Termination of Agency

1. Rest. Agency §396(a): After the termination of the Agency, the agent has no duty not to compete with the principal.

xviii. Rest. Agency §399: Remedies of Principalxix. Rest. Agency §§400-404: Liability of the Agent

e. Casesi. Gorton v. Doty: Doty loaned car to HS coach, who drove it to a football game. En route, he hit Gorton and his son.

Issue was whether the coach was the agent of Doty. Court held yes – agency relationship exists when one person allows another to act on his behalf and subject to his control.

ii. A.Gay Jenson Farms v. Cargill: Cargill entered into a contract with Warren where Cargill loaned money and working capital to Warren, and in exchange Warren appointed Cargill as its grain agent. There was significant control by Cargill over the financial activities and affairs of Warren. Warren got into financial trouble and collapse. In turn, farmers and other agricultural businesses sued Warren and Cargill to recover payments for grain they sold to Warren. Issue was whether Cargill was liable as Warren’s principal. Court held yes – Cargill had significant control and influence over Warren, which may be proved by circumstantial evidence.

1. Principal must be shown to have consented to the agency relationship, which was shown by Cargill directing Warren to implement it operational recommendations.

iii. Reading v. Regem: P was sergeant in the British Army. P wore a uniform when he escorted certain lorries through Cairo, and was paid a lot to do so. When the government found out, they took possession of the money he made. Issue was whether P was entitled to recover the money he made outside the scope of his employment. Court said No – if a servant unjustly enriches himself by virtue of his service without his master’s sanction, law says he cannot be allowed to keep the money. Because P got money solely by reason of his position, he must turn that money over to the principal.

iv. General Automotive Manufacturing v. Singer: Singer was general manager of GAMC; Singer had certain duties as laid out in his employment contract. He had a great reputation as a machinist, thus attracting a lot of business. He then started taking orders and hiring out another machine shop to do the work and kept the profits from that side business. Issue was whether D breached his fiduciary duty to P by failing to inform P of the existence of other orders? Court held Yes – D was behaving as a broker for his own profit in a field where, by contract, he had a duty to work only for P.

v. “Grabbing and Leaving” – Duties Post termination: Town & Country v. Newberry: T&C was a home-cleaning service. Newberry and others were former employers who, after leaving their employment, set up their own home-cleaning business that directly competed with T&C and solicited its customers. Issue was whether T&C could enjoin Newberry from soliciting its customers. Court held Yes – trade secrets, like customer lists, are only trade secrets if the


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information could not be obtained easily, like by looking in a phone book. But the list was a trade secret if such customers were screened and pooled after considerable effort and expense.

III. Liability of Principal to Third Parties in Contracta. Authority

i. Five Types of Authority1. Apparent Authority

a. Rest. Agency §8 – the power to affect the legal relations of another person by transactions with third persons, professedly as agent for the other, arising from and in accordance with the other’s manifestations to such third parties.

b. Rest. Agency §27: Creation of Apparent Authority: General Rule – such authority is created as to a third person by written or spoken words or any other conduct of the principal which, reasonably interpreted, causes the third person to believe that the principal consents to have the act done on his behalf by the person purporting to act for him.

c. i.e. this is authority which the agent is held out by the principal as possessing; depends on the principal’s manifestations to third parties

d. Black Letter Law – Agents do not have the authority to espouse their own agency without the principal granting the authority to do so (Lind v. Schenley)

2. Actual Authoritya. Rest. Agency §7 – the power of the agent to affect the legal relations of the principal by acts done

in accordance with the principal’s manifestations of consent to him.b. Rest. Agency §26: Creation of Authority: General Rule – written or spoken words or other conduct

of the principal which, reasonably interpreted, causes the agent to believe that the principal desires him so to act on the principal’s account.

c. i.e. this is authority which depends on communications between the principal and the agent; it may be expressly conferred or reasonably implied by custom, usage, or the principal’s conduct

3. Implied Authority [a.k.a. Incidental Authority]a. Rest. Agency §35: When Incidental Authority is Inferred – authority to conduct a transaction

includes authority to do acts which are incidental to it, usually accompany it, or are reasonably necessary to accomplish it.

b. An agent may reasonably infer implied authorityc. Black letter law indicates that Implied Authority is inherent in Actual Authorityd. Considerations

i. Arises if it is incidental to express authorityii. May be implied from conduct

iii. May be implied from custom and usageiv. May be implied because of an emergency

4. Ratificationa. Rest. Agency §82 – the affirmance by a person of a prior act which did not bind him but which was

done or professedly done on his account, whereby the act, as to some or all persons, is given effect as if originally authorized by him

b. i.e. if a principal adopts a negotiated contract by an unauthorized agent to act on their behalf, the principal will still be liable to the 3d party for the contract

c. Ways ratification may be manifestedi. Express affirmation by the principal

ii. Implied affirmation by the principal by acceptance of benefits, at a time when it is acceptable to accept or reject the benefits, and with a full understanding of what the benefits are connected with

iii. Silence or Inactiond. Ratification requires Intent and Full Knowledge

5. Estoppela. Rest. Agency §8B(1)b. Basically, if the principal behaves with some intentional, negligent, or culpable manner, and creates

a reasonable belief with respect to the acts of someone else (who may or may not be an actual agent), and a 3d party acts in reliance of that holding out on part of the “agent,” principal may be estopped from claiming non-liability

6. Inherent Agency Power (somewhat confusing)a. Rest. Agency §8A – Inherent agency power is a terms used to indicate the power of an agent which

is not derived from authority, apparent or estoppel, but solely from the agency relation and exists for the protection of persons harmed by or dealing with a servant or other agent.

b. Recognizes that in the course of an agent performing her duties may harm a 3d party, either by mistake, negligence, or misinterpretation of her authority. Agency power arises in absence of authority or estoppel, and from the designation by the principal of a kind of agent who ordinarily possesses certain powers.

c. Based on understanding of those powers which are reasonably foreseeable by the principal that the agent would take such action

d. This principle is not applicable when the principal is disclosed. Only when he is undisclosed.


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ii. Rest. Agency §34: Circumstances in Interpreting Authority1. the situation of the parties, their relations to one another, and the business in which they are engaged2. the general usages of business, the usages of trades or employments of the kind to which the authorization

relates, the business methods of the principal3. facts of which the agent has notice respecting the objects which the principal desires to accomplish4. nature of the subject matter, circumstances under which the act is to be performed, the legality or illegality of

the act5. the formality or informality, and the care or lack thereof, with which an instrument evidencing the authority

is drawnb. Rules of Liability Depending when the Principal is Disclosed, Partially Disclosed, or Undisclosed in Contract Disputes

i. This primarily is at issue as to whether the agent is/should be personally liableii. Disclosed/Partially Disclosed Principals

1. Rest. Agency §144: General Rule – D or PD principals are subject to liability upon contracts made by an agent acting within his authority if made in proper form and with the understanding that the principal is a party.

2. Rest. Agency §145: Authorized Representations – D or PD is responsible for authorized representations of an agent made in connection with it as if made by himself, subject to the rules as to the effect of knowledge of and notifications given to the agent.

3. Rest. Agency §159: Apparent Authority – D or PD principal is liable upon contracts made by an agent acting within his apparent authority if made in proper form and with the understanding that the apparent principal is a party. Principal is also liable for unauthorized acts which are apparently authorized.

4. Rest. Agency §161: Unauthorized Acts of General Agent – D or PD is liable when general agent does acts which usually accompany or are incidental to transactions which the agent is authorized to conduct if, although forbidden by the principal, the 3d party reasonably believes that the agent is authorized to do them and has no notice that he is not so authorized.

iii. Undisclosed Principals1. Rest. Agency §186: General Rule – UnD principal is liable for acts done by an agent acting within his

authority, except that the principal is not bound by a contract which is under seal or is negotiable, or upon a contract which excludes the principal.

2. Rest. Agency §194: Acts of General Agents – UnD principal is liable for acts done by an authorized agent if such acts are usual or necessary in such transactions, although forbidden by the principal to do them

3. Rest. Agency §195: Acts of Manager Appearing to be Owner – UnD principal whose agent manages the business is liable to 3d persons with whom the agent enters into transactions usual in such businesses and on the principal’s account, although contrary to the direction of the principal.

4. Rest. Agency §195A: Unauthorized Acts of Special Agents – A special agent for an UnD principal has no power to bind his principal by contract which he is not authorized to make unless:

a. The agent’s only departure from authority isi. not disclosing the principal, or

ii. having an improper motive, oriii. being negligent in determining the facts upon which his authority is based, oriv. in making misrepresentations; or

b. the agent is given possession of goods or commercial documents with authority to deal with them.c. Cases

i. Actual/Implied Authority1. Mill Street Church of Christ v. Hogan: Church hired Hogan to paint inside church. Hogan had done this a

number of times in the past, and had previously hired his brother to help him. He again asked his brother to help him. Brother fell from a ladder and broke his arm in the church. Hogan told the church, who paid both brothers for the work completed. Brother filed workers’ comp claim against the church. Issue was whether Hogan had authority to hire his Brother. Court held Yes – had to be determined whether the agent reasonably believed principal wished him to act in a certain way. Based on historical relationship between Hogan and Church and on the discussion Hogan had with church elder about hiring out, Hogan had reasonable belief he could hire his brother.

ii. Apparent Authority1. Lind v. Schenley Industries: Involving the apparent authority of a supervisor. VP of Schenley told Lind to

report to Kaufman, a sales manager, to find out his new duties and salary. Kaufman told Lind to expect a raise and 1% commission. Lind never received these payments, and was told Kaufman was not authorized to offer him the money. Issue is whether Schenley is liable even if Kaufman had no authority to make such offers. Court held Yes – Although Kaufman merely lacked actual/implied authority, that is irrelevant as to whether he possessed apparent authority. Schenley caused Lind to reasonably believe Kaufman had such authority and that he spoke for the company based on representations to Lind by the VP.

2. Three-Seventy Leasing v. Ampex: Involving the apparent authority to accept a contract. Breach of contract claim where 3-70 contracted with a computer salesman of Ampex to purchase 6 computer memory units. P entered into the contract, signed it despite the fact that no representative of D had signed it. D’s representative sent a confirmation letter to P. Ampex then claimed they never properly accepted the contract. Issue is whether Ampex, through the conduct of its agent, accepted the contract. Court held Yes – although on the face of the contract it is not demonstrable that D had the intent to accept the contract, but the


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confirmation letter sent by Ampex’s agent can reasonably be interpreted as such acceptance. And although D has a policy that only supervisors have the authority to enter into contracts on its behalf, this was never communicated to 3-70. And it is reasonable for a 3d party to assume that a salesperson has authority to bind his employer to sell/buy.

iii. Inherent Agency Power1. Watteau v. Fenwick: Humble owned a bar, but transferred ownership to Fenwick, while he continued to act as

manager. Humble maintained the liquor license and had his name over the door, but in the agreement, Humble only had authority to buy beer and water. Watteau delivered cigars and other supplies ordered by Humble. Watteau sued Fenwick to recover payment. Issue was whether an undisclosed principal (Fenwick) may be liable for the acts of an agent taken in the ordinary course of business even if the principal did not authorize the agent to act, nor held the agent out as his agent. Court held Yes – the principal is liable for all acts of the agent that are within the authority usually confided to an agent of that character, regardless of limitations put on that authority by the principal.

2. Kidd v. Thomas A. Edison Inc.: D, a record company hired Fuller to audition singers for ‘tone tests’. Kidd auditioned and sued D for breach of contract, arguing that Fuller represented the tone test contract as an unconditional engagement for a singing tour. Issue is whether the D should not be held liable where there was a question of fact as to Fuller’s authority to act. Court held No – D should be liable (this was a jury verdict in P’s favor). Although Fuller had certain actual authority known to him, a singer dealing with him had no reason to assume that there would be conditions to the agent’s authority to contract with the singer when he does so.

3. Nogales Service Center v. Atlantic Richfield: Involving a jury instruction discussing inherent authority, which the trial court initially denied admission of. The requested jury instruction read: “D’s employees who dealt with P in the claimed oral agreements made D responsible for any such agreements if they are acts which the agent is authorized to conduct, even if the employees were forbidden to make such agreement, if the persons from P reasonably believed that D’s employees were authorized to make them, and has no notice that they were not so authorized.

a. 3 Situations in which issues of Inherent Agency Power may arisei. Applying Rest. Agency §§ 161&194: general agent does something similar to what he is

authorized to do, but in violation of ordersii. Applying Rest. Agency §§ 165&262: an agent acts purely for his own purposes in

entering into a transaction which would be authorized if he were actuated by a proper motive

iii. Applying Rest. Agency §§ 175&201: an agent is authorized to dispose of goods and departs from the authorized method of disposal

iv. Ratification1. Botticello v. Stefanovicz: D (H&W) owned a farm as tenants in common. P made an offer of $75K to buy the

farm. W said she’d never sell the farm for less than $85K. P and H agreed to a price of $85K with an option to purchase. When P attempted to exercise the lease option, D refused. Issues were (a) whether H acted as W’s agent, and (b) whether W ratified the contract by subsequent conduct. Court held No to both – (a) agency is not proved by marital status alone, but conferring a manifestation for the agent to act on the principal’s behalf, and principal consenting to the conduct in question. (b) Since ratification requires acceptance of the results of a prior act with an intent to ratify and with full knowledge of all the circumstances, no facts shown that Mary had intent or knowledge to ratify the contract.

v. Estoppel1. Hoddeson v. Koos Brothers: P thought she bought furniture from D’s store when a man in the store

approached her, said he was a salesman, and placed an order for bedroom furniture, to which P gave the man money. Furniture was never delivered b/c the man she gave money to was an imposter. Issue is whether the furniture store can be held liable. Court held Yes (essentially) – because principals and store proprietors have a duty of care for the safety and security of its customers, and such duty extends to reasonable care to protect customers from loss occasioned by deceptions of imposter salespeople.

IV. Liability of Agent’s on the Contracta. Such liability depends on the status of the principal: whether he is disclosed or undisclosed.

i. Disclosed principal: agent who purports to contract for a disclosed principal is not personably liable. ii. Undisclosed or partially disclosed principal: In undisclosed agency, the fact of agency and the principal’s identity are

not disclosed. In partially disclosed cases, the 3d party knows the agent is acting as an agent, but the identity of the principal is unknown.

1. When agent acts for undisclosed principal, the agent is personally liable on the contract itself.2. If the agent has signed or described himself as an agent for an undisclosed principal, he is personally liable.

b. Atlantic Salmon: D purchase salmon from P and sold it to wholesalers. D represented himself as an agent of BISE, but BISE as a company did not actually exist. D had created a corporation called Marketing Designs. When P discovered BISE did not exist, D argued he was acting as an agent of Marketing Designs, and should not be held personally liable. Issue was whether an agent contracting on behalf of a partially disclosed principal is personally liable on the contract. Court held Yes – P knew D was acting as an agent, but did not know the identity of the principal. P does not have a duty to seek out the identity of the principal; D has a duty to reveal the principal. Under Rest. Agency, unless otherwise agreed, a person purporting to make a contract on behalf of a partially disclosed principal is a party to the contract. In order to avoid personal liability, the agent must disclose that he is acting as an agent and the identity of his principal.


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V. Liability of Principal to Third Parties in Torta. Generally, liability of the Principal will depend on the relationship between the Principal and the Agent/Tortfeasor

i. Servants vs. Independent Contractors (Rest. Agency §2)1. A master-servant relationship exists when a servant, under some physical control of the master, renders some

sort of service. a. Essential consideration: CONTROLb. Rest. Agency §219: When Master is Liable for Torts of his Servants

i. Respondeat superior doctrine – an employer is liable for all torts committed by an employee acting within the scope of her employment

ii. Master is not subject to liability when servants act outside the scope of his employment unless:

1. the master intended the conduct or consequences, or2. the master was negligent or reckless3. the conduct violated a non-delegable duty of the master, or4. the servant purported to act or to speak on behalf of the principal and there was

reliance upon apparent authority, or he was aided in accomplishing the tort by the existence of the agency relation.

c. Rest. Agency §220: Definition of a Servanti. Servant is a person employed to perform services and the physical conduct in the

performance of the services is subject to the other’s controlii. Considerations

1. Extent of control which, by the agreement, the master may exercise over the details of the work

2. Whether or not the one employed I engaged in a distinct occupation or business3. The kind of occupation, with reference to whether, in the locality, the work is

usually done under the direction of the employer or by a specialist without supervisions

4. The skill required in the particular occupation5. Whether the employer supplies the instrumentalities, tools, place of work for

the person doing the work6. Length of time for which person is employed7. Method of payment, whether by time or by job8. Whether or not the work is a part of the regular business of the employer9. Whether or not the parties believe they are creating the relation of master and

servant10. Whether the principal is or is not in business

d. Rest. Agency §228: General Statement of Scope of Employment Doctrinei. Conduct of a servant is within the scope of employment if, but only if:

1. it is of the kind he is employed to perform;2. it occurs substantially within the authorized time and space limits; 3. it is actuated by a purpose to serve the master; and4. if force is intentionally used by the servant against another, the use of force is

not unexpectable by the masterii. Conduct of a servant is not within the scope of employment if it is different in kind from

that authorized, far beyond the authorized time and space limits, or too little actuated by a purpose to serve the master.

e. Rest. Agency §229: Kind of Conduct Within Scope of Employmenti. Conduct must be of the same general nature as that authorized, or incidental to the

conduct authorized.ii. Considerations of whether or not the conduct, although not authorized, is so similar or

incidental to authorized conduct as to be within the scope of employment:1. whether the act is one commonly done by such servants;2. time, place, and purpose of the act;3. previous relations b/w the master and servant4. extent to which the business of the master is apportioned between different

servants5. whether the act is outside the enterprise of the master or, if within the

enterprise, has not been entrusted to any servant6. whether the master has reason to expect that such an act will be done7. similarity in quality of the act done to the act authorized8. whether the instrumentality by which the harm is done has been furnished by

the master;9. extent of departure from the normal method of accomplishing an authorized

result10. whether the act is seriously criminal

2. Independent contractors


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a. This situation arises when a principal retains someone to do a certain job or achieve a specific objective. Prinipal retains no right of control. Respondeat superior is inapplicable. Employers may be responsible in limited situations, but such liability is based on principal’s negligence in hiring the independent contractor, or in the inherent dangerousness in the acts to be performed by the contractor.

b. While the general rule is that an employer will not be liable for negligent acts of an independent contractor, the following exceptions apply:

i. Where the landowner retains control of the manner and means of the doing of the work which is the subject of the contract

ii. Where he engages an incompetent contractoriii. Where the activity contracted for constitutes nuisance per se/’inherently dangerous’

activitiesii. The issue of whether someone is a servant or an independent contractor is always a question of fact, and must be

analyzed in light of the considerations of Rest. Agency §220, but especially in light of the extent of the control exercised over the agent by the principal

iii. The issue of control and liability is also apparent in Franchising Agreement cases1. a Franchiser may also be held liable under theories of apparent agency

b. Casesi. Facts demonstrating a Master-Servant Relationship

1. Humble Oil Refining v. Martin: Lady left car at a service station owned by Humble (D). While at the service station, the car, left unattended, rolled down a hill and struck Martin (P). P sued D for negligence, but D argued it was not liable b/c the service station was operated by an independent contractor. Issue was whether the facts demonstrated a master-servant relationship. Court held Yes – the contract between Humble and the station owner and Humble’s exercise of control over the station indicated that D owned the station, exercised financial control over it, set the hours, provided its products for sale, and set the price for those products. The only business discretion the owner had over it was as to hiring, discharging, and payment of employees.

ii. Facts demonstrating an Independent Contractor Relationship1. Hoover v. Sun Oil Company: P injured when his car caught fire while filling up at a gas station owned by Sun

and operated by Barone. Accident was due to negligence by station employee. Issue was whether Barone was an agent of Sun. Court held No – facts showed D had no control over the day-to-day operations of the station. All business decisions were made by Barone alone, and although Sun’s representatives made suggestions on how to run the station, Barone was under no obligation to follow the advice.

iii. Control test and Franchise Agreements1. Murphy v. Holiday Inns: Slip and Fall. Issue was whether the franchise contract created an agency

relationship between Holiday Inn and Betsy (owner of the franchise). Court held No – agency relationship only arises if the agreement so regulates the activities of the franchisee as to vest the franchiser with control over the operation of the franchisee. The regulatory provisions of the agreement did not constitute control because their purpose was to achieve system-wide standardization of business identity, uniformity of service, and optimum public good will. They did not give Holiday Inn control over the day-to-day operations of the business, like expenditures, room rates, nor a share of profits.

iv. Tort Liability and Apparent Agency in Franchise Agreements1. Miller v. McDonald’s: A sapphire was found in P’s Big Mac. Issue was whether agency relationship existed

between McDonald’s Corp. and 3K, the franchisee. Court held Yes – 3K was held out as McDonald’s apparent agent. The agency relationship exists if a franchise agreement goes beyond the stage of setting standards and gives the franchiser the right to exercise control over the daily operations of the franchise. The issue became whether the alleged principal “held the third party out” as an agent and whether Plaintiff relied on that holding out. Such holding out was a question for the jury, based on the extent of the control, and the terms of the franchise agreement.

v. Scope of Employment Case1. Ira S. Bushey v. US: drunken US seaman case. Issue was whether the US should be liable for the acts of its

drunken sailor. Court held Yes – conduct is within the scope of employment if it is “actuated by a purpose to serve the master.” Lane turning the wheel of the valve, despite the fact that he was drunk, was “reasonably foreseeable” conduct, since seamen are prone to getting drunk when they come to port. NOTE – this is a 2d Cir. case, and the “reasonable foreseeability” test is not applicable in all jurisdictions.

2. Manning v. Grimsley: P was at a baseball game, and during warm-ups and the game, while he was heckling the pitcher, the pitcher threw a wild pitch that hit P. Issue was whether the baseball club should be liable for the pitcher’s acts, which constituted a battery. Court held Yes – basically they remanded the case, which was dismissed on motion for summary judgment, and said a question of fact existed for the jury as to whether the pitcher intended to hit the hecklers. The employer was also potentially liable because P must show that the employee’s assault was in response to the plaintiff’s conduct that was interfering with the employee’s ability to perform his duties.

vi. Statutory Claims – Racial Discrimination1. Arguello v. Conoco: Suit was by a group of African-American and Hispanic patrons at various Conoco gas

stations in Texas who alleged that the cashier refused them service on the basis of their race. Issues were whether agency relationship existed between Conoco and its branded stores, whether the cashiers were acting within the scope of their employment. Court held No to first, and Yes to second – No agency relationship


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existed because the agreements for the ‘franchise’ did not provide for Conoco to control the day-to-day operations. However, when determining whether liability may be incurred for a servant acting in the scope of his employment, must consider the §228 considerations. Since the cashier was an employer, authorized by Conoco to interact with customers. This does not mean that Smith’s racist conduct was within the scope of his employment, nor that his conduct could have been reasonably foreseeable, but such questions are questions of fact that should go before the jury.

vii. Liability for torts of Independent Contractors1. Majestic Realty Associates Inc. v. Toti Contracting: City hired Toti to demolish buildings. Majestic owned

an adjacent building which was damaged in the demolition of the other buildings. Issue was whether the City could be held responsible for the negligent acts of IC if the work done was a nuisance per se. Court held Yes – statute provides that razing a building is ‘inherently dangerous,’ and employers can be held liable for such activities.

PARTNERSHIPS

I. What is a Partnershipa. UPA §6: Partnership Defined – (1) an association of 2 or more persons to carry on as co-owners a business for profit

i. i.e. there is a share of control, loss, profit, and assetsii. RUPA §101(6)

iii. Rules governing1. Uniform Partnership Act (1914) – adopted by most states (UPA)2. Revised Uniform Partnership Act (1997) – adopted by National Conference of Commissioner on Uniform

State laws; applies to all partnerships formed after its adoption in any given state (RUPA)iv. Entity vs. Aggregate Theory

1. Partnerships are treated as both separate entities from its partners for some purposes, and as an aggregate of separate individual partners in other situations

a. Aggregate Theory – UPA §15: partners will be jointly and severally liable for obligations of the partnership under UPA §§13 & 14; and jointly liable for all other debts and obligations of the partnership; but any partner may enter into a separate obligation to perform a partnership contract

b. Entity Theory – UPA §8: a partnership can own and convey title to real or personal property in its own name without all the partners joining in the conveyance

2. HOWEVER, RUPA expressly states that a partnership is an entity: RUPA §201v. Types of Partners

1. General Partner: partner of either a general or limited partnership whose liability for partnership indebtedness is unlimited, has full management powers, and shares in the profits

2. Limited Partner: a member of a limited partnership is liable for firm indebtedness only to the extent of the capital he contributed or agreed to contribute

3. Silent Partner: no voice and elects to take no part in the partnership business4. Secret Partner: membership is not disclosed to the public5. Dormant partner: partner who is both silent and secret partner

b. Formation of a Partnershipi. UPA §7: Rules for Determining the Existence of a Partnership

1. RUPA §202: Formation of a Partnership2. NOTE – profit-sharing is prima facie evidence of a partnership, and the person asserting non-existence of a

partnership must rebut this presumption.ii. General Requirements

1. Partnership Agreementa. Usually a written agreement creating the partnershipb. Partnership can be created orally, but a contract for ongoing partnership for more than 1 year falls

under the Statute of Frauds2. General considerations of existence of a partnership

a. Association: 2 or more persons or entities each with the capacity to form a partnershipb. Business for Profitc. Co-ownership of the business: sharing in the profits, losses, assets, and control of the business

iii. Considerations as to existence of a Partnership 1. Partners compared with Employees: Fenwick v. Unemployment Compensation Commission: Fenwick opened

beauty shop; hired Chesire as receptionist. Fenwick agreed to pay her a higher wage depending on the shop income. They entered into an agreement, drafted by attorney, which called their agreement a “partnership.” A few years later, Chesire quit. Issue was whether, for unemployment purposes, Chesire was an employee or a partner. Court held No Partnership existed:

a. Considerations: (1) intention of the parties; (2) right to share in profits; (3) obligation to share in losses; (4) ownership and control of the partnership property and business; (5) community of power in administration; (6) language of the “partnership agreement;” (7) conduct of the parties toward third parties; (8) rights of the parties on dissolution

2. Partners compared with Lenders: Martin v. Peyton: KNK was a partnership in trouble. Hall (partner of KNK) borrowed money from friend Peyton. Agreement w/ Peyton provided he was not a partner, but would


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share in the profits. Creditors claimed the agreement constituted a partnership agreement. Issue was whether a partnership was formed. Court held No – although sharing in profits is an element of partnership, not all profit-sharing agreements de facto form a partnership. Language in the agreement saying there was no partnership is not conclusive. Entire agreement and situation must be looked at as a whole.

3. Southex v. Rhode Island Builders Association: RIBA entered agreement with SEM (predecessor in interest to Southex) regarding RIBA’s home shows. RIBA would sponsor SEM shows, members would be persuaded to exhibit at SEM shows, and SEM could use RIBA’s name for promotions. SEM would obtain such licenses, indemnify RIBA for losses, RIBA could accept or decline exhibits, SEM would audit the show incomes, and SEM would advance capital. Other decisions could be made mutually. Southex took SEM over and renegotiated the agreement. Southex sued RIBA to enjoin them from holding the home show in 2000, that a partnership by estoppel had been formed, and RIBA breached its fiduciary duty through wrongful dissolution. Issue was whether a partnership existed. Court held No – must assess under the “totality of the circumstances” test. There was no intent to form a partnership between RIBA and SEM. Agreement was for a fixed term, and not indefinite. There was no sharing in profits, losses, assets. SEM managed most decisions, and entered into agreements in its own name, not that of the partnership or of RIBA mutually. No profits or property were communally generated. Although evidence of profit-sharing is prima facie evidence of the existence of a partnership, other circumstances undermined existence of partnership.

iv. Partnership by Estoppel1. UPA §16: Partner by Estoppel

a. When a person by words or conduct, represents himself or consents to another, as a partner in an existing partnership or with one or more persons not actual partners, he is liable to any such person to whom such representation has been made, who has, on the faith of such representation, given credit to the actual or apparent partnership, and if he has made such representation or consented to its being made in a public manner he is liable to such person, whether the representation has or has not been made or communicated to such person so giving credit by or with knowledge of the apparent partner making the representation or consenting to its being made.

i. When a partnership liability results, he is liable as though he were an actual partner.ii. When no partnership liability results, he is liable jointly with the other persons so

consenting to the contract as to incur liability, otherwise separately.b. When a person has been represented as a partner, he is an agent of the persons consenting to such

representation to bind them to the same extent and in the same manner as though he were a partner in fact.

c. This is an exception to the general rule (under UPA §7) that persons who are not actual partners as to each other are not partners as to third persons.

d. EX. A tells C she has a partner, B, to obtain credit. B knows of the representation and does nothing to inform C that he is not a partner. C makes the loan. B will be held to be a partner with A for the purposes of the loan, but he has no rights to participation in A’s business.

2. Young v. Jones: Price Waterhouse Bahamas and Price Waterhouse US (in New York) are general partnerships, but separate. Young invested in SAFIG based on an unqualified audit letter by PW-Bahamas. P learned that SAFIG lied on its financial statement, so Young sued both PW-Bahamas and PW-US. Young urged that the two PWs were partners by estoppel, and that PW-US is liable for its individual partners negligent acts in PW-Bahamas. Issue was whether a US partnership and its foreign affiliate are partners by estoppel when they both use the firm name and trademark, and the US makes no distinction in its advertising between itself and its foreign affiliates. Court held No – the two firms were organized separately; however, the exception kicks in. But, here P did not say that they relied on the representations of the existence of the partnership in their decision to invest; nor was the reliance effectuated so as to “give credit” to the other alleged partnership.

II. Fiduciary Obligations of Partnersa. Uniform Rules

i. RUPA §404: General Standards of Partner’s Conduct1. The only fiduciary duties a partner owes to the partnership are duties of loyalty and care2. (b) Duty of Loyalty

a. account and hold property as trustee of the partnershipb. refrain from dealing with partnership interests on behalf of a party having an adverse interest to the

partnershipc. refrain from competing before dissolution of the partnership

3. (c) Duty of Carea. limited to refraining from engaging in grossly negligent or reckless conduct, intentional

misconduct, or knowing violation of law on behalf of the partnership4. (d) – (g) other duties and obligations, or lack thereof

ii. UPA §20: Duty of Partners to Render Information – partners shall render on demand true and full information of all things affecting the partnership to any partner or the legal representative of any deceased partner or partner under legal disability.

iii. UPA §21: Partner Accountable as a Fiduciary


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1. every partner must account to the partnership for any benefit, and hold as trustee for it any profits derived by him without the consent of the other partners from any transaction connected with the formation, conduct, or liquidation of the partnership.

2. This is also applicable to representatives of deceased partners.b. Partnership Opportunities: Meinhard v. Salmon: Salmon owned hotel lease for 20 years. Salmon entered in joint venture with

Meinhard to pay ½ the money to alter and manage the hotel, and Meinhard would share in the profits. Salmon was sole manager of the property, and the lease was never assigned to Meinhard. 3d party (who originally leased Salmon the hotel) and Salmon entered lease on adjoining property, which called for destruction of the hotel and building a new one. Meinhard insisted he had an interest in the new lease. Issue was whether the new lease fell within Salmon’s fiduciary obligation to Meinhard as a ‘partnership opportunity.’ Court held Yes – partners, even joint venture partners, owe one another highest obligation of loyalty, including the obligation not to usurp opportunities incident to the partnership. There was sufficient nexus between the partnership and the opportunity that brought Salmon under the fiduciary duty to disclose the opportunity to his partner, as the opportunity was an ‘extension and enlargement’ of the subject of the old lease.

c. Fiduciary Duties after Dissolution of the Partnershipi. In general, there is no fiduciary obligation owed to former partners, which includes when one partner retires

ii. Bane v. Ferguson: ILB was a law firm that had a retirement plan entitling retired partners to a pension. The plan provided that the pension would end upon dissolution of the partnership. The partnership dissolved, and a retired partner sued ILB for negligence and breach of fiduciary duty to him as a former partner. Issue was whether a retired partner had any common law or statutory claim against ILB for his lost pension. Court held No – there is generally no fiduciary duty owed to former partners.

d. Grabbing and Leavingi. Meehan v. Shaugnessy: PC was a law firm/partnership. 2 partners began discussing leaving and forming their own firm,

Meehan and Boyle. M&B began targeting associates to come with them, and having them make a list of cases to take to the new firm. They continued preparations to leave, including contacting clients of PC. During this time, M&B continued to working diligently for PC. M&B were confronted 3 times by other partners about rumors of their intent to leave, which M&B denied. They then gave notice they were leaving, and provided a list of the cases they intended to take with them. M&B left, taking a number of their clients with them. PC sued for breach of fiduciary duty. Issue was whether M&B had breached their fiduciary duty. Court held Yes – such a fiduciary duty is breached when partners secretly prepare to start their own law firm and do not disclose important and truthful information that could have an effect on the partnership to the other partners (See UPA §9)

e. Expulsion of a Partneri. UPA §31(1)(d): Dissolution is caused without violation of the agreement between partners, . . . by the expulsion of any

partner from the business bona fide in accordance with such a power conferred by the agreement between the partners.ii. Lawlis v. Kightlinger & Gray: Lawlis was senior partner at law firm, K&G. L began abusing alcohol, and ceased his

practice of law for a period of time to seek help. K&G also got him help. K&G and L also signed a document setting forth conditions on his continuation in the partnership, and provided for him no second chance. He started abusing alcohol again, and K&G gave him a second chance. He ceased abusing alcohol, but the firm recommended severance of his status as a senior partner, and ultimately to expel him from the firm. P sued for damages for breach of contract. Issue was whether L was expelled in bad faith. Court held No – his expulsion was in conformance with the manner prescribed in the partnership agreement. When a partner is involuntarily expelled, it must be bona fide and in good faith. Such expulsion will be upheld if it is not done with a “predatory purpose.”

III. Partnership Propertya. General Statutory Provisions

i. UPA §8: Partnership Property1. All property brought into the partnership or subsequently acquired by the partnership is partnership property2. Property acquired with partnership funds is partnership property3. Estate in real property may be acquired in partnership’s name, and such title can only be conveyed in the

name of the partnership4. Conveyance to a partnership in the partnership name, without words of inheritance, passes the entire estate of

the grantor unless contrary intent appears.ii. UPA §10: Conveyance of Real Property of the Partnership

iii. UPA §24: Extent of Property Rights of a Partner – the property rights of a partner are (1) his rights in specific partnership property, (2) his interest in the partnership, and (3) his right to participate in management.

iv. UPA §25: Nature of a Partner’s Right in Specific Partnership Property1. Partner is co-owner with partners, held as a tenant in partnership2. Incidents of the tenancy

v. UPA §26: Nature of Partner’s Interest in the Partnership – a partner’s interest in the partnership is his share of the profits and surplus, and the same is personal property.

1. the effects of this being personal property is important in issues of inheritance of an interest in the partnershipvi. UPA §27: Assignment of a Partner’s Interest (i.e. when a partner conveys his property interest to another party, either

by death or sale)1. Such conveyance does not in and of itself dissolve the partnership; nor does it, in the absence of such

agreement, permit the recipient of the conveyance to interfere in the management or administration of the partnership, nor are they due an accounting; merely entitles the assignee to receive profits the assigning partner would be entitled.

2. in case of dissolution, assignee is entitled to the share the assigning partner would have received.


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vii. RUPA §501: A partner is not a co-owner of partnership property and has no interest in partnership property which can be transferred.

viii. RUPA §502: The only transferable interest of a partner in the partnership is the partner’s share of the profits and losses and right to receive distributions.

ix. RUPA §503: Transfer of Partner’s Transferable Interest1. Such a transfer is (1) permissible; (2) does not cause dissolution; (3) does not entitle transferee/assignee to

participate in management, access information, or inspect/copy books.2. Transferee has right (1) to receive distributions; (2) to receive amount appropriate upon dissolution; (3) to

seek under §801(6) a judicial determination that it is equitable to wind up the partnership business.3. Upon dissolution transferee is entitled to an accounting.4. Upon transfer, transferor retains rights and duties of a partner5. Partnership must have notice of transfer.6. Transfer of a transferable interest in violation of an agreement restriction is ineffective as to a person having

notice of the restriction at the time of transfer.b. Effect of Conveying a Partnership Interest

i. Putnam v. Shoaf: Frog Jump Gin (FJG) operated as a partnership between the Charltons and Putnams (each a H&W pair). By agreement, when Mr. Putnam died, his interest passed to his wife. Ms. Putnam decided to sever her relationship. She was given her ½ interest in the partnership, and the Shoafs took over her interest. When the Shoafs took over, a new bookkeeper discovered the old bookkeeper had embezzled money, and FJG sued the old bookkeeper to recover these funds. Ms. Putnam intervened, claiming she was entitled to ½ the money recovered. Issue was whether when a partner conveys her partnership interest to another, she can later claim interest in recovery of embezzled interest existing during her partnership. Court held No – the real interest of a partner is in her share of the profits and surplus and losses. It is the partnership, and not the individual partners, that own the property and assets. When a partner conveys her interest, she only conveys her interest, and not the property held by the partnership at the time. Therefore, she does not have an interest in unknown choses in action relating to partnership property.

IV. Rights of Partners in Managementa. General Rules and Statutory Provisions

i. UPA §18: Rules determining Rights and Duties of Partners – The rights and duties of the partners in relation to the partnership shall be determined by the following rules.

1. Repayment of contributions 2. Indemnity of every partner in respect of payments and personal liabilities incurred in the ordinary and

property conduct of the business3. A partner who pays extra or advances in the partnership shall receive interest4. Partner shall receive interest on capital contributed by him5. All partners have equal rights to management.6. No partner is entitled to remuneration for acting in the partnership business7. all partners must consent before a new member is admitted as a partner8. Any difference arising as to ordinary matters connected with the partnership business may be decided by the

majority of the partners, but no act in contravention of the agreement between partners may be done without the consent of all the partners.

ii. RUPA §103: Effects of a Partnership Agreement, and Nonwaivable Provisionsiii. RUPA §401: Partner’s Rights and Duties

1. Each partner has an account equal to the money plus value of any other property contributed by that partner, and charged with an amount equal to the money plus value of property, net amount of liabilities, distributed by the partnership to the partner

2. Each partner entitled to equal share of profits and losses3. Partnership shall reimburse partner for payment made and indemnify a parter for liabilities incurred by the

partner in the ordinary course of business4. Partnership shall reimburse a partner for advances to the partnership beyond the amount the partner agreed to

pay5. Entitlement to interest accrued on advances or loans under the previous two provisions6. Equal rights to management7. Partner may only use or possess partnership property on behalf of the partnership8. Not entitled to remuneration for services performed for the partnership9. All partners must consent to admission of a new partner10. Majority of partner vote required for matters in the ordinary course of business. Unanimous consent required

for matters outside the ordinary course of business or the agreement.b. Cases

i. National Biscuit Company v. Stroud: Stroud and Freeman entered partnership agreement for a grocery store. There were no limitations in the agreement as to management of the company. Stroud notified NBC they would no longer order bread. Freeman ordered bread from NBC. Stroud and Freeman dissolved the partnership, and Stroud was in charge of winding up the affairs. Stroud refused to pay NBC. Issue was whether Stroud could avoid responsibility for obligations accrued by the other partner for activities done in the ordinary course of business when he did not agree to the action taken. Court held No – the acts of one partner within the scope of the business partnership binds all other partners.


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ii. Moren v. Jax Restaurant: Tort liability case. Moren (mother) was a partner in Jax. She asked her sister to watch her son, who brought son to Jax. Son was injured at Jax. Moren (father) sued the partnership. Issue was whether Jax could be indemnified from liability. Court held No – RULE: RUPA §201, 307: partnership is an entity distinct from its partners, and the partnership may sue and be sued. RUPA §305(a): partnership is liable for loss or injury caused to a person resulting from a wrongful act or omission or a partner acting in the ordinary course of business. RUPA §401(c): partnership shall indemnify partners for liabilities incurred by the partner in the ordinary course of business. RUPA §301(2): an act of a partner no in the ordinary course of business binds the partnership only if the act was authorized by the other partners. Mother could indemnify personal liability from the partnership, but the partnership could not indemnify itself from liability by Mother’s acts. Moren’s acts were in the ordinary course of business, even though for personal objectives.

iii. Summers v. Dooley: Summers and Dooley formed partnership for garbage pickup. Summers wanted to hire a third person, but Dooley refused. Summers hired one anyway. Summers sued for reimbursement from partnership funds for money paid to 3d person. Issue was whether in a 2-person partnership, can one partner, over the objection of the other partner, take action which will bind the partnership. Court held No – in equal partnerships, differences on business matters must be decided by a majority of the partners. One of two in an equal partnership is not a “majority.”

iv. Day v. Sidley & Austin: Day was a senior partner at S&A law firm. Day was entitled to certain percentages of the firm’s profits. The executive committee considered merging with another firm, and created a proposal to merge. Day was not a part of the discussions, but he did execute the merger agreement. Despite Day’s objections, S&A decided to combine the merged firms at the Washington office, which Day managed. P resigned, and sued for damages from loss of income and personal embarrassment resulting from his ‘forced’ resignation, alleging the committed made certain misrepresentations that had the effect of voiding the approval of the merger. Issue was whether his resignation was precipitated by any illegality. Court held No – the partnership agreement did not mention Day’s position at the DC office, and it gave the executive committee complete authority to decide firm policy. Day had no legal right to remain at the DC office as chair. Majority approval was required for a merger under the agreement, and this was met. There was also no breach of fiduciary duty because this duty in a partnership does not extend to disclosing information regarding changes to the infrastructure of the partnership when its concealment does not result in profits for alleged wrongdoers or loss to the partnership.

V. Partnership Dissolutiona. General Rules and Statutory Provisions

i. UPA §29: Dissolution Defined – is the change in the relation of the partners caused by any partner ceasing to be associated in the carrying on as distinguished from the winding up of the business.

ii. UPA §30: Partnership is not Terminated by Dissolutioniii. UPA §31: Causes of Dissolution

1. Without violation of the agreement between the partners: (a) by termination of the definite term or undertaking specified in the agreement; (b) by express will of any partner when no definite term or undertaking is specified; (c) express will of all partners who have not assigned their interests; (d) by expulsion of any partner

2. In contravention of the agreement, where circumstances do not permit dissolution under any provision herein3. By event which makes it unlawful for the business to continue4. Death of any partner5. Bankruptcy of partner or partnership6. Court Decree (UPA §32)7. In general:

a. Expiration of the partnership term in the partnership agreementb. Choice of a Partnerc. Assignmentd. Death of a partnere. Withdrawal or admission of a partnerf. Illegalityg. Death or Bankruptcyh. Dissolution by Court decree

iv. UPA §32: Dissolution by Decree of Court1. will be effectuated on application by or for a partner

v. UPA §33: General Effect of Dissolution on Authority of Partner1. Dissolution terminates all authority of any partner to act for the partnership

vi. UPA §34: Right of Partner to Contribution from Co-Partners after Dissolution1. Where dissolution is caused by the act, death or bankruptcy of a partner, each partner is liable to his co-

partners for his share of any liability created by any partner as if the partnership had not been dissolved unless

a. Dissolution being by act of any partner, the partner acting for the partnership had knowledge of the dissolution; or

b. The dissolution being by death or bankruptcy of a partner, the partner acting for the partnership had knowledge or notice of the death or bankruptcy knowledge of the dissolution

vii. UPA §35: Power of Partner to Bind Partnership to Third Persons after Dissolutionviii. UPA §36: Effect of Dissolution on Partner’s Existing Liability

ix. UPA §37: Right to Wind Up


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x. UPA §38: Rights of Partners to Application of Partnership Property1. When dissolution is caused by 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 their interests in the partnership, unless otherwise agreed, may have the partnership property applied to discharge its liabilities, and the surplus applied to pay in cash the net amount owing to the respective partners. But if dissolution is caused by expulsion of a partner, bona fide under the partnership agreement and if the expelled partner is discharged from all partnership liabilities, either by payment or agreement under §36(2), he shall receive in cash only the net amount due him from the partnership.

2. When dissolution is cause in contravention of the partnership agreement, the rights of the partners shall be as follows:

a. Each partner who has not caused dissolution wrongfully shall have (a) all the rights specified in ¶1; and (b) the right as against each partner who has caused the dissolution wrongfully, to damages for breach of agreement.

b. The partners who have not caused the dissolution wrongfully, if they all desire to continue the business in the same name, either by themselves or jointly with others, may do so, during the agreed term of the partnership and for that purpose may possess the partnership property, provided they secure the payment by bond approved by the court, or pay to any partner who has caused the dissolution wrongfully, the value of his interest in the partnership at the dissolution, less any damages recoverable under 2(a)(II) herein, and in like manner indemnify him against all present or future partnership liabilities.

c. Partner who has caused dissolution wrongfully shall have (I) if the business is not continued under this all the rights of a partner under ¶1, subject to cl. 2aII of this section; (II) if the business is continued the right as against his co-partners and all claiming through them in repect of their interests in the partnership to have th value of his interest in the partnership, less any damages, ascertained and paid to him in cash, or the payment secured by bond; in ascertaining the value, good will shall not be considered.

xi. UPA §39: Rights where Partnership is Dissolved for Fraud or Misrepresentationxii. UPA §40: Rules for Distribution

1. Absolute priority to creditors paid first, then owed to partners other than capital and profits, then owed for capital, then owed for profit.

b. The Right to Dissolvei. Significant Disagreement between Partners: Owen v. Cohen: Partnership agreement between O and C did not contain

provisions for duration. They opened the business. Each paid part of debt and received salary. O and C had disputes. O then sued for dissolution of the partnership. Trial court permitted dissolution, citing reasons as C’s breaching the partnership agreement and conducting himself in a way not reasonably practicable to continue the partnership. C appealed. Issue was whether decree of dissolution was warranted. Court held Yes – California law permitted court decree of dissolution where partners cannot act in confidence and harmony.

ii. Breach of Agreement: Collins v. Lewis: C & L entered partnership agreement. C put up money, and L managed business. Agreement said C would be paid back from net income, and they would share profits equally. Costs were significant, and the business operated at a loss. Development costs began being paid out of operating revenue rather than by C, as promised in the agreement. C sued for receiver, dissolution, and foreclosure on the mortgage. L cross-sued saying C breached the agreement. Issue was whether C had the right to dissolve the partnership under these circumstances. Court held No – while C had the right to dissolve, he could not do so without damages since his conduct was the source of the partnership problems, which amounted to a breach of the agreement. C could either continue the partnership agreement, or dissolve and subject himself to damages for breach of the agreement. Basically, mere disagreement between parties is not sufficient reason for dissolution in breach of the agreement. Must show that dissolution is warranted because such disagreements make it impracticable for continuation of the partnership.

iii. Partnership at Will: Page v. Page: P & D were partners. P supplied essentials to business and was managing partner. The partnership as such owed him $47K. Each partner contributed $43K. No written agreement existed. Business lost money for 8 years until construction of a nearby army base caused an increase in profits. P sued to dissolve the partnership. D claimed they had an agreement to continue the business until the indebtedness was repaid, and P was terminating the partnership wrongfully. Issue was whether the partnership was for term or at will. Court held it was a partnership at will – that the partnership understanding was not that it would continue until their debts were repaid, and at-will partnerships may dissolve upon express notice from one partner to the other. If P was found to be acting in bad faith, D could sue for breach of fiduciary duty, because such at-will dissolution must be in good faith.

c. Consequences of Dissolutioni. Distribution of Assets: UPA §40

ii. Rights of the Partners upon Dissolution: UPA §38, 41iii. Partner may bid for the partnership’s assets at dissolution: Prentiss v. Sheffel: 3-man partnership at will. 2 partners were

majority partners and excluded D from partnership management and affairs. P sought to dissolve the partnership, saying D was derelict in partnership duties and failed to contribute his balance of his share in losses. P also sought to continue the partnership by buying D’s interest. D counterclaimed seeking a winding up of the partnership. Issue was whether Ps should be allowed to purchase D’s partnership assets when Ps excluded D from management and affairs. Court held Yes – there was no demonstration that D’s exclusion was done in bad faith, and there was no evidence that he would be injured by P’s participation in a judicial sale of his interest.


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iv. Disotell v. Stiltner: P & D formed partnership to develop, construct, and operate a hotel. Agreement said P would purchase ½ interest in the hotel property, and the funds for this purchase would come from P’s hotel profits. Dispute as to who was obligated to put up cash for the project. P notified D that he thought a pipeline needed to be put in, but D denied P access to the property and refused to continue the project. Partnership generated no profit. D wanted to buy P’s partnership interest. Court held: it was okay for court to permit Stiltner to buy out Disotell’s interest; that objective evidence was necessary to determine value of Disotell’s interest before the buyout; that partners’ intent needed to be determined as to whether Disotell’s obligation would come from hotel profits; that neither party was at fault for dissolution, so no damages for wrongful dissolution should have been awarded; but that Stiltner was accountable to the partnership for any benefit he derived from his personal use of the partnership property.

v. Pav-Saver v. Vasso: This case not very well decided. Dissolution of partnership went according to the agreement, but contrary to certain UPA provisions, which disallowed unilateral dissolution of the partnership, which was what happened. Issue was whether the terms of the partnership agreement control at dissolution if the result of following them would likely run afoul of the purpose of a UPA provision. Court held No – although the partnership agreement contemplated a permanent partnership, and was terminable only upon mutual approval fo the partners, when PS unilaterally terminated the partnership, this wrongful termination invoked provisions of the UPA. While the partnership agreement provided that P would retain its patents upon dissolution, the UPA governs the right to possess partnership property and continue the partnership upon wrongful termination. Therefore, Vasso was entitled to retain patents PS created under the UPA, but not under the partnership agreement.

vi. Sharing of Losses: Kovacik v. Reed: K asked R to be his job super and estimator for K’s business of kitchen remodeling. K put in money for venture, and profits would be split 50/50. R acted as superintendent, and K provided financing. K then told R the venture lost money, and K demanded R pay for portion of losses. R refused, and K sued. Issue was whether a party who has contributed only his services and not capital to a joint venture is liable for a portion of the venture’s losses. Court held No – as general rule, in the absence of an agreement to the contrary, it is presumed that partners intend to share in profits and losses equally. Here, where one partner contributes capital, while other contributes skill and labor, then neither party is liable to the other for losses.

1. NOTE: RUPA §401(b) expressly rejects this holding.vii. Buy-Out Agreements: G&S Investments v. Belman: G&S and Nordale were general partners of Century Park, and Jones

and Chaplin were limited partners. Nordale started using cocaine and changed personalities, including poor business performance, threatening other partners, irrational behavior. He also lived in the CP apartment complex, and refused to give up possession or pay rent, started soliciting underage tenants, and causing disturbance at the partnership property. G&S sought to dissolve partnership and buy out Nordale’s interest by filing such a complaint. Nordale died. G&S sought to continue the partnership and acquire his interest. Nordale’s estate claimed filing the complaint constituted dissolution of the partnership, and required liquidation of his assets and sitribution of net proceeds. G&S alleged Nordale’s behavior was the cause of the dissolution. Issue was (a) whether G&S could continue the partnership after N’s death, and (b) whether a buy-out agreement is valid even if the agreed-upon purchase price is less or more than the actual value of the interest at the time of the buy-out. Court held (a) Yes and (b) Yes – N’s behavior contravened the agreement, and court has authority to dissolve partnership under UPA §32. Filing a complaint does not in and of itself constitute dissolution; dissolution only occurs when decreed by the court or by other acts. The buy-out agreement provided for a means of determining the price, which was less than the market value, and the buy-out agreement governs.

viii. Law Partnership Dissolutions: 1. Jewel v. Boxer: 4 attorneys were partners in a firm. They decided to dissolve the partnership: 2 & 2. Each

partner took with him the active cases he was handling. Clients agreed to continued representation under fee agreements they entered with the old firm. P sued for attorneys’ fees received form these cases. Issue was whether upon dissolution of a law partnership, attorneys’ fees that are received on cases in progress upon the firm’s dissolution are to be shared according to the former parterns’ rights under the former partnership agreement. Court held Yes – UPA provides a dissolved partnership continues until unfinished partnership business is wound up. There needed to be an agreement providing for new fee agreements of former partnership clients. Until then, income generated through a dissolved partnership’s continuing business are due to the former partners in accordance with the former partnership agreement.

2. Meehan v. Shaughnessy: (continued from above – the grab and run case): Issue was whether partnership agreement provisions regarding dissolution supersede the UPA. Court held Yes – partnership agreement provisions governing dissolution will govern; UPA applicable in absence of applicable partnership agreement provisions.

d. Limited Partnershipsi. Governed by the Uniform Limited Partnership Act

1. ULPA §303(b): defines limited partner as making a contribution of cash, property or services, but is not active in management and has limited liability for partnership debts.

ii. To determine whether one is a Limited or General Partner: Holzman v. de Escamilla: where the labeled ‘limited partners’ controlled the finances of the business and actions taken by the general partner, they are liable as general partners, because they have overstepped their role as limited partners by effect of taking part in the control of the business of the partnership.


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PRELIMINARY CORPORATE ISSUES

I. The Nature of the Corporationa. Promoters

i. A promoter is generally one who contracts for products or services on behalf of a corporation which is not yet formed. Model Business Corporation Act (MBC) §2.04

1. In general, a promoter who contracts solely in the name of the corporation cannot be held liable if the corp. is never formed.

ii. Corporate Liability1. if the corporation ratifies the K after incorporation, corp. may be held liable on the pre-incorporation

promoter K.2. If the corp. repudiates K, corp. is still liable for the value of anything that it makes use of in quasi-contract3. Adoption by implication – Ratification is retroactive; adoption is not. For a corp. to adopt a K, it must have

knowledge of the terms of the K. Adopton may be by implication, and is generally not held to be a novation.b. Formalities of Incorporation

i. MBC §2.02: Articles of Incorporation1. lays out what must be set forth therein, and what may be set forth therein, and what need not be set forth

ii. MBC §2.03: When Incorporation Effectuatesiii. MBC §2.05: Organization of Corporation

1. what must happen after incorporation: meeting of initial directors to appoint officers, adopt bylaws, and other business

2. depends on whether or not initial directors have been set forth in the articles of incorporation what must take place at the initial meeting

iv. MBC §2.06: Bylaws – which must be adopted initiallyc. What if there is Defective Incorporation

i. This may occur when the formalities are omitted or improperly performed, steps to complete internal organization is not complete, things are lost in the mail, etc.

1. de jure corporation – all mandatory provisions have been strictly complied with; this corp. exists under law2. de facto corporation – common law doctrine; even if a corp. has not complied with all the mandatory

requirements, it may have complied sufficiently to be given corporate status as against 3d parties, but not against the state

3. Corporation by estoppel – existence as a corporation may be attacked by 3d parties; in certain situations court will say the attacking party is estopped from attacking the entity as a corp. and must treat it otherwise

a. Like in the Atlantic Salmon case (where this doctrine was not applied), this is an equitable doctrine and will only be invoked when the party seeking to invoke it has ‘clean hands’

ii. Application of De Facto and Estoppel Doctrines1. Contract Cases: all doctrines of incorporation may apply.2. Torts: de facto corporation most applicable; estoppel arguments for tort claims generally not applicable

because recognition of existence of a corporation has no relevance to the commission of the tort3. Liability of Associates: when a court finds no corporate status, the associates are held liable as partners

a. Apply laws of partnership and/or agencyd. Southern-Gulf Marine v. Camcraft: SGM (not a fully formed company) contracted to buy a boat from C. C began working to

construct the boat. SGM eventually became incorporated, but in Cayman, not the US. C defaulted on its boat-building obligations. SGM sued for breach of contract. C said SGM had no status to sue b/c it lacked corporate existence at the time K was formed. Issue was whether a party to a K should be permitted to escape performance by raising an issue as to the character of the organization to which it is obligated if its substantial rights are not affected. Court held No – where C contracts with an entity it acknowledges to be and treats as a corp., incurs obligations in its favor, and is sued for performance, it is generally estopped from claiming corporate existence as a defense.

II. Corporate Entity and Limited Liabilitya. General Characteristics of a Corporation

i. Is a separate legal entity, apart from the individuals that own it (shareholders) or manage it (officers and directors). It has legal rights and duties separate from these individuals.

ii. Limited Liability of the shareholders, directors and officers – a corporations debts and liabilities belong to the corporation, not the shareholders.

1. Exceptions – occur when there is a necessity to “pierce the corporate veil”iii. Perpetual existenceiv. Shares are easily transferablev. Specialized control structure – controlled by a board of directors

vi. Taxation1. C Corporations – taxed as an entity distinct from its owners: must pay income taxes on profits, and

shareholders do not have to pay tax on such profits until the profits are distributed to the shareholdersa. Corporate tax rate is lower than the personal tax rate, and so this arrangement can be advantageous

to persons who want to delay realization of incomeb. Double taxation: occurs because when the corporation makes distributions to shareholders, the

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2. S Corporations – taxed like partnerships and retain the other advantages of the corporate forma. Profits and losses flow directly through to the ownersb. Advantageous when losses are expected for the first few years that the business will be operating,

since it allows owners to offset the losses against their current incomesc. Can result in lower overall taxes on profits because there is no double taxationd. Restrictions on the S corporation not applicable to the C corporation

b. Piercing the Corporate Veil (i.e. disregard of the corporate entity)i. Generally, ‘piercing the corporate veil’ dissolves the distinction between the corporate entity and its

shareholders/officers/directors, and holds those individuals personally liableii. Where the corporate veil may be pierced

1. When necessary to prevent fraud or to achieve equality or promote injustice2. When individual(s) use control of the corporation to further his personal rather than the corporation’s

interestsa. Evidenced when corporate records are not maintained, required meetings are not held, money is

commingled between individuals and corporation, or transferred back and forth)b. When the corporation is ‘undercapitalized’ to handle liabilities, debts, or risks (i.e. lack of proper

insurance – Walkovszky), such may be emblematic that control is for personal interestsc. Also called in some cases the “alter ego” theory – a corporation used by an individual in

conducting personal business3. In any other situation where it is only “fair” that the corporate form be disregarded

iii. Two-part test1. “unity of interest” between the individual and the corporate entity2. Failure to pierce the corporate veil would sanction a fraud or promote injustice

iv. Cases1. Walkovszky v. Carlton: Taxicab accident and injuries. Ps sued corporate owner, C, who owned 9 other

corporations, each holding 2 cabs each with minimum liability insurance permitted by state ($10K). Complaint alleged the corporations operated as a single entity and constituted a fraud on the public. Issue was whether this constituted a cause of action. Court held No – courts will only pierce the corp. veil when necessary to prevent fraud or achieve equity. There is no problem with one corp. being part of a larger corp. enterprise. Issue must be whether the business is really carried on in a corp. form but by and for another entity or person with a disregard of corp. formalities. If undercapitalization is due to liability insurance which is inadequate, state legislature is the cause of this inadequacy, and not for the courts to undermine.

2. Sea-Land Services v. Pepper Source: SLS ocean carrier who shipped peppers for PS. PS refused to pay one of its bills. SLS sued PS’s sole shareholder, Marchese individually and some of the other corporations he owned, to pierce the corp. veil. Issue was whether piercing the corp. veil was appropriate when the court could no longer differentiate between the corp. and the individual and it would be unjust to protect the individual. Court held Yes – 2 requirements to piercing the corp. veil: (1) must be such unity of interest and ownership that the separate personalities of the corp. and the ind. no longer exists; and (2) circumstances must be such that adherence to the fiction of separate corporate existence would sanction a fraud or promote injustice. Looked to common law of Ill. factors: (i) failure to comply with formalities or keep sufficient corp. records; (ii) commingling of corp. assets; (iii) undercapitalization; and (iv) one corp.’s treatment of another corp.’s assets as its own.

3. Roman Catholic Archbishop v. Sheffield: S bought dog from monastery in Switzerland. Dog shipped to LA after S’s first installment. S never got dog, and sued RCA b/c monastery was controlled by RCA, and all such monasteries were alter egos of RCA. The Archbishop moved for summary judgment. Under alter ego theory, the corp. must not only influenced and governed by that person or entity, but there is such unity of interest and ownership that individuality ceased to exist, and recognition of this separate existence would sanction a fraud or promote injustice. Court held that – the RCA of SF was a corp. under Cal. Code, there were triable issues of fact that the monastery was an alter ego of the Pope, but not of the RCA, and there was no showing that piercing the corp. veil was necessary to sanction fraud. RCA not liable.

4. In re Silicone Gel Breast Implants Product Liability Litigation: Bristol-Myers Squibb (D) sole shareholder of breast implant supplier, MEC. BMS had significant control over MEC. Issue was whether an entity which is the sole shareholder (i.e. parent corporation) of a corporation (subsidiary) that makes a product subject to a products liability action but which does not itself manufacture or market that product can be found liable through piercing the corporate veil. Court held Yes – parent corps. exert some control over subsidiaries. When subsidiary is controlled to such an extent that it is merely an alter ego or instrumentality of the shareholder, veil should be pierced in the interest of justice. Piercing the corp. veil can happen even absent a finding of fraud or misconduct if the subsidiary is found to be an alter ego or mere instrumentality of its shareholder.

5. Frigidaire Sales Corp. v. Union Properties, Inc.: FSC contracted with Commercial Investors (CI), a ltd. partnership. Ds were limited partners of CI, and shareholder, director, and officers of UP. D controlled UP and, through that control, exercised management of CI. CI breached contract. Issue was whether limited partners incur general liability for limited partners obligations merely because they are directors/officers/shareholders of the corp’s general partner. Court held No – if a general partner is inadequately capitalized, a creditor is protected under corp. law doctrine of piercing the corp. veil. There was no improper activity on D’s part, therefore no reason to pierce the corp. veil.


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III. The Role and Purposes of Corporationsa. MBC Chapter 3: Purposes and Powers

i. §3.01: Purposes1. (a) engaging in any lawful business unless a more limited purpose is set forth in the articles of incorporation

(i.e. like a non-profit corporation)ii. §3.02: General Powers

1. has perpetual duration and succession in its corporate name; has same powers as an individuala. to sue/be suedb. have corp. sealc. make and amend bylawsd. hold real/personal propertye. sell/lease/etc. propertyf. purchase/hold/etc. any other entityg. make contracts, incur liabilitiesh. lend money/invest fundsi. promoter/partner of another entityj. conduct business in other states beside state of incorporationk. elect directorsl. pay pensionsm. make donations for the public welfare or for charitable, scientific, or educational purposesn. transact any lawful business that will aid governmental policyo. make payments/donations, or do any other act, no inconsistent with the law, that furthers the

business and affairs of the corporationiii. §3.03: Ultra Vires

1. validity of corp. act not provided for above may not be challenged on the grounds that the corp. lacks power to act

2. corp.’s power to act may be challengeda. in a proceeding by a shareholder against the corporation to enjoin the act (shareholder derivative

actions)b. in a proceeding by the corporation against an incumbent or former director/officer/employee/etc.c. in a proceeding by the attorney general

3. in shareholder derivative actions, court may enjoin or set aside the act, if equitable and if all affected persons are parties to the proceeding, and may award damages for loss suffered by the corporation or another party because of enjoining the unauthorized act

b. General theoriesi. Business vs. Legal theories

1. Business theory – purposes of corporation depends on a business strategy, and challenges to corporate acts tend to demand when the corporation does something which deviates from this purpose/strategy

2. Legal theory – demands what purposes are within the bounds of those set in the articles of incorporation and statutory law; i.e. articles of incorporation are a contract between the state and the incorporators

a. Challenges to corp. acts are that a corp. has exceeded the powers granted under statute or articles of incorporation, or whether it has remained within the purposes of the articles or state law

b. If the corp. engages in an improper purpose, or uses an improper power, that purpose or act is ‘ultra vires’

ii. Other powers1. express powers – set forth by MBC §3.03, or by state law2. implied powers – do whatever is ‘reasonably necessary’ for the purpose of promoting their express purposes,

unless such acts are expressly prohibited by law3. Corporations have a responsibility to:

a. Shareholdersb. Officersc. Directorsd. Employeese. Society/Neighborhood

c. Cases regarding a corporation acceding its purpose/powersi. Charitable Contributions: AP Smith Manufacturing Comp. v. Barlow: AP gave $1500 to Princeton. Shareholder

challenged the gift. Issue was whether such a gift was ultra vires act. Court held No – charitable gifts (that are reasonable) are within the implied powers of the corporation.

ii. Accumulation of Surplus: Dodge v. Ford Motor: Shareholders sued Ford to prevent expansion of a new plant and to compel directors to pay additional dividends. P charged that D’s new purposes are charitable in nature and unlawful. Issue was whether when directors’ purpose in not paying a dividend is to benefit the interests of persons other than the shareholders, will the court intervene to force payment of those dividends. Court held Yes – corps. are primarily organized for purpose of shareholder profit. Directors must use their power primarily to that end. The corp’s discretion to expand the business and cut prices will be upheld so long as it is part of a long-range business plan. Directors also have discretion to pay dividends, and court will not interfere unless there is fraud, misappropriation or bad faith. Expansion was going to result in surplus dividends. Court may order the surplus be paid out as additional dividends.


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iii. Shlensky v. Wrigley: Shlensky, minority shareholder of corp. owning Cubs, brought derivative suit for their refusal to install lights at the ball park and schedule night games. Issue was whether shareholder may bring such action without allegation of fraud, misconduct, or bad faith, or conflict of interest. Court held No – court will not disturb the ‘business judgment of majority of directors absent showing of bad conduct. The decision not to install lights or have night games was business judgment.

CORPORATE FIDUCIARY DUTIES

I. Duty of Carea. MBC §8.30: Standards of Conduct for Directors

i. Directors must act (a) in good faith, and (b) in a manner the director reasonably believes to be in the best interests of the corporation.

ii. Members of board or committee shall discharge their duties with the care that a person in a like position would reasonably believe appropriate under similar circumstances.

iii. Duty to disclose information to other board members known to be material to the discharge of their decision-making or oversight function, except when disclosure would violate a duty under law, legally enforceable obligation of confident, or professional ethics rule.

iv. May rely on performance of other of duties that have been delegated with authority to perform certain function’s of the board that are delegable under applicable law.

v. Is entitled to rely on information, opinions, reports or statements prepared by following individuals1. other officers or employees who director reasonably believes is reliable and competent in those functions2. legal counsel, public accountants, other experts3. committee of directors

b. MBC §8.42: Standards of Conduct for Officersi. An officer, when performing in such capacity, shall act:

1. in good faith;2. with the care that a person in a like position would reasonably exercise under similar circumstances; and3. in a manner the officer reasonably believes to be in the best interests of the corporation.

ii. Obligations of the officer enumerated, particularly those obligations the officer owes to his superior officers, the board of directors

iii. Very important: reliance standards: In discharging his duties, an officer who does not have knowledge that makes reliance unwarranted is entitled to rely on

1. the performance of properly delegated responsibilities by one or more employees of the corporation whom the officer reasonably believes to be reliable and competent in performing the responsibilities delegated; or

2. information, opinions, reports or statements, including financial statements and other financial data, prepared or presented by one or more employees of the corporation whom the officer reasonably believes to be reliable and competent ni the matters presented or by legal counsel, public accountants, or other persons retained by the corporation as to matters involving skills or expertise the officer reasonably believes are matters (i) within the particular person’s professional or expert competence, or (ii) as to which the particular person merits confidence.

iv. Officer not liable for any decision to take or not take action, if the duties of the office are performed in compliance with the terms herein.

c. Common law then dictates what that “standard of care” and “reasonable exercise” and “reasonably reliance” standards are.d. Directors have duty to manage the corporation these duties delegated to officers. Directors must therefore supervise officers.

i. Performance of these duties is enforced by action on behalf of the corporation brought by an individual shareholder (i.e. the shareholder derivative action)

ii. Directors stand in a ‘fiduciary’ relationship to the corporation. These are the duties of loyalty/good faith; reasonable care; business judgment

1. In general, the business judgment rule (differentiates by court): when a matter of business ‘judgment’ is involved, the directors meet their responsibility of reasonable care and diligence if they exercise an honest, good-faith, unbiased judgment.

2. Basic elements of the BJR: good faith, loyalty, and due caree. Damages

i. In a cause of action must be shown that the director failed to exercise reasonable care/breached fiduciary duty, and as a direct and proximate result, the corporation has suffered damages.

ii. Determination of whether there has been a breach of the duty of reasonable care is to look at the totality of the circumstances and all of the facts to see if the situation is one in which the director/officer should be held liable. The standard is normally applied to each director/officer individually to account for their actions in taking the action they did.

1. Many of these claims are based on the information the director/officer relied on in taking certain action in the best interest of the corporation

f. Casesi. Kamin v. American Express: Action by shareholders requesting court declaration that a certain dividend being paid is a

“waste of corporate assets.” AE acquired 2 million shares of publicly traded common stock in DLJ, which cost $29.9 million and had a current value of $4 million. Board declared a special dividend distributing shares of DLJ to shareholders in order to generate tax savings of $8 million, because a public sale of the stock would result in about $25


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million loss. Ps demanded distribution of the shares be rescinded to the board. Board rejected. Issue was whether minus a showing of bad faith, fraud, oppression, arbitrary action, or breach of trust the business judgment decisions of the board are judicially rescindable for imprudence or mistaken judgment. Court held No – the allegations in the complaint go to the business judgment of the directors. The decision of whether to declare a dividend is exclusively a matter of business judgment, and mere errors of judgment are not sufficient grounds for court interference. All of the directors carefully considered the facts in taking the action, and there were no facts alleged that they acted improperly.

ii. Smith v. Van Gorkom (Delaware Case; use Del. Corp. Code): Shareholder derivative action seeking rescission of a merger of TU to become New T company. Van Gorkom was chairman of the board, who requested a study from Romans, the CFO, regarding the leveraged buy-out. The report said they could generate enough cash to pay $50/share, but not $60/share. Van Gorkom said he would take $55/share of his own shares. Market price of the shares was $39/share. No study was done to determine the intrinsic value of the shares. TU had 3 days to consider the offer. VG hired outside legal counsel to review the deal, and called a board meeting 2 days after the offer. TU’s investment banker not present, nor were copies of the proposed merger, senior management opposed the merger, and Romans said the price was too low. VG announced, in a 20 minute presentation, that it wasn’t necessarily the best deal, but it was fair. Board accepted the merger offer. TU began soliciting other offers, and got one for $60/share. VG said it was a bad idea, and said offer was cancelled and never presented to the board. Other offers for more were made but later withdrawn. 70% of the shareholders approved the merger in Feb., after commencement of the derivative suit. Issue was whether the directors acted in accordance with requirements of the business judgment rule. Court held No – while the BJR presumes that directors act on informed basis, in good faith, and in the honest belief that their actions are for the good of the company. P must rebut this presumption. While there was no fraud or bad faith, issue was whether the directors informed themselves properly. Duty of care requires all reasonably material information available to be looked at prior to the decision. Directors held to be “grossly negligent” in failing to properly inform themselves, based on evidence about the activities at the relevant board meetings.

1. the emphasis is not on the ends achieved, but the means in achieving those ends.iii. Brehm v. Eisner: Disney hire Ovitz as Pres. Board approved a 5-year compensation package, and contained a severance

package in the event Ovitz left before the 5-years and it was not his fault. Ovitz had problems working. 1 year later Eisner let Ovitz terminate his contract under the non-fault basis. The board then approved the non-fault termination agreement, resulting in a severance package of over $140 million. Shareholder derivative action ensued. Issues were (a) whether 1995 board breached fiduciary duty by failing to properly inform itself of the terms of the employment agreement; and (b) whether the 1996 board breached the duty by approving the non-fault termination of the employment agreement. Court held No and No – board relied on a corporate compensation expert in evaluating the contract. Although the non-fault termination was not quantified did not mean the board did not consider its potential cost. When negotiating the employment contract, the board considered the value of the contract against the value of the particular employee to the company. This is inherent in the business judgment. Approving the non-fault termination also did not demonstrate breach, b/c the “fault” termination amounted to Ovitz behaving grossly negligent or with malfeasance. Although he didn’t put forth best efforts, cannot be said his conduct amounted to gross negligence or malfeasance.

iv. Francis v. United Jersey Bank: Pritchard Corp. was a reinsurance company. Their business was arranging contracts between insurance companies seeking indemnification against losses under their own policies (ceding companies) and other insurance companies (reinsurers). Industry practice was to segregate insurance funds from the brokers’ general accounts. PC commingled its funds with clients. The officers/shareholders withdrew funds from the commingled account and labeled them as ‘shareholder loans.’ PC filed for bankruptcy. UJB represented the estates of the Pritchards. Ps sued Mrs. Pritchard, alleging her negligence in allowing her sons to steal money from her company (even though they were also shareholders/officers, she was effectively the ‘board’). Issues were (a) whether Mrs. P was a corporate director, individually liable in negligence for the acts of the corporation, and (b) if she was negligent, whether her negligence was the proximate cause of Ps’ losses. Court held Yes and Yes – Directors have a duty to act in good faith as the ordinarily prudent person in a similar situation would act. As such, the director(s) should have a basic understanding of the corporation’s business and knowledge of its activities. Mrs. P did not fulfill her obligations b/c she never reviewed the books/records, which would have demonstrated to her the illegal commingling of funds and ‘loans’ being taken out by her sons. As to causation, that requires determining what ‘reasonable steps a director could have taken and whether those steps would have prevented the loss.’ Mrs. P’s failure to act was a substantial factor in the harm, and therefore her non-action was proximate cause of P’s loss.

v. Graham v. Allis-Chalmers: Derivative action based on anti-trust activities. Ds claim immunity from liability as they had no knowledge of the illegal activities. Basically, because of the nature of the corporate structure, the board does not have a say in the price-setting of certain products manufactured by the company, but the board meets annually to review the books and records of the corporation. The indictments to which Allis-Chalmers and the four non-director defendants pled guilty charge that the company and individual non-director defendants, commencing in 1956, conspired with other manufacturers and their employees to fix prices and to rig bids to private electric utilities and governmental agencies in violation of the anti-trust laws of the United States. None of the director defendants in this cause were named as defendants in the indictments. Some reports had been created in 1937 for the board at the time alerting them to possible anti-trust activities taking place at the time. The current directors who are named defendants were not members of the board at the time those reports were released. Issue was whether the directors had breached their duty of care in not knowing of the anti-trust activities. Rule is that directors in managing the corporate affairs are bound to use that amount of care which ordinarily careful and prudent men would use in similar situations. Whether they are liable for failure to exercise proper care/control depends on the circumstances and facts of the particular case. Directors are entitled to rely on the honesty and integrity of their subordinates until something occurs to put them on


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suspicion that something is wrong. If something happens and the directors ignore it, then they may well be liable. Absent cause of suspicion, there is no duty upon the directors to install and operate a corporate system to seek out malfeasance which they have no reason to suspect exists. Holding – No Director Liability.

1. Be prepared to use similar facts of this case, but apply the updated standard in Caremarkvi. In re Caremark International Inc. Derivative Litigation: Involving a proposed settlement of derivative suits against

director Ds. Allegation that D breached duty of care for allegations involved in a fed. govt. investigation against the corp. Caremark was indicted with multiple felonies and pled guilty to one such felony. Shareholders brought suit to recover money from the individual board members. Issue is whether the settlement agreement should be approved, even though the benefits it confers are ‘modest,’ in exchange for dismissal of the derivative claims. Court held Yes – because this is a claim of failure on the part of the directors to effectively monitor the corporate activities/performance, they must show, per the Allis-Chalmers rule, that they failed to exercise ordinary reasonable care. While Allis-Chalmers held that the directors did not have an obligation to “ferret out” wrongdoing, this may be overcome by the following rule: P must show that directors breached their duty of care by showing: (1) the directors knew or (2) should have known that violations of law were occurring, and in either event (3) the directors took no steps in a good faith effort to prevent or remedy the situation, and (4) such failure proximately caused the losses complained of. This standard is a narrow interpretation of the Allis-Chalmers standard. As to the ‘good faith’ effort, especially regarding corporate reporting structure, the board must exercise good faith judgment that the system in place is in ‘concept and deisgn adequate to assure the board’ receives appropriate information. The ‘should have known’ standard relies on a ‘sustained or systematic failure of the board to exercise oversight, like an utter failure to attempt to assure a reasonable information and reporting system exists.’ This evidences a lack of good faith, and therefore a breach of duty of care.

II. Duty of Loyaltya. Directors and Manager

i. General rule – directors must place the interests of the corporation above their own personal interests/gains. 1. Where most problems arise: contracts between corporations and one of its directors; transactions by a director

that results in profits that the corporation might have engaged in; contracts for directors’ compensation; basically any transaction where individual directors experience personal gain.

ii. Self-Interested Transactions (i.e. Conflicts of Interests)1. MBC §8.61(b): Director’s conflicting interest transaction may not be subject of equitable relief in a

shareholder derivative action on the ground that director has a self-interest in the transaction if:a. Action was taken in compliance with §8.62; orb. Shareholders’ action was in compliance with §8.63; orc. Transaction is established to have been fair to the corporation.

2. MBC §8.62: Directors’ Actionsa. Director’s conflicting interest transaction is effective if it was authorized by affirmative majority

vote of directors, after qualified disclosure by conflicted director or modified disclosure noted below, so long as:

i. Qualified directors have deliberated and voted outside the presence and without participation of conflicted director; and

ii. Action has been taken by a committee.b. Notwithstanding subsection (a), when director’s conflicted transaction only because a person

related to the conflicted director is a party or has a material financial interest in the transaction, the conflicted director is not obligated to make required disclosure if the director reasonably believes disclosure would violate a separate legal duty, so long as he discloses:

i. All information required to be disclosed so that it is not violativeii. Existence and nature of the conflict; and

iii. Nature of the director’s duty not to disclose.3. MBC §8.60(6): Definition of “fair to the corporation:” (i) fair in terms of the director’s dealings with the

corporation, and (ii) comparable to what might have been obtainable in an arm’s length transaction, given the consideration paid or received by the corporation.

4. Where a conflict of interest exists:a. Where the director knows that he or someone related to him (relativity extends no more that cousin

relationships):i. Is party to the transaction

ii. Has a financial interest in the transaction, and that interest would reasonably be expected to influence the director’s judgment; or

iii. Is a director, general partner, agent, or employee of another entity with whom the corporation is transacting business.

b. (Basic understanding of MBC §8.61): Conflicting transaction permitted so long as:i. There has been full disclosure of all material facts to the voting directors/shareholders

ii. Approved by majority of board without a conflict; or has been approved by majority of unconflicted shareholders; or

iii. Transaction was fair to the corporation.c. Burden of proof – the person challenging the action has burden of proving with clear and

convincing evidence that standards above have not been met.d. Possible remedies: enjoining transaction; setting aside the transaction; damages

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a. Bayer v. Beran: Shareholder derivative action alleging corporate waste and breach of duty of loyalty where board spent $1 million on radio advertising for the corporation, where the wife of one of the directors would sing the advertisement. Issue was whether directors breached fiduciary duties. Court held No – the amount expended on the ad campaign was ‘reasonable and not excessive.’ The nature and character of the ad program (classical music) was in keeping with their corporate purpose. Although the wife and her singing career may have benefited from the transaction, and although the director has the burden to demonstrate not only good faith of the transaction and the inherent fairness to the corporation, that was demonstrated here because she was a good singer, there was no evidence some other singer could have enhanced the quality of the ad, her compensation was in conformance with other singers in the program (actually she was paid less).

i. Elaboration of the Business Judgment Rule: “questions of policy of management, expediency of contracts or action, adequacy of consideration, lawful appropriation of corporate funds to advance corporate interests, are left solely to [the board’s] honest and unselfish decision, for their powers therein are without limitation and free from restraint, and the exercise of the common and general interests of the corporation may not be questioned, although the results show that what they did was unwise or inexpedient.”

b. Lewis v. SL&E: Lewis Sr. owned SLE and LGT. SLE owned real property that LGT used. Lewis transferred SLE shares to his 6 children. 3 kids were directors/officers of SLE. P was not. Kids sold shares of SLE to LGT. The SLE lease of LGT property expired and not renewed. P sued SLE claiming directors had committed waste. Issue was whether D carried burden of proof to show that transaction was fair to corporation when there was self-interest in the dealings by officers/directors. Court held No – Rule was when there was conflict of interest in a transaction, burden of proof to show the transaction was fair and reasonable rests with the directors. They did not carry that burden.

iii. Corporate Opportunities1. MBC §8.70: Business Opportunities

a. Director may not be liable for taking advantage of an opportunity on the ground that such opportunity should have first been afforded to the corporation, if the director:

i. Brings the opportunity to the attention of the corporation; andii. The directors disclaiming the opportunity is taken in compliance with §8.62 (see above);

oriii. Shareholders’ action disclaiming the corporate opportunity is taken in compliance with

§8.63 (see above);b. Except that ‘required disclosure’ is not required, but that the director made prior disclosure to other

actors of all material facts concerning the opportunity then known to the director.c. Should the director not take the above actions does not create an inference that the opportunity

should have been presented to the corporation.2. Del. Corp. Code §144: Interested Directors; quorum

a. Question arises in context of use of the word “solely” under §144(a)3. In general, the director fiduciary duty prohibits him from taking the corporate opportunity without first

disclosing the opportunity to the corporation and giving them the opportunity to act. a. Factors in determining whether a transaction is a “corporate opportunity” for the purposes of

determining whether the director breached his duty by acting on the opportunity (from Broz):i. The company is financially able to undertake the opportunity;

ii. The transaction is in the same line of business as the corporation;iii. The company has a reasonable expectancy to the type of opportunity; and

1. a ‘reasonable expectancy’ exists when it is reasonably foreseeable that the corporation would be interested in the transaction in question (like if the opportunity relates closely to the type of business in question)

iv. The director’s self-interest conflicts with the interest of the company.4. Defenses to Usurping the Corporate Opportunity

a. D was presented with the opportunity in his individual capacity, and not as a fiduciary of the corporation;

b. Corporation is financially unable to take advantage of the opportunity; or c. The Corporation refuses the opportunity.

5. Also, there may be a breach of fiduciary duty if the corporate opportunity exists in competition with the interests of the corporation, even if it is a valid corporate opportunity.

6. Casesa. Broz v. Cellular Information Systems: B was pres and sole shareholder of RFB Cellular, which

provided cellular service in the Midwest. He was also a board member of CIS, which owned certain cellular licenses in Michigan. Mackinac Cellular wanted to sell one of its licenses, and received a list of potential purchasers which included RFB, but not CIS. CIS told B they weren’t interested in purchasing the license, so B offered to buy the license. PriCellular, in the mean time, was in the process of making a tender offer to purchase CIS. Pri became aware of B’s purchase of the license. CIS (after ownership by Pri became effective, which was after B acquired the license) sued B. Issue


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was whether B breached his fiduciary duty by usurping the corporate opportunity. Court held No – B became aware of the opportunity in his capacity as an individual. At the time of the license offer (which the seller considered CIS to not be a financially viable candidate), CIS was not in a financial opportunity to buy the license. Therefore they did not have a reasonable expectancy to it. No formal presentation of the type of offer made to B was not required under the circumstances that CIS did not have an interest, expectancy, or financial ability to buy it. And B was not obligated to refrain from competing with Pri, especially where Pri’s acquisition interest of CIS was uncertain and speculative at the time B bought the license.

b. In re Ebay Shareholders Litigation: Founders of Ebay hired Goldman Sachs to serve as underwriters in their formation of Ebay. Stock value of Ebay increased substantially, and they decided to issue more shares, still keeping GS as their lead underwriters and financial advisors. GS ‘rewarded’ D (founders and directors of eBay), with thousands of IPO stocks (which were initial shares in upcoming shares). Besides eBay’s internet business, they were also in the business of investing. The IPO shares were kept individually by Ds. Shareholders sued for usurping the corporate opportunity, alleging these shares Ds kept should have gone to the corporation. Court held No usurpation of corporate opportunity – investing was not an integral or significant aspect of eBay’s business. There was no ‘reasonable expectancy’ that investment was going to become a primary characteristic of the corporation.

i. NOTE – Rest. Agency 2d §§387 & 388 – agents have a duty to not receive secret profits in connection with transactions conducted on behalf of the principal; and the agent has a duty to act for the benefit of the principal in such transactions, and not for personal gain/benefit.

b. Dominant Shareholdersi. Generally, majority shareholders are fiduciaries to the corporation and to the minority shareholders. Therefore they

have an obligation to act in good faith in transactions, and a duty not to act/vote in a manner which would be ‘unfair’ to minority shareholders.

1. When a majority shareholder deals with the corporation in an individual transaction, the transaction will be subject to ‘closest scrutiny’ to see that minority shareholders are being treated fairly.

ii. Cases1. Sinclair Oil v. Levien: SO owned 97% of stock of a subsidiary corporation, Sinven. SO appointed directors as

officers of Sinven. SO drained dividends from Sinven to meet its own cash needs. L (minority shareholder of Sinven) sued SO for limiting Sinven’s ability to grow, thereby breaching its fiduciary duty to L. Court applied the “intrinsic fairness” test – requires a high degree of fairness when a parent/majority shareholder affects the corporate dealings of the subsidiary, and the burden shifts to SO/parent corp. to prove that its transactions with Sinven were objectively fair. Issue was whether application of the intrinsic fairness test was appropriate in defining the fiduciary duty of the parent corporation as to its controlled subsidiary. Court held Yes – whenever there is self-dealing, intrinsic fairness test must be applied. Where evidence showed there was no self-dealing (majority shareholders did not receive a benefit to the detriment or exclusion of minority shareholders), and did not usurp any opportunities that would normally have gone to the subsidiary, then the business judgment rule applies.

2. Zahn v. Transamerica: Z owned class A common stock. 2 other classes of stock existed: class B and preferred stock. Upon liquidation, class A got $2/stock, and class B got $1. T bought all class A and B stocks, thus giving it majority shareholder control over the corp. When the assets were liquidated, T paid off preferred shares and itself the remainder, after having called the class A stocks. Z sued, claiming that had he been included in the liquidation, he would have received $240/share, as opposed to the $80/share pursuant to the call. Issue was whether the majority shareholders could use its control of the board to gain at the expense of minority shareholders in a transaction that complied with state law. Court held No – while a majority shareholder may vote to further its own interests, it still has a fiduciary duty to the corporation and minority shareholders. Such actions, then, are governed by good faith and fairness. The call of the class A stocks, which were controlled by the majority shareholders, showed the directors/majority shareholders acted in their self-interest.

c. Ratificationi. Del. Corp. Code §144

1. involves situations where a transaction between a corporation and one of its directors or officers that is ratified by the board

2. state law says that such a transaction will not be void or voidable if the transaction is fair as to the corporation as of the time it is ratified by the board/committee/shareholders.

3. the interested directors have the burden of proving the transaction was fair to the corporation when it was ratified

ii. Fliegler v. Lawrence: Agau was mining business which owned property rich in silver and gold, but lacked the capital to mine it. L was an officer/director of Agau, and he individually purchased some land and offered to sell it to Agau. Board decided it couldn’t pursue the corporate opportunity, so the directors formed a separated corporation, USAC (closely held corporation) for the purpose of purchasing L’s property. Director (Ds) gave Agau option to purchase USAC, which was eventually executed. Agau shareholders approved the transaction. Shareholder filed suit against Ds to recover the 800K shares transferred from Agau to USAC, arguing that Ds usurped corporate opportunity for Agau. Issue was whether the directors were required to prove fairness of the transaction even when the decision was ratified


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by the shareholders. Court held Yes – while shareholder ratification of an interested director transaction shifts the burden of proof to P to demonstrate that the terms of the transaction were unfair, this burden shift does not apply when the majority share votes are cast by the interested directors. Also, Del. CC §144 only protects such transactions that are properly ratified by shareholders. It does not relieve D from having to prove fairness of the transaction.

iii. In re Wheelabrator Technologies, Inc. Shareholders Litigation: Merger of WTI and Waste Management. Certain members of the Waste board were also on the WTI board. Merger negotiations continued. When came time for a vote, the non-Waste directors approved the merger. Then the full board approved the merger. The directors reviewed reports and opinions from investment bankers that said the merger was fair. They prepared and distributed proxy statements explaining the merger to WTI shareholders. Majority of WTI shareholders voted and approved the merger. Other WTI shareholders filed derivative action alleging failure by directors to use due care in reviewing the merger, and that proxy statements were materially misleading; also claimed D breached duty of loyalty, and argue that D has burden of proof on the issue of loyalty under the entire fairness standard of review. Issues were (a) whether D is entitled to summary judgment on the duty of care claims; (b) whether D is entitled to summary judgment on disclosure claims; and (c) whether D bears the burden of proof under the entire fairness standard of review. Court held (a) Yes; (b) Yes; and (c) No.

1. Directors have duty to disclose fully and fairly all material facts that would have a significant effect on shareholder’s vote. P bases their failure to disclose claim on the idea that the statements in the proxy statements were ‘materially misleading.’ No evidentiary support for this claim. Based on the facts: long-term working relationship between WTI and Waste; WTI directors had substantial working knowledge of Waste; proxy statements were based on information from reports by investment bankers and outside counsel. Because proxy statements fully informed shareholders, no breach of duty of care.

2. Duty of loyalty: Standard of Review and Burden of Proofa. When action has been ratified by shareholders, standard of review and burden of proof depend on

type of underlying transaction.i. “Interested Director” transactions – approval by fully informed, disinterest shareholders

invokes BJR, limiting judicial review to issues of waste or gift. Burden of proof is on the party attacking the transaction.

1. this is the case hereii. Transactions between the corporation and controlling shareholder. Usually involve

parent-subsidiary mergers. Standard of review is “entire fairness,” and directors have burden of proof.

1. this is not the type of case at present, b/c Waste did not exercise de jure or de facto control over WTI, nor was it a majority shareholder (only owned 22%)

III. Shareholder Derivative Actionsa. Primary Requirements of SDA

i. P must have been a shareholder at the time of the acts complained of;ii. P must still be a shareholder at the time of the suit; and

iii. P must make a demand (unless excused) upon the board, requesting that the board attempt to obtain redress for the injury claimed

b. MBC §7.41-7.46: governs derivative actionsi. MBC §7.41: Shareholder Standing

ii. MBC §7.42: Demand1. Written demand must have been made upon the directors; and2. 90 days must have expired from time demand was made and commencement of the derivative action.

iii. MBC §7.43: Stay of Proceedingsiv. MBC §7.44: Dismissal

1. May be dismissed by court on motion of the corporation if one of the below groups has determined in good faith, after conducting a reasonable inquiry, that the maintenance of the derivative is not in the best interests of the corporation.

2. Determination shall be made bya. Majority vote of qualified directors; orb. Majority vote of a committee

3. If derivative action is commence after determination is made rejecting the shareholder demand, complaint shall allege with particularity facts establishing:

a. A majority of directors did not consist of qualified directors or b. Requirements of (a) have not been met (i.e. good faith; reasonable inquiry; best interests of the

corporation)4. P will have burden of proving the requirements have not been met if the majority of the board consisted of

qualified directors. If majority of directors did not consist of qualified directors at the time the determination was made, corporation has burden of proving (a) requirements met.

5. Upon corp. motion, court may appoint a panel to determine whether maintenance of derivative proceeding is in best interest of corp. In such case, P has burden of proving (a) requirements.

v. MBC §7.45: Discontinuance or Settlement: discontinuance or settlement of derivative action cannot occur without court approval

vi. MBC §7.46: Payment of Expensesc. Difference between Direct and Derivative Suits


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i. Direct suits are on behalf of the individual shareholder, claiming that management’s breach deprived that shareholder of some right that is not contingent to the rights of the other shareholders, and he sues in his own name

1. these may also be brought as class actions2. Nature of the action is a breach of fiduciary duty owed to the shareholder and/or other shareholders

a. This distinguishes the fiduciary duty owed to the shareholders as opposed to the duty owed to the corporation

b. Basic tests:i. Who suffers the most immediate/direct damage; and

ii. To whom did the defendant’s duty run?3. Cannot require plaintiff to posting security, because the alleged injury is against the shareholders, not the

corporation.ii. Derivative suits claim that the management’s breach ‘reduced the residual value of the business,’ and must sue in the

name of the corporation/on behalf of other shareholders1. Nature of the action is representative because the shareholders are enforcing the rights of the corporation2. The corporation is a named defendant, although the case of action asserted belongs to the corporation, it is

being brought by shareholders against the directors of the corporation for the failure of the corporation to assert its own claim; this justifies the action as being brought against the corporation itself.

3. May require posting of security or bond for expenses incurred as a result of the litigationiii. Cohen v. Beneficial Industrial Loan Corp (Supreme Court case): C brought SDA, alleging that individual Ds engaged

in continuing conspiracy to enrich themselves at the corporation’s expense. NJ enacted a statute requiring Ps owning less than 5% of shares liable for reasonable expenses and fees of defense if the derivative suit fails. Corp. D moved to require P to post security bond. P appealed. Issue was whether a fed. ct. sitting in diversity apply a statute of the forum state providing for the post of security for the corporation. S.Ct. held Yes – a stockholder who brings a derivative action assumes a position of fiduciary b/c he is suing as a representative of a class (i.e. the other shareholders). The statute does not offend due process requirements because it calls for security for only reasonable expenses. Fed. Cts. must apply NJ statute in this diversity action (as required by jurisdiction and choice of law standards).

iv. Eisenberg v. Flying Tiger Line: Stockholders approved a merger of parent and wholly owned subsidiary companies by 2/3 vote. When merger took effect, FTL ceased to exist, and resulted in all business operations being confined to a wholly owned subsidiary. Eisenberg, allegedly on behalf of himself and all other former stockholders of FTL, sued to enjoin reorganization and merger. Issue was whether asserting that stockholders had been deprived of any voice in the affairs of the company was a derivative action for purposes of the statute. Court held No – NY law indicated that NY law governs even when another state’s substantive law controls the merits of the case (here, Del. Law). So even if Del. Law governed, but has no security requirement, the NY law requiring security controls on the issue of the security. Also, because P’s action only claims that he and fellow stockholders lacked a voice in the affairs of the corp., and does not make a claim regarding management of the corp. on behalf of the corp., the action is not a derivative action, but a direct action. Since the law regarding securities only applied to derivative actions, he was not required to post security.

d. Requirement of Demand i. Fed. Rule. Civ. Pro. 23.1: “In a derivative action, the complaint shall be verified and shall allege that P was a

shareholder . . . The complaint shall also allege with particularity the efforts, if any, made by P to obtain the action he desires from the directors, or the reasons for his failure to obtain the action or for not making the effort. The derivative action may not be maintained if it appears that P does not fairly and adequately represent the interests of the shareholders or members similarly situation in enforcing the right of the corporation.”

ii. MBC §7.44: Demandiii. Purposes of Demand requirement

1. invokes ADR to avoid litigation2. if litigation is beneficial, the corporation can control the proceedings3. if demand is excused, the stockholder will control the proceedings

iv. Difference between wrongful refusal of demand and excusal of demand1. demand is not required in every case; but a stockholder who makes demand is entitled to know what action

the board has taken in response to the demand2. Demand is excused only if the shareholder has a reasonable doubt that the board could exercise appropriate

judgment and demand would be futile (i.e. the futility exception)3. If demand is rejected, the presumption is that the board acted properly unless the shareholder can allege the a

basis from which reasonable doubt could be raiseda. once a shareholder makes such demand, he cannot argue that demand has been excusedb. normally, if demand has been made and rejected, the court will usually apply the business judgment

rule, and P has burden of proving some bad faith, malfeasance, etc. v. Grimes v. Donald: P claimed directors failed to use due care, committed waste, approved excessive compensation, and

unlawfully delegated duties and responsibilities. Issue was whether a shareholder may proceed directly on an abdication claim when he seeks only a declaration that an agreement between the board and its CEO is invalid. Court held Yes – Whether a claim may proceed as a direct or derivative claim depends on the nature of the wrong alleged and the relief sought. Abdication claims are more likely to qualify as direct claims, so they may proceed despite no demand being made on the Corp.

vi. Marx v. Akers: Marx never made demand on IBM’s board, but filed a shareholder derivative suit alleging corporate waste by awarding excessive compensation to officers. Issues were whether (a) futility excuses a derivative plaintiff from making demand in connection with claims of excessive compensation paid to executive officers and the majority


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of the board consists of outside directors; (b) futility excuses demand when a majority of board consists of outside directors and claims regard excessive compensation to outside directors; (c) whether P stated a cause of action when alleging: compensation paid to outside director ‘bears little relation to the services rended by the or to the profitability of the company, and compensation increased in excess of cost of living when their duties and responsibilities did not change.’ Court held (a) No; (b) Yes; (c) No – Futility exception permits shareholders to bring claims on behalf of the corporation when it is evident that directors will wrongfully refuse to bring such claims. To qualify for exception, P must allege with particularity (a) majority of the board is interest in the challenged transaction, by virtue of self-interest or control by a self-interested director; (b) the board did not fully inform themselves of the challenged transaction to the extent reasonably appropriate under the circumstances, or (c) the challenged transaction is egregious on its face and could not have been product of sound business judgment. Futility not shown as to executive compensation, but was as to director compensation because of allegation that outside directors comprised a majority of the board indicates that the majority of the board was self-interested. However, the compensation claim for outside directors did not state a cause of action because did not allege the rates were excessive, made in bad faith, or product of invalid business judgment.

e. The Role of Special Committeesi. MBC §7.44(a): Dismissal and the reasonable inquiry determinations by committees

ii. Auerbach v. Bennett: GTE directors investigated possible improper payments to public officials and political parties in foreign countries. Board furthered the investigation. Found that improper payments had been made. A brought derivative action, seeking to compel D to account for money paid in bribes. Board created a special litigation committee, consisting of 3 disinterested board members, who determined that it was not in the best interest of the corporation to proceed with the derivative action. Court granted D’s motion to dismiss. Issues were (a) whether decision by a special committee not to continue litigation protected the corp. from judicial inquiry by business judgment doctrine; (b) whether business judgment rule precludes inquiry into the disinterested independence of the committee members or the appropriateness and sufficiency of the investigative procedures; (c) whether an investigative committee authorized by the board and consisting of defendant directors was incapable of determining whether to continue suit against those directors; and (d) whether SJ should be withheld upon motion for disclosure made by an intervenor. Court held (a) Yes; (b) No; (c) No; and (d) No – derivative actions require application of business judgment rule. Before a shareholder may bring such action, he must make demand of board to bring such a suit, and board must refuse. If refusal is based on good faith business judgment of committee/board, court will dismiss the derivative suit. When such refusal is in bad faith, court may continue the suit. Bad faith inquiry is into the disinterested independence of those chosen to decide whether to continue with the litigation. While the substantive decision of the committee may not be inquired into by the court as it is protected by the business judgment, the methods and procedures may be inquired into by the court. The procedures and methods used by the special committee did not demonstrate bad faith, summary judgment for the corporation was appropriate.

iii. Zapata Corp. v. Maldonado: Special committee instituted to determine whether litigation on derivative action should continue. Committee decided not to continue litigation. Issue was whether the committee had the power to discontinue the action. Court held Yes – Unless a decision to discontinue a derivative suit is wrongful, a board’s decision will be respected as a matter of business judgment rule. Stockholder may initiate action himself when demand may be properly excused as futile. But excusing demand does not strip board of its corporate power. Where discontinuance of suit may be in corporation’s best interests, that decision may be respected.

1. Court has 2-step balancing test in determining whether corporation may avoid litigation:a. Court must recognize that board, even though tainted by self-interest, can legally delegate its

authority to a committee of disinterested directors; but Court may inquire on its own into the independence and good faith of the committee and the bases supporting its conclusion

b. If court is satisfied as to the first two things, then court may apply its own business judgment as to whether motion should be granted

iv. In re Oracle Corp. Derivative Litigation: Same issues as above; the question of independence of the committee turns on whether, for any substantial reason, a director is incapable of making a decision with only the best interests of the corporation in mind.

SECURITIES REGULATIONS

I. Introduction to Regulation of Securities, Disclosures and Fairnessa. Two types of markets that are regulated now by federal law:

i. Primary Markets – The Issuer of the Securities (i.e. the company that created the security) sells securities to the investors

1. this is primarily regulated by the Securities Act of 1933a. the Sec. Act creates a scheme of mandatory disclosure for initial public distributions of securities

by issuers, underwriters, and dealers.b. Revolves around a disclosure document being provided called the “registration statement”

i. Includes the registration statement that must be filed with the SEC and the prospectus which must be provided to prospective investors

c. The 1933 act renders issuing corporations strictly liable for ‘misrepresentations’ or omissions in their registration statements

ii. Secondary Market – Investors trade securities among themselves without any significant participation by the original issuer


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1. this is primarily regulated by the Securities Exchange Act of 1934, and is at the heart of most of the issues raised in following case law

a. Exchange Act creates scheme of mandatory continuous disclosures for corporations where certain qualifications are met.

II. Definition of a Securitya. Why is it important to determine whether or not something is a ‘security’ – (a) indicates whether the registration requirements of

the Securities Act apply to the transaction; and (b) plaintiffs generally have an easier time bringing suit under federal securities laws then under state common law fraud rules.

b. Federal Definition: Securities Act §2(a)(1): “The term ‘security’ means any note, stock, treasury stock, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, . . . investment contract, voting trust certificate, . . . any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities, . . . or in general, any interest or instrument commonly known as a ‘security.’”

i. “context clause” – says terms used in the Act shall be defined in accordance with the various provisions of §2 “unless the context otherwise requires”

ii. S.Ct. two-part test to determine whether an investment contract is a security (SEC v. Howey):1. Defined investment contract: a contract, transaction or scheme whereby a person invests his money in a

common enterprise and is led to expect profits solely from the efforts of the promoter or a 3d party2. Two part test

a. Is it a profitmaking venture?b. Is the investor passive in management?

i. If yes to both, then it is probably a security/investment contractc. Robinson v. Glynn: R alleges G committed federal securities fraud when he sold R interest in G’s company, Geophone; R

invested $25 million in increments, forthcoming investments dependent on field tests done by G. G faked the field tests. R was given 33,333 shares of 133,333 in GeoP. R was also named treasurer in the company. R discovered the fake field tests. Issues were whether R’s membership interest in GeoP (which was an LLC), qualifies as either an investment contract or stock under Sec. Act.

i. Whether an investment contract is dependent on P being a “passive investor.” Since R was heavily involved in the management of the corp., he was no passive investor, and therefore his interest was not an investment contract.

ii. Whether his interest was “stock”1. Characteristics of “common stock:”

a. Right to receive dividends contingent upon an apportionment of profitsb. Negotiabilityc. Ability to be pledged or hypothecatedd. Conferring of voting rights in proportion to the number of shares ownede. Capacity to appreciate in value

2. R’s interest was not stock b/c there was no sharing in profits, his interest was not freely negotiable, he could only acquire distribution rights and not control rights, and his membership interest was not viewed by the parties involved as “stock”

iii. Court held R could not claim federal securities fraud because his membership interest was not a “security” as defined by the Sec. Act.

III. The Registration Processa. General requirements

i. Securities are prohibited from being sold unless they have been registered with the SEC1. Sec. Act §5 Language

a. Unless a registration is in effect as to a security, it shall be unlawful for any person, directly or indirectly:

i. (1) to make use of any means or instruments of transportation or communication in interstate commerce or of the mails to sell such security through the use or medium of any prospectus or otherwise

b. It shall be unlawful for any person directly or indirectlyi. (1) to make use of any means or instruments of transportation or communication in

interstate commerce or of the mails to carry or transmit any prospectus relating to any security with respect to which a registration statement has been filed under this title, unless such prospectus meets the requirements of §10

c. It shall be unlawful for any person directly or indirectly, to make use of any means or instruments of transportation or communication in interstate commerce or of the mails tooffer to sell or offer to buy through the use or medium of any prospectus or otherwise any security, unless a registration statement has been filed as to such security.

2. Sec. Act §5: 3 rules for registering securities before they are issueda. A security may not be offered for sale through mails or by use of other means of interstate

commerce unless a registration statement has been filed with the SECb. Securities may not be sold until the registration statement has become effectivec. The prospectus (disclosure statement) must be delivered to the purchaser before a sale

ii. SEC will not register certain securities unless the registration statement and prospectus contains the requisite disclosures required by statute and SEC rules

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1. Some securities entirely exempted (i.e. they never need be registered)2. Some transaction exempt when they would not otherwise be exempt (i.e. one-time exemption; eventually

must be registered)b. Exemptions

i. Private Offering Exemption: Sec. Act §4(2): Doran v. Petroleum Management Corp: D purchased a limited partnership interest in PMC for $125K. D’s share was used to make payments on the note owed to MCS. Oilwells were overproduced, violating WY law, and forced to close for 388 days. When they opened they operated at a loss. D sued PMC for breach of contract and rescission of contract based on violation of Sec. Act. No registration statement for PMC was ever filed. It was assumed by the court that the limited partnership interest was a ‘security’ as defined in Sec. Act §2.

1. Prima facie case for violation of federal securities law:a. No registration statement was filed with any federal or state regulatory body in connection with

PMC’s offering of securitiesb. PMC sold or offered to sell these securitiesc. PMC used interstate transportation or communication in connection with the sale or offer of sale

2. Private Offering Exemption (an Affirmative Defense) under Sec. Act §4(2): Four Factors for Considerationa. The Number of offerees and their relationship to each other and the issuer

i. Most critical factorii. The more offerees, the more likely the transaction is to be a public offering

1. Here, there was a relatively small number of offereesiii. Relationship between Offerees and Issuer

1. Depends on the “sophistication” of the offeree in connection with the issuera. evidence of a high degree of business or legal sophistication is not

sufficient to bring the offering within the private placement exemption; rather, “access to the kind of information which registration would disclose” is more relevant

b. There must be a sufficient basis of accurate information upon which the sophisticated investor may exercise his skills

2. PMC must show that all offerees had available information a registration statement would have afforded a prospective investor in a public offering

b. The Number of units offeredi. The more units offered, more likely it is a public offering

c. The Size of the offeringi. Depends on the size of the financial stakes involved; the smaller the stakes (by

comparison to potential overall stakes), the more likely it is a private offerd. The Manner of the offering

i. Personal contact between the offeree and issuer vs. public advertising or use of intermediaries in the transaction

ii. Regulation D: SEC Rules 501-5061. Provides a safe harbor for private offerings under Sec. Act §4(2)

a. Rule 504: if amount raised is under $1 million, offer can be directed to an unlimited number of people

b. Rule 505: if amount raised is under $5 million, offer can be made up to 35 offereesc. Rule 506: If amount raised is over $5 million, offer can be made up to 35 offerees who pass certain

tests of financial sophistication2. Issuer cannot advertise publicly, and must file a notice of the sale with the SEC shortly after it issues

securities3. this generally exempts only the initial sale; Buyers can therefore resell, but only if they find another

exemptiona. Sec. Act §4(1): If the buyer is not an issuer, underwriter, or dealer, then are exempt to resell

i. NOTE – an “underwriter” is defined as one who buys securities “with a view to” reselling them

ii. Issuers should make a ‘reasonable inquiry’ into the buyer’s plans and inform buyers of resell restrictions before selling them to offerees

4. Rule 144: subject to various qualifications, allows buyers to resell stock acquired in a Regulation D offering if they first hold it for 1 year and resell it in limited volumes

c. Overview of Securities Act Civil Liabilitiesi. Express Private Rights of Action

1. Sec. Act. §11 – directed at fraud committed in connection with the sale of securities through the use of a registration statement: “In case any part of the registration statement, when such part became effective, contained an untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statements therein not misleading”

a. Defendant has burden of proving his misconduct did not cause plaintiff’s injuriesb. May not be used in connection with an exempt offeringc. P must prove that any misstatement or omission was of a material fact

i. Reliance and Causation are not elements of plaintiff’s prima facie case


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ii. Privity of contract is not required. Provides an non-exhaustive list of potential defendants: §11(a)

i. Every person who signs the registration statementii. Every person who was a director of the issuer

iii. Every person who is named (with his consent) as about to become a directoriv. Every “expert” who gives a certificate that part of the registration was prepared by himv. Every underwriter involved in the distribution

vi. Control persons – i.e. persons who ‘control’ any person who might be liable abovee. Defenses: Sec. Act §11(b)(3): “Due Diligence” Defenses [see Escott v. BarChris]

i. No person, other than the issuer, will be liable if they sustain their burden of proof in showing:

1. with regard to “nonexpert” portions of the registration statement, after reasonable investigation he had reasonable ground to believe and did believe at the time such part of the registration statement became effective, that the statements therein were true, and there was no omission as to a material fact

2. with regard to “expert” portions, after reasonable investigation he had reasonable ground to believe and did believe at the time that part became effective, that statements therein were true and there was no omission of material fact, or that such part of the registration statement did not fairly represent his statement as an expert or was not a fair copy of or extract from his report or valuation as an expert

ii. §11(c): “reasonable investigation” defined – standard of reasonableness shall be that of a prudent man in the management of his own property

1. does not require that an independent auditor review the statement; but reasonable investigation must go beyond merely trusting the opinions and responses of the issuer’s officers as to material facts

2. Sec. Act §12(a)(1) – strict liability for offers and sales in violation of Sec. Act §5a. Available if the seller registers but fails to deliver a statutory prospectus, violates the “gun-

jumping” rules, or any other §5 violation3. Sec. Act §12(a)(2) – private civil liability on any person who offers or sells security in interstate commerce,

who makes material misrepresentations or omissions in connection with the offer or sale, and cannot prove he did not know of the misrepresentation or omission and could not have known even with the exercise of reasonable care

a. P’s prima facie case:i. Sale of a security

ii. Through instruments of interstate commerce or mailiii. By means of a prospectus or oral communicationiv. Containing an untrue statement or omission of a material factv. By defendant who offered or sold the security

vi. Which defendant knew or should have known of the untrue statement1. If plaintiff pleads that defendant had knowledge, burden shifts to D to prove

otherwiseb. Note – P need not prove reliancec. Defenses

i. If D conducts a reasonable investigation, he cannot be held liableii. D’s liability may be reduced if D proves that damages were the cause of other factors

ii. Implied Causes of Action1. Exchange Act §10(b)2. Exc. Act §14(a) and proxy rules

d. Escott v. BarChris: §11 action. Issue was whether individual defendants met the required standard of due diligence. Court held in most cases No due diligence under §11(b) and No “reasonable investigation” under §11(c)

i. Definition of “material” under §11 as it pertains to misrepresentations or omissions – limits the information required to those matters as to which an average prudent investor ought reasonably to be informed before purchasing the security registered

1. such matters are those which such an investor needs to know before he can make an intelligent, informed decision whether or not to buy a security

ii. Found material misrepresentations or omissionsiii. Applied the §11(b)(3) “due diligence” defenses to each of the defendants, individually

IV. Securities Exchange Act Fraud: §10(b) and Rule 10b-5a. Exchange Act §10(b): “It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of

interstate commerce, or of the mails, or of any facility of any national securities exchange . . . to use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, or any securities-based swap agreement . . . any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission (SEC) may prescribe as necessary or appropriate in the public interest or for the protection of investors.”


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b. Rule 10b-5: “It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails, or any facility of national securities exchange:

i. To employ any device, scheme, or artifice to defraud;ii. To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the

statements made, in the light of the circumstances under which they are made, not misleading; oriii. To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any

person:in connection with the purchase or sale of any security.

c. Elements of a 10b-5 violationi. Jurisdictional nexus: use of any means or instrumentality of interstate commerce; i.e. disclosure

ii. Transactional nexus: in connection with a purchase or saleiii. Fraud, deception, or misrepresentationiv. Materiality

1. Test (TSC Industries v. Northway): an omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important (

v. Reliance1. where materially misleading statements have been disseminated into a well-developed market the reliance of

individual plaintiffs on the integrity of the market price may be presumed for the purposes of a 10b-5 action2. Two possible scenarios

a. Affirmative misrepresentationsi. Actual reliance is shown; or

ii. Effect on the market/”fraud on the market” shownb. Nondisclosure

i. Issue will be whether P would have acted differently had he known of the material facts not disclosed

vi. Causation1. Transactional causation – but for the misrepresentation P would not have purchased or sold the security

(courts will generally presume this)2. Loss causation – the misrepresentation caused P’s loss/injury3. this is closely related to issues of “materiality” and “reliance”

vii. Scienter: Ernst & Ernst v. Hochsfelder1. must be an intent to deceive, manipulate, or defraud, or a reckless disregard to do so

viii. Standing: Blue Chip Stamps v. Manor Drug: Rule 10b-5 protsections extend only to purchasers and sellers of a corporation’s securities

d. Basic Inc. v. Levinson (S.Ct. case): Despite participating in merger discussions, Basic three times publicly denied engaging in merger discussions with Combustion. After the merger was announced, L and other shareholders brought a class action under §10(b) and rule 10b-5. On the basis of the “fraud on the market theory,” dist. ct. adopted a rebuttable presumption of reliance by members of the class. Issues were (a) whether statements about preliminary merger discussions were “material” and must be disclosed under 10b-5; and (b) whether a rebuttable presumption of reliance is appropriate.

i. Materiality: an omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote

1. Mergers discussions are speculative, so all relevant facts bearing on the (a) probability of the merger in discussions when the statements were made and (b) the magnitude of the merger are facts that are considered.

a. Therefore, materiality depends on the significance the reasonable investor would place on the withheld or misrepresented information

2. No absolute rule regarding materiality of merger discussions was established. Is a fact-dependent inquiry, that requires plaintiff to show that the “statements were misleading as to a material fact,” not just that the statements were false or incomplete.

ii. Reliance: requires a causal connection between D’s misrepresentation and P’s injury1. in face-to-face negotiations, issue is whether the buyer subjectively considered the seller’s representations2. in case of securities market, the dissemination of information by the issuer affects the price of the stock in the

market, and investors rely on the market price as a reflection of the stock’s value (i.e. misleading information affects the market price, which investors thus rely on – the “fraud on the market” theory)

a. dissent – ‘fraud on the market theory’ is in opposition to the fundamental policy of full disclosure, which is based on the idea that investors looking out for themselves by reading and relying on publicly disclosed information

3. a rebuttable presumption of reliance shifts burden of proof to Ds in situations where Ps have relied on the integrity of the market

a. Ways to rebut the presumption: i. Show that misrepresentation or omission did not distort the market price

ii. An individual plaintiff sold his shares for other reasons than market pricee. West v. Prudential Securities: Hofman was a securities broker who told 11 clients that Jefferson Bancorp was ‘certain’ to be

acquired in the near future. No such acquisition was pending. Issue was whether a class action for ‘fraud on the market’ reliance can be maintained in cases involving non-public information. Court held No – requirement of reliance and fraud on the market is that information is disseminated “publicly.” This was a private exchange of information. Problem lies in proving “causation,”


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which is shown when publicly disseminated information has an effect on the stock price/market, thereby causing investors to take action regarding the status of their shares.

f. Santa Fe Industries v. Green (S.Ct. case): SFI owned 90% of stock of subsidiary corp. In an effort to eliminate minority shareholders, SFI used a Del. short-form merger statute that allowed a corp. holding more than 90% of the stock of a subsidiary to merge the subsidiary corp., pay off minority shareholders in the subsidiary, given them 10 days notice of merger, and restrict minority shareholders an appraisal action in state courts if they were dissatisfied with the price. SFI paid $150/share to minority shareholders, when price of shares was valued at $125/share. Shareholders sued to enjoin the merger alleging a 10b-5 breach. Issue was whether 10b-5 provides a remedy for breach of fiduciary duty by officers/directors and majority shareholders (i.e. is there fraud) in connection with a sale of the corporation’s securities by its minority shareholders even if there is full disclosure of all facts, no misrepresentations, and transaction is valid under state law. Court held No – purpose of 10b-5 and §10(b) was to protect investors in their fully informed choices in the face of full disclosure of corporations. The transaction here was neither deceptive nor manipulative.

g. Deutschman v. Beneficial Corp.: Deu. filed class action against BC and its CEO and CFO for 10(b) and 10b-5 violations in relation to decline in the market price of BC’s stock. CFO and CEO released public statements that they knew were false and misleading in an effort to prevent further decline in the stock market price. Said statements had the effect of temporarily stabilizing the stock price. Issue was whether a plaintiff who traded in stock options in reliance of misstatements by corporate management have standing to sue under 10b-5. Court held Yes – the only standing limitation in 10b-5 is the requirement that P be a purchaser or seller of a security. This includes option contracts in the definition of a security. P has standing as a purchaser of an option contract to seek damages.

V. Insider Tradinga. Primary issue concerns what duty the corporate “insider” may owe to another party (usually outside shareholders)

i. Who is an “insider?” – someone related to the corporation (like an officer, director, or shareholder owning a large amount of stock) and who is in a position to have inside information about how the corporation is doing and what the corporation’s stock is or will be worth.

ii. Insider trading occurs when the ‘insider’ buys or sells stock with this inside informationb. The primary action is brought under §10(b) and Rule 10b-5c. Common law background: Directors and Officers had no duty to present or prospective shareholders and could deal with them at

“arm’s length” with no duty to disclose inside informationi. Goodwin v. Agassiz (1933): G saw newspaper article that a company he held stock in had discontinued copper

exploration. G sold his stock. A was pres. of the company, and he knew of a geologist’s theory that he believed had value and that he planned to have the company test on company property. Without disclosure, A bought G’s stock. This theory later proved true, and stock price rose. Issue was whether those privy to ‘inside information’ have a duty to disclose it in purchase and sales transaction over a stock exchange involving the corporation’s stock. Court held No – while directors with superior knowledge sometimes have fiduciary duty to shareholders in buying or selling stock, the sell/purchase of stock in this situation was not a face-to-face transaction, but was impersonal on a public exchange. No privity = no fiduciary obligation. Also, A had no duty to disclose because the theory was only a “hope,” not a proven reality.

d. Modern lawi. SEC Rule 10b5-1: Trading “on the basis of” material nonpublic information in insider trading cases – defines when a

purchase constitutes trading ‘on the basis of’ material nonpublic information in insider trading cases brought under §10(b) and Rule 10b-5. Law of insider trading is otherwise defined by judicial opinions construing Rule 10b-5.

1. “manipulative and deceptive devices” in insider trading cases involves the purchase or sale of securities, on the basis of material nonpublic information, in breach of a duty of trust or confidence that is owed directly, indirectly, or derivatively to the issuer or shareholder of the security.

2. “on the basis of” means the person making the purchase or sale was aware of the material nonpublic information when the person made the purchase or sale.

3. Affirmative defensesa. Purchase or sale is not “on the basis of” nonpublic information if person making the purchase or

sale demonstratesi. Before becoming aware of the inside info he had (a) entered into a contract to buy or sale

the security; (b) instructed someone else to purchase or sell the security; (c) adopted a written plan on trading securities;

ii. The contract/instruction/plan detailed (a) specific amount of securities; (b) included written formula for determining the amount or (c) did not permit the person to exercise subsequent influence over how, when, or whether to effect trading; provided any other person did exercise influence was not aware of the nonpublic info;

iii. The purchase or sale was pursuant to the contract, instruction or planiv. Individual making the investment was not aware of the nonpublic information, and

reasonable policies and procedures were taken into consideration of the person’s business to ensure individuals made trades in securities that did not violate laws prohibiting insider trading laws.

ii. SEC Rule 10b5-2: Duties of trust or confidence in misappropriation insider trading cases – this is a non-exclusive definition of circumstances where a person has a duty of trust or confidence in misappropriation theory of insider trading. Law of insider trading is otherwise defined by judicial opinions construing Rule 10b-5.

1. This applies to trading securities on the basis of material nonpublic information misappropriated in breach of duty of trust or confidence.


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2. “duties of trust or confidence” exist in the following situations:a. When person agrees to maintain information in confidence; b. Person communicating the material nonpublic info and the person to whom it is communicated

have a history, pattern, or practice of sharing confidences, such that the recipient knows or reasonably should know the communicator expects the recipient will maintain confidentiality; or

c. When person receives or obtains material nonpublic info from spouse, child, parent or sibling, provided, however, that the person receiving the info may demonstrate no duty of trust or confidence is expected by establishing (a) he neither knew nor reasonably should know the person who was the source of the info expected the recipient to keep info confidential based on history, pattern, or practice of sharing and maintaining confidences, and because there was no agreement or understanding to maintain confidentiality.

iii. Exchange Act §14(e): “It shall be unlawful for any person to engage in any fraudulent, deceptive or manipulative acts or practices in connection with any tender offer. The SEC shall, by rules and regulations, define and prescribe means reasonably designed to prevent such acts and practices.”

iv. SEC Rule 14e-3: Transaction in securities on the basis of material, nonpublic information in the context of tender offers1. It will constitute a fraudulent, deceptive or manipulative act for any person in possession of material

information relating to a tender offer, which information he knows or has reason to know is nonpublic, from (a) the tender offer/offering person; (b) issuer of the securities sought; or (c) any officer/director/any person acting on behalf of the offering person or issuer – to purchase or sell any securities or option or right, unless within a reasonable time prior to such transaction such information and its source are publicly disclosed by either press release or other means.

2. Defensens: Section (a) will not be violated if the person transacting shows:a. He did not know of the material/nonpublic information; andb. Such person had implemented policies and procedures to ensure investment decisions did not

violate section (a).3. Notwithstanding section (a), following transactions are not violations:

a. Purchases of securities are by a broker or another agent on behalf of an offering person;b. Sales of the securities to the offering person.

4. Issues of unlawfulness of communicating nonpublic info relating to a tender offer to any other person under circumstances it is reasonably foreseeable that such communication is likely to result in a violation of this section (except as to communications made in good faith):

a. This does not apply to communications made to:i. To officers/directors/partners/employees of offering person, its advisors, or other

involved in planning/financing/preparation/execution of the tender offer;ii. Issuers whose securities are sought by similar people above;

iii. Any person pursuant to a requirement by statute or ruleb. This does apply to communications by:

i. Offering persons;ii. Issuers of the securities sought;

iii. Anyone acting on behalf of the above persons;iv. Any person in possession of material information of a tender offer which info he knows

or has reason to know is nonpublic and which he knows or has reason to know has been acquired directly or indirectly.

v. SEC v. Texas Gulf Sulfur Co.: TGS detected large mineral deposit. Drilled a test hole and discovered good stuff. Several corp. officers who knew of the test purchased TGS stock on the open market before public disclosure of the drilling test results. TGS then issued a press release downplaying the significance of the test results. SEC claimed TGS, officers, and geologists who purchased stock violated Rule 10b-5. TGS stock price rose from $17 3/8 to $58 ¼. Issues were whether (a) information about the mineral test results were material as a matter of law; and (b) whether issuance of the press release violated rule 10b-5. Court held (a) Yes, and (b) Maybe.

1. Insider rule – “anyone possessing material inside information must either disclose it to the investing public, or, if he is prohibited from disclosing it in order to protect a corporate confidence, or he chooses not to do so, he must abstain from trading in or recommending the securities concerned while such inside information remains undisclosed.”

2. Materiality test – whether a reasonable person would attach importance to the information in making choices about the information. Whether facts are material depends on balancing the indicated probability the event will occur and the anticipated magnitude of the event in light of the totality of the company’s activities. The test results were certainly material facts in that capacity.

3. As to the press release, SEC failed to demonstrate that it was false or misleading. While it did provide some potential for growth, there was evidence that the price of TGS stock declined following the press release.

vi. Chiarella v. United States (S.Ct. case): S.Ct. held that Chiarella (a ‘markup man’ at a printing company who discovered inside information about a tender offer and instigated securities transaction based on that information) did not violate 10b-5 because he was not an ‘insider’ of the corporation whose shares he had traded, therefore he did not have a duty to abstain, because such a duty only arises from a relationship of trust between a corp’s shareholders and employees. Since no relationship of trust existed between Chiarella and shareholders, he had no ‘duty to abstain’ from trading.

vii. Dirks v. SEC (S.Ct. case): Dirks was a stockbroker specializing in providing investment analyses of insurance company securities to institutional investors. He received information from insiders of a corporation with which he had no


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personal connection. He disclosed this information to investors who relied on it in trading in shares of the corporation. D was also told that the corp. was engaging in fraudulent practices. D urged Wall Street Journal to publish a story, but WSJ declined. Stock price dropped dramatically. SEC investigated D and ruled D had aided and abetted violations of securities law, including Rule 10b-5. Issue was whether a “tippee” is always under an obligation to disclose inside information before trading or to refrain from trading. Court held No:

1. insider’s will be liable under 10b-5 where he fails to disclose material nonpublic information and makes transactions based on that information in violation of a duty to others, like shareholders

a. there can be no duty to disclose where the person who has traded on inside information was not the corporation’s agent, was not a fiduciary, or was not a person whom the sellers had placed their trust and confidence

2. Tippee’s only inherit an insider’s duty to shareholders when the information has been improperly disclosed to them by the insider (i.e. the insider breaches the fiduciary duty to the shareholders by disclosing the information to the tippee and the tippee knows or should have reasonably known there was a breach)

a. Test of whether the insider’s tip breaches his fiduciary duty is whether the insider will personally benefit, directly or indirectly, from his disclosure. Absent this breach by the insider, there is no derivative breach.

viii. Response to Chiarella and Dirks: SEC passed Regulation FD1. adopted to create a non-insider trading-based mechanism for restricting selective disclosure (such as officers

giving information to a market analyst)2. if someone acting on behalf of a public corporation discloses material nonpublic information to securities

market professionals or holders of the issuer’s securities who may well trade on the basis of the information, the issuer must also disclose the information to the public

3. Another Response was the passage of Rule 14e-3ix. US v. O’Hagan (S.Ct. case): O’Hagan was a partner at lawfirm representing a potential tender offer by GrandMet of

common stock of Pillsbury. O did not personally work on the transaction, but he began buying Pillsbury stocks. Stock price rose from $39 to $60/share. O was indicted by SEC for, among other things, violating §10(b) and Rule 10b-5, and §14(e) and Rule 14e-3(a). Issues were whether (a) a person who trades in securities for personal profit, using confidential information misappropriated in breach of a fiduciary duty to the source of the information, is guilty of violating §10(b) and 10b-5; and (b) whether the SEC exceeded its rulemaking authority in adopting Rule 14e-3(a), proscribing trading on undisclosed information in the tender offer setting, even in the absence of a duty to disclose. Court held (a) Yes and (b) No (i.e. 14e-3 is a valid rule).

1. “misappropriation theory” – holds a person in breach of a duty owed to information source when a person commits fraud in connection with a securities transaction when he misappropriates confidential information for securities trading purposes.

a. Under 10b-5, misappropriation of information must involve some deceptive device or connivance. O “feigning fidelity to the source of confidential information” while secretly trading on information for personal gain constitutes deception.

b. Thus, misappropriation theory can provide violation of §10(b).2. 14(e) prohibits fraudulent acts in connection with a tender offer. It gave the SEC to create such rules and

regulations in accordance with this rule. 14e-3’s rule prohibiting certain acts are valid to prohibit acts that are not themselves fraudulent if the prohibition is reasonably designed to prevent acts and practices that are fraudulent.

e. General Overview of Insider Trading Analysisi. §10(b) and 10b-5 violation: “Traditional Theory” of fraudulent or deceptive misrepresentations

1. Is D in possession of material nonpublic informationa. NO – no liabilityb. YES – Is D a statutory insider or temporary insider?

i. NO – Is D a tippee (subjecting him to derivative liability)?1. NO – no liability for either the tippee or the tipper2. YES – Did the tippee know or reasonably should have known of the tipper’s

breach of duty of confidentiality?a. YES – Both tipper and tippee liable under 10b-5b. NO – Tipper liable, but tippee not liable

ii. YES – Did D trade or cause to trade without disclosing the information?1. YES – Liable under 10b-52. NO – Did D tip others?

a. NO – No Liabilityb. YES – See tippee liability analysis

ii. 10b-5 Misappropriation theory application1. Is D in possession of material nonpublic information

a. NO – no liabilityb. YES – Does D owe a fiduciary duty of confidentiality to the possessor of the information, and is

the information within the scope of his fiduciary duty?i. NO – No liability under misappropriation theory unless D received a tip from someone

who did have a fiduciary duty, in which case “yes”


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ii. YES – Did D trade or cause securities to be traded without disclosing this information?1. YES – Subject to liability for personal trades under 10b-52. NO – Did D tip others?

a. NO – No liability under misappropriation theoryb. YES – Did insider tip others recklessly and for personal benefit

without publicly disclosing the information?i. NO – no liability to either the tipper or tippee

ii. YES – Did the tippee know or reasonably should know of the tipper’s breach?

iii. NO – Tipper liable under 10b-5iv. YES – Both tipper and tippee liable under 10b-5

iii. 14e-3 Special rule for tender offersVI. Indemnification and Insurance: MBC §§ 8.50-8.59

a. MBC §8.50: Definitionsb. MBC §8.51: Permissible Indemnification

i. Corp. may indemnify an individual who is a party to a proceeding b/c he is a director against liability if:1. Dir. conducted himself in good faith; and2. he reasonably believed

a. his conduct was in the best interest of the corporation when acting in his official capacity; andb. in other cases, his conduct was not opposed to the best interests of the corporation; and

3. in Criminal proceedings, he had no reasonable cause to believe his conduct was unlawful.ii. Dir.’s conduct respecting an employee benefit plan, for purposes in best interest of participants and beneficiaries,

conduct was not opposed to best interests of corporation.iii. Termination of proceedings or upon plea of nolo contendere is not determinative that the dir. met relevant standard of

conduct.iv. Corp. may not indemnify a dir.:

1. in connection with proceeding, except for reasonable expenses, if it is determined that the director has met the relevant standard of conduct, or

2. in connection with a proceeding where the dir. has been adjudged liable.c. MBC §8.52: Mandatory Indemnification

i. Corp. shall indemnify a dir. who was successful in defense of any proceeding to which he was a party b/c he was a director against expenses incurred by him

d. MBC §8.53: Advance for Expensesi. Corp. may advance funds for reasonable expenses incurred for a dir. if the dir. delivers to the corp:

1. written affirmation of dir.’s good faith belief that standard of conduct under §8.51 has been met, or conduct where liability has been eliminated; and

2. written undertaking of dir. to repay any fund advanced if the dir. is not entitled to mandatory indemnificationii. the written undertaking must be an unlimited general obligation of the dir.

iii. Authorizations shall be made by:1. the board of directors; or2. by the shareholders.

e. MBC §8.54: Court-Ordered Indemnification and Advance for Expensesi. Dir. party to proceedings may apply for indemnification or advances to the court. Court will

1. order indeminifcation if court determines director is entitled to mandatory indemnification; or2. order indemnification if director is entitle pursuant to provision authorized under §8.58; or3. order indemnification that is fair and reasonable:

a. to indemnify the director, orb. to advance expenses to the director.

ii. If court determines director indemnification is proper, it shall order the corp. to pay the dir.’s reasonable expenses incurred.

f. MBC §8.55: Determination and Authorization of Indemnificationi. Corp. may not indemnify a dir. under 8.51 unless authorized for a specific proceeding after determination made that

indemnification is permissible.ii. Determination shall be made

1. if 2 or more qualified directors, by board by majority vote, or majority vote of a committee;2. by special legal counsel3. by shareholders

g. MBC §8.56: Indemnification of Officersi. Corp. may indemnify officers:

1. to the same extent as directors; and2. if he is an officer but not a director, to such further extent as may be provided by the articles of incorporation,

bylaw, resolution, or contract except for:a. liability with a proceeding by or in right of the corporation for other than reasonable expenses; orb. liability arising out of conduct that constitutes:

i. receipt by him of a financial benefit to which he is not entitled,ii. intentional infliction of harm on the corp. or shareholders, or


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iii. intentional violation of criminal lawii. (a)(2) applies to officers who are also directors if basis of the proceeding is an act solely related to conduct in his

capacity as an officeriii. Entitled to mandatory indemnification and may apply to the court for such to the same extent as a director.

h. MBC §8.57: Insurancei. Corp. may purchase and maintain insurance on behalf of individuals against liability asserted against or incurred by

him in that capacity, whether or not the corporation would have power to indemnify him against such liability under this section.

i. MBC §8.58: Variation by Corporate Action; Application of Subchapteri. Corp. may by provision in articles of incorporation or bylaws obligate itself in advance to provide indemnification.

Obligatory provisions shall satisfy requirements for authorization under 8.53(c) and 8.55(c).ii. Any provision under (a) shall not obligate corp. to indemnify directors unless otherwise specifically provided for.

iii. Corp. may limit indemnification in its articles of incorporation.iv. This subchapter does not limit corp.’s power to pay expenses by a dir. or officer for reasonable expensesv. Nor does it limit corp.’s power to indemnify or maintain insurance for employees or agents

j. MBC §8.59: Exclusivity of Subchapter: A corporation may provide indemnification or advance expenses to a director or an officer only as permitted by this subchapter.

PROBLEMS OF CONTROL

I. Closely Held Corporationsa. Definition – a closely held corporation is one with very few shareholders. It is essentially an “incorporated partnership.”b. Control Problems

i. Formal roles assigned by law (i.e. distinctions between officers/directors and shareholders) tend to be irrelevantii. Certain corporate formalities may not be relevant, and there is little possibility of injury to the public from internal

deviations from formal corporate requirementsiii. Minority shareholders usually want more control, so voting requirements tend to be set higher (i.e. may require

unanimous vote rather than majority). Voting agreements may be arranged for, such as in a voting trust.iv. Conflicts can arise from agreements between the corporation and one or more founding members (i.e.

directors/shareholders) who may not be involved in the day-to-day operation of the business.v. Restrictions normally imposed on ability to transfer control of stocks

c. Agreements controlling matters within the board’s discretion—most courts hold that shareholders cannot make agreements as to how they will vote as directors because directors must be free to act independently in their roles as directors in order to faithfully execute their fiduciary duties. Shareholders may agree on how they will elect directors, then directors may act as they choose.

i. McQuade v. Stoneham: Corp. had 2500 outstanding shares: Stoneham owned 1306; McGraw owned 70; McQuade owned 70. All parties agreed to use best efforts to elect themselves as directors and officers, take salaries, etc. Stoneham appointed 4 other directors. At a directors meeting, Stoneham and McGraw refused to vote, allowing the other 4 directors to outvote McQuade in removing his as an officer of the corp. P sued for specific performance of the shareholder agreement. Issue was whether shareholders may agree among themselves as to how they will act as directors in managing the affairs of the corp. Court held No – shareholders may not agree to control the directors in exercise of their independent judgment. Although concurrence found the contract/shareholder agreement valid, but concurs in the judgment because the otherwise valid contract is unenforceable because it resulted in illegal employment of McQuade, who was a city magistrate.

ii. Clark v. Dodge: Clark owned 25%; Dodge owned 75% of 2 corporations. C ran business and knew a secret formula. C and D agreed C would be kept as a director so long as he was ‘faithful and efficient.’ C sued for specific performance of the agreement when he was discharge without cause. Issue was whether their original agreement was enforceable. Court held Yes – contract was not void on policy grounds because there was no attempt to sterilize the board from performing its duties faithfully. All shareholders agreed, there was no injury to the shareholders, creditors, or the public, and this was a closely held corporation.

1. See NY Bus. Corp. Law §620: permitting voting/shareholder agreements2. See Del. Gen. Corp. Law §§ 141(a) and 142(b)

d. Many jurisdictions now permit shareholder agreements that commit to electing themselves or their representatives as directorsi. Agreement requiring the appointment of certain individuals as officers or employees are usually enforceable, as long as

they are signed by all shareholders1. however, they may still be objectionable if they unduly deprive directors of the independent judgment

ii. “Voting Trusts”1. Shareholders who wish to act in concert turn their shares over to a trustee; trustee then votes all the shares in

accordance with instructions in the document establishing the trustiii. Galler v. Galler: Agreement among family members who were shareholders of closely held corporation. Issue was

whether the agreement should be sustained. Court held Yes.II. Abuse of Control

a. Fiduciary Obligations of Shareholders in a Closely Held Corporation: Law partners in a partnership have a fiduciary duty to each other, so there is an implied-in-law fiduciary duty of shareholders to each other in a close corporation.

b. Wilkes v. Springside Nursing Home: W had option to purchase a building and lot. R, Q, and P joined W to form a close corporation to run a nursing home on the property. Each invested equally, and it was understood each would be a director. P sold his shares to C, now dead. Q wanted to buy part of the property. W convinced the other shareholders to sell the property at a


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higher price. This pissed Q off. So Q, C and R voted to put themselves on salary for the corporation, but did not give W salary. They then voted W out of office and director position. W sued for breach of agreement and fiduciary duty. Issue was whether the majority of shareholder breached their duty of good faith and loyalty to P. Court held Yes – rule is that shareholders in a close corporation have same duty to each other as partners. “Freezing out” another shareholder breaches this duty. Courts are required to analyze the action taken by the controlling stockholders in the individual case, and whether they can demonstrate a legitimate business purpose for the ‘freeze out.’ This requires balancing rights of the group against their duty to minority shareholders.

c. Ingle v. Glamore Motor Sales: Glamore was sole shareholder in GMS. Ingle was hired as a sales manager. I wanted to purchase shares, and was eventually permitted to purchase 22%. Agreement provided a stock option purchase. Glamore’s 2 sons later became shareholders, and a new agreement was drawn up. I was voted out of his corp. post and fired as manager. Glamore bought his shares back from I. I sued. Issue was whether an at-will employee acquires fiduciary-rooted protection against being fired when he is a minority shareholder in a close corporation. Court held No – Corp. owed him no duty in his capacity as an at-will employee, only as a shareholder. The shareholder agreement did not offer him job security.

III. Dissolutiona. Chapter 14: Dissolution

i. MBC §14.30: Grounds for Judicial Dissolution1. Basically lays out considerations of a court when application is made to judicially dissolve a corporation

a. Attorney general may applyb. Shareholders may apply (applicable especially in close corporations, and does not apply to publicly

traded corporations)c. Creditor proceedingsd. Corporation application to have voluntary dissolution continuede. Shareholder application when corporation has abandoned its business and failed to liquidate its

assetsii. MBC §14.02: Dissolution by Board of Directors and Shareholders

b. Alaska Plastic, Inc. v. Coppock: 3 men equal shareholders in AP, each owning 300 shares. In a divorce settlement, one of the men transferred 150 shares to ex-wife. Wife (P) was not notified of annual shareholder meetings in 3 years. At one meeting, the shareholder decided to offer her $15K for her shares. Accountant advised wife her shares were worth from $23K to $40K. She offered $40K, they refused; counter-offered $20K, she refused. AP was then destroyed in a fire. Wife filed suit requesting the company buy her shares for a fair and equitable price. Court ordered they buy it for $32K. Issue was whether the trial court erred in obligating the corp. to repurchase wife’s shares. Court held Yes – in close corporations, there is not likely to be a market for trading shares, and the corp. may not be interested in purchasing the shares. Majority shareholders are in a position to squeeze out minority shareholders.

i. Court remanded case for determination an appropriate remedy for wife. While the most successful remedy was to have the corp. buy out her shares. This can occur in 4 ways:

1. Articles of Incorporation may contain buyout provision. (not the case here)2. Alas. Corp. Code provides for shareholder action to liquidate or dissolve upon showing the majority

shareholders acted illegally, oppressively, or fraudulently, or that corporate assets were wasted. a. Remanded to find whether majority shareholders acted in such a manner. This was found, and trial

court entered judgment for wife for $32K.3. Forced purchase of shares – not available here b/c no fundamental change in corporate structure, like in a

merger or sale of corporate assets4. Breach of duty – since non of the other shareholders here sold their shares back to the corporation, they did

not enjoy a benefit that wife could have been entitled to, thereby prompting a finding of breach of fiduciary duty.

IV. Transfers of Controla. Issue arises when a majority shareholder (who would then be a “controlling shareholder”) sells that stock/control in a transaction

from which other shareholders are excluded. Or in situations where all shareholders sell, but the owner of the control shares receives more per share than others.

i. “Control” has value.ii. General rule

1. A shareholder may sell his stock to whomever he wants to at the best price he can get.2. Majority shareholders have the same right.

a. This has become subject to some scrutiny, in that if stocks are sold for illegal purposes, in bad faith, contrary to fiduciary relationships of directors (who may also be majority shareholders) to minority shareholders. See cases below.

b. Zetlin v. Hanson Holdings: Z owned 2% of Gable. A group of shareholders (Ds) sold their interest in Gable to a 3d party, which gave him effective control, for $15/share. Market price for shares was $7.38/share. Z wanted same price and sued. Issue was whether, absent fraud, a controlling shareholder can sell control for a premium price. Court held Yes – absent looting, conversion of a corporate opportunity, or other acts of bad faith, controlling shareholder can sell the right to control the affairs of the corporation at a premium price. (Called “control premium”)

c. Perlman v. Feldmann: Derivative action by minority shareholders of Newport. F was pres, chairman of board, and owned 37% of stock in company. F sold his shares at $20/share to Wilport, after which the directors resigned, and new purchasers were appointed as the board. Market price for shares was $12/share; book value was $17/share. P claimed D’s compensation was for sale of a “corporate asset,” held in trust by F as fiduciary for all shareholders (the asset was corporate control). Issue was whether there is a breach of fiduciary duty by officer/director/majority shareholder in selling majority control in these factual circumstances. Court held Yes – directors/officers/majority shareholders have a fiduciary duty to corporation (1st) and minority


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shareholders (2d). Normally a majority shareholder may sell his stock, but in current circumstances (market shortage, corporation’s product demands large premium, and Newport could not compete profitably but could have used time of shortage to build of business), corporate goodwill belongs to all shareholders, and F could not as a fiduciary take this profit for himself.

i. NOTE – this is a rare case, and suggests that there was an alternative opportunity short of selling all majority shares at a premium price that F should have taken, separate from the control premium

V. Mergers and Acquisitionsa. Freeze-out Mergers

i. Purposes of a merger may be for controlling shareholders to “freeze out” minority shareholder. Effect is that the minority shareholders will have to accept cash for their shares. Actions are brought for minority shareholders who voted against the merger to insist that the corporation buy their shares at a price set by the court. The focus of such actions are on the interest of the minority shareholders in the merger.

1. Courts will analyze the “entire fairness” of the merger in freeze out mergers. a. 2 Factors in “Entire Fairness”

i. Fair Dealing/Procedure1. Even in cases of ratification, D has burden to prove fairness of the transaction if

there was/was not full disclosure to the minority shareholders. Lack of full disclosure renders ratification illusory.

ii. Fair Price1. Although a price per share given to minority shareholders may have been

“fair,” if a higher price would have been equally fair, an investigation of the inherent fairness of the higher price and why it was not offered to minority shareholders needs to be conducted.

b. This is “enhanced scrutiny” of the business judgment rule.ii. Weinberger v. UOP: Signal proposed to acquire controlling interest in UOP for $19/share. UOP shares traded on NYSE

for $14/share. UOP sought $25/share, but ended up taking $21/share. Signal acquired controlling shares in UOP and nominated/elected 13 members on UOP’s board. Signal then investigated feasibility of acquiring balance of UOP’s outstanding shares. Study revealed that a good investment would be at $24/share. The two officers who conducted the study did not disclose this conclusion to non-Signal UOP directors or shareholders. Signal offered $20-21/share, which was authorized by UOP board. Outside counsel was hired to render fairness opinion on this price. Found that $21/share was “fair.” Merger proposal considered by both Signal and UOP boards based on financial statements and data and the outside counsel’s “fairness opinion letter” in deciding to accept the offer. Merger approved. W brought shareholder class action against UOP and Signal, saying the cash-out merger was unfair to minority shareholders. P’s investment analyst said a ‘fair’ price would have been $26/share. Issues were (a) whether Signal bore the burden of showing the merger was “fair” to minority shareholders; (b) whether evidence showed Signal dealt fairly with UOP’s minority shareholders; (c) what method of valuation to use; (d) whether evidence showed Signal paid a ‘fair price;’ and (e) whether when minority shareholders challenge a freeze out merger the controlling shareholders must demonstrate the merger serves a legitimate business purpose. Court held (a) Yes; (b) No; (c) No; (d) No; (e) No. [Note: Analyzed under Del. Corp. Code §262, which provides in ascertaining a ‘fair’ price, court should consider ‘all relevant factors’]

1. P has the initial burden in challenging a cash-out merger to allege specific acts of fraud, misrepresentation, or other acts of misconduct to demonstrate the unfairness of the merger terms. But the majority shareholder has the ultimate burden to show by a preponderance of the evidence that the transaction is “fair.” This is applicable when directors of a corporation are on both sides of a transaction, they are required to demonstrate their utmost good faith and most scrupulous inherent fairness of the bargain.

a. Analysis of Entire Fairness has 2 aspects: Fair Dealing and Fair Pricei. Fair Dealing: questions of when the transaction was timed, how it was initiated,

structured, negotiated, disclosed to the directors, and how the approvals of the directors and shareholders were obtained

1. Duty of Candor: one possessing superior knowledge may not mislead any stockholder by use of corporate information to which the latter is privy.

2. Problem here was the existence of the field study that said $24/share was a fair price.

3. Another problem was the existence of Signal directors sitting/voting as directors on the UOP board.

ii. Fair Price: relates to the economic and financial considerations of the proposed merger. Relevant factors include: assets, market value, earning, future prospects, and any other elements that affect the intrinsic value of a company’s stock.

1. Not all relevant factors were considered here, like the prospect of future earnings (which although speculative, is still relevant and ascertainable)

2. Corporate planning: What might Signal have done to avoid problematic litigation? (i.e. what would you advise Signal to do?)

a. Make sure members of Signal (the “seeker” corporation) who are on the board of the UOP (the corporation sought) are kept entirely isolated from decision making process of the merger

b. Appoint an independent committee to supervise the isolation.c. Get an independent investment banker to do financial analysis (i.e. one who does not have an

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d. Make sure full disclosure is made to shareholders; i.e. all material information is disclosedVI. Takeovers

a. Tender offers and regulationi. Tender offerer makes conditional public offer to buy a target’s shares.

1. 2-Tiered, Front-Loaded offers: Offerer makes initial offer of $70/share to acquire 51% (i.e. controlling shares) of company. After those are acquired, they will make a lower offer (like $60/share) for the remaining shares.

a. These offers require a heightened level of scrutiny in determining their validity/fair price of the second tier offer

i. “fair price” usually defined as: (a) highest price paid by the bidder for any shares acquired during or immediately before the tender offer; (b) the highest price at which the stock has traded during some period; (c) a price that is in the same proportion of the share price at the time the 2d step transaction was announced as the tender offer price was to the share price at the time the tender offer was announced; and (d) the product of multiplying the target’s average earnings per share by the bidder’s average price-earnings ratio.

2. Is usually a matter of proportionalityii. Unocal v. Mesa Petroleum: A “hostile takeover/tender offer.” Mesa made 2-tier tender offer for Unocal shares, of

which Mesa already owned 13% of shares. Purpose was to motivate shareholders to sell their shares during the first-tier of the offer before the price reduced during the 2d tier. Board of Unocal issued an exchange of its own stock in the first tier at an amount higher than that offered by Mesa. Members of Mesa board were excluded from the self-tender offer. Mesa brought action for restraining order on Unocal from proceeding with the offer unless Mesa was included. Issue was whether under the business judgment rule a corporation may defend itself against a hostile takeover by means of a self-tender for its own shares which excludes from participation the stockholder making the hostile tender offer. Court held Yes – Directors have power to oppose a tender offer, which is derived from its fundamental duty and obligation to protect the corporation and shareholders from reasonably perceived harm (Del. Corp. Law §141(a)). Del. Corp. Code §160(a) confers broad authority on the directors to deal in its own stock, provided the directors have not acted solely to entrench themselves in office.

1. Business judgment rule presumes that directors making a business decision acted on informed basis in good faith and in the honest belief that the action was in the best interests of the company. BJR is applicable in context of a takeover bid.

a. Directors must show that they had a reasonable grounds for believing that danger to corporate policy and effectiveness existed because of another person’s stock ownership, and that they are not just acting in self-interest. Burden is met when they demonstrate acting in good faith and upon reasonable investigation of the fact in their duty to protect the corporation.

b. Defensive measures taken must be reasonable in relation to the threat posed.i. Considerations of the defensive measure taken:

1. inadequacy of the price offered2. nature and timing of the offer3. questions of illegality4. the impact of the sale on stockholders and other interested parties

2. Reasoning – Mesa’s participation in Unocal’s offer to sell would have thwarted the purpose of the offer.iii. SEC Rule 13e-4

1. passed in response to Unocal2. now forbids reporting companies from employing a selective self-tender; i.e. prohibits issuer tender offers

other than those made to all shareholders3. Does not prohibit “poison pills” – rights the exercise of which makes the takeover less profitable to the

acquirer, typically by lowering the value of the target’s or acquirer’s shares4. Basically grants all shareholders except the offerer valuable rights to purchase target stock’s at a discount or

to sell their shares at a premiumiv. Revlon v. MacAndrews & Forbes Holdings: Pantry Pride expressed interest in acquiring Revlon. R opposed all of P’s

subsequent offers for a friendly takeover. R discussed possibility of hostile takeover by PP, who made tender offer of $45/share. R adopted defensive measure, proposing to buy 5 million of its 30 million outstanding shares, and adopted a “Note Purchase Rights Plan” under which each of R’s shareholders would receive a dividend in the form of one “Note Purchase Right,” entitling the holder to exchange one common share for $65 principal note at 12% interest with 1 year maturity. These Rights were not made available to PP (the acquirer). R eventually announced a leveraged buy-out by Forstmann (a “white knight”) for $57.25/share. Part of the buy-out agreement was a ‘no-shop’ provision requiring R to only deal with F. F required immediate approval of the proposal or it would be withdrawn, so R’s board unanimously approved the proposal. Issue was whether the defensive measures taken to avoid the hostile takeover were consistent with the directors’ duties to the shareholders. Court held No.

1. FIRST, under the business judgment rule, board must satisfy the principles of care, loyalty, and independence in resisting the takeover, and that they were not acting primarily in their self-interest in adopting defensive measures.

a. In adopting the “Rights Plan,” the directors were acting in good faith because they were protecting their shareholders from the hostile takeover.


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b. R’s counter-offers were also reasonable, because the board reasonably concluded that PP’s tender offer was grossly inadequate.

c. BUT, when the board entered into the lock-up agreement, which preferred noteholders over shareholders, they breached their primary duty of loyalty to the shareholders. This is because at this point, it became clear that the company was going to be auctioned off, and the board’s primary focus became selling to the highest bidder instead of protecting the shareholder interests.

i. While F’s bid was higher, negotiating solely with him did not yiled value for the shareholders, but protected the board through the lock-up provisions. (Lock-up provisions are not per se illegal, but when they end a bidding contest on an insubstantial basis and the result is to protect the directors from personal liability or loss, the action fails the enhanced scrutiny test provided in Unocal).

d. The “no-shop” agreement was also illegal because another bidder was actively bidding, and the goal was to sell to the highest bidder.

2. Essential effect of Revlon: when a takeover is inevitable, the allowable standard of defensive measures allowed by Unocal is less, and Revlon now requires “value-maximization” in the adoption of such measures. Basically, measures must be taken to sell to the highest bidder for the benefit of the shareholders, and not for protection of the directors (this is consistent with their fiduciary duty of care and loyalty to the shareholders).

v. Paramount v. Time: Time began pursuing options to expand. Time entered merger negotiations with Warner. Time wanted to maintain control of the board, and the parties could not agree on these terms. Negotiations recommenced after a time though, and they approached what seemed to be a “done deal.” Paramount then made a better offer than Warner, but Time rejected the offer, reasoning that the long-term benefits of the Time-Warner deal outweighed short-term gains of a merger with Paramount. Paramount made an even higher offer, which Time again rejected. Time shareholders and Paramount sought to enjoin the Time-Warner merger. Issues were whether the Time-Warner agreement effectively “put Time up for sale,” thus triggering duties under Revlon, and whether the Time-Warner agreement was proper exercise of the business judgment rule. Court held (a) No, and (b) Yes.

1. Revlon claim – that Time’s decision for merger with Warner effectively put them up for sale, and when a company is “for sale,” their duty is to maximize immediate share value and consider all offers on an equal basis.

a. However, here, unlike in Revlon, Time was seeking to expand its corporate entity through the merger, and not effectively “dissolve” Time by putting it under the effective control of Warner. Thus, Revlon duties not triggered.

i. Revlon duties are triggered in 2 situations:1. when a corporation initiates active bidding process seeking to sell itself or to

effect a business reorganization involving a clear break-up of the company.2. where, in response to a bidder’s offer, a target abandons its long term strategy

and seeks an alternative transaction (i.e. a friendly takeover) involving the break-up of the company.

2. Unocal claim – that Time’s decision to take up defensive measures in response to Paramount’s offer (i.e. by rejecting offers from Paramount) was not a proper exercise of business judgment

a. Two things Time must prove to legitimate defensive measures, and therefore application of the business judgment rule

i. There were reasonable grounds to believe there was a danger to corporate policy and effectiveness

ii. The defensive measures used were reasonably related to the threat imposedb. If these are satisfied, the BJR applies, and board will be presumed to act disinterestedly, in good

faith, and exercise due care and loyalty in making the decisionvi. Paramount v. QVC

1. HOLDING – the sale of control here implicates enhanced judicial scrutiny of the conduct of the Paramount Board under Unocal and Revlon; this arises out of a proposed acquisition of Paramount by Viacom

2. Defensive provisions at issuea. no shop provision

i. Paramount board agreed that Paramount would not solicit, encourage, discuss, negotiate, or endorse any competing transactions unless

1. A third party makes an unsolicited, written bona fide proposal which is not subject to any material contingencies reatling to finances, and

2. The Paramount Board determines that discussions or negotiations with the third party are necessary for the Paramount Board to comply with its fiduciary duties

b. Termination feei. Viacom would receive $100 million termination fee if

1. Paramount terminated the Original Merger Agreement because of a competing transaction

2. Paramount’s stockholders did not approve the merger; or3. The Paramount Board recommended a competing transaction

c. Stock Option Agreementi. Granted to Viacom an option to purchase approximately 19.9 %

ii. Two provisions were both unusual and highly beneficial to Viacom:


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1. Viacom was permitted to pay for the shares with a senior subordinated note of questionable marketability instead of cash; and

2. Viacom could elect to require Paramount to pay Viacom in cash a sum equal to the difference between the purchase price and the market price of Paramount’s stock

3. RULES OF LAWa. Under normal circumstances, neither the courts nor the stockholders should interfere with the

managerial decisions of the directors; business judgment rule embodies the deference to which such decisions are entitled

b. in certain situations, a court subjects the directors’ conduct to enhanced scrutiny to ensure that it is reasonable

i. circumstances where such enhanced scrutiny will be applied1. the approval of a transaction resulting in a sale of control 2. the adoption of defensive measures in response to a threat to corporate control

c. Significance of Sale or Change of Controli. Because of the intended sale of control, stockholders are entitled to receive, and should

receive, a control premium and/or protective devices of significant value; since there were no protective provisions in the transaction, the directors had an obligation to take the maximum advantage of the current opportunity to realize for the stockholders the best value reasonably available

d. Obligations of Directors in a Sale or Change of Control Transactioni. Special obligations of the board arise in the sale of control; in particular they have an

obligation of acting reasonably to seek the transaction offering the the best value reasonably available to stockholders

ii. In the sale of control, the directors must focus on their primary objective – to secure the transaction offering the best value reasonably available for the stockholders – and they must exercise their fiduciary duties to further that end

1. Directors should analyze all facts considerable and evaluate in a disciplined manner the consideration being offered

iii. Enhanced Judicial Scrutiny of a Sale or Change of Control Transaction1. Scrutiny mandated by:

a. threatened diminution of the current stockholders’ voting powerb. the fact that an asset belonging to public stockholders is being sold

and may never be available againc. the traditional concern of Delaware courts for actions which impair or

impede stockholder voting rights2. Enhanced scrutiny test

a. a judicial determination regarding the adequacy of the decisionmaking process employed by the directors, including the information on which the directors based their decision

b. a judicial examination of the reasonableness of the directors’ action in light of the circumstances then existing

iv. Directors have burden of proving that they were adequately informed and acted reasonably

v. Requires a review of the reasonableness of the substantive merits of a board’s actionse. Discerning Revlon and Time-Warner

i. Revlon Holdings1. The directors’ role changed from defenders of the corporate bastion to

auctioneers charged with getting the best price for the stockholders at a sale of the company

2. When a board ends an intense bidding contest on an insubstantial basis, that action cannot withstand the enhanced scrutiny which Unocal requires of director conduct

a. A breakup of the company does not have to be present and inevitable before directors are subject to enhanced judicial scrutiny

ii. Time-Warner1. Held that there was no change of control in the original stock-for-stock merger

between Time and Warner because Time would be owned by a fluid aggregation of unaffiliated stockholders both before and after the merger

4. Breach of Fiduciary Duties by Paramount Boarda. Paramount directors had following obligations

i. To be diligent and vigilant in examining critically the transaction and tender offersii. To act in good faith

iii. To obtain and act with due care on all material information reasonably available, including information necessary to compare the two offers to determine which of these


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transactions, or an alternative course of action, would provide the best value reasonably available to the stockholders

iv. To negotiate actively and in good faith with both Viacom and QVC to that endb. Effects of State and Federal Legislation

i. CTS Corporation v. Dynamics Corp. of America (S.Ct. 1987)1. ISSUE – whether the Control Share Acquisitions Chapter of the Indiana Business Corporation Law is

preempted by the Williams Act or violates the Commerce Clause of the Constitution Art. I §8 cl. 32. Sub Issues

a. Whether the Williams Act preempts the Indiana Acti. RULE – absent an explicit indication by Congress of an intent to preempt state law, a

state statute is preempted only where compliance with both federal and state regulations is a physical impossibility, or where the state law stands as an obstacle to the accomplishment and execution of the full purposes and objectives of Congress.

1. Williams Act Requirementsa. Requires the offeror to file a statement disclosing information about

the offer; andb. Establish procedural rules to govern tender offers

2. Reasoning – the Indiana statute protects the independent shareholder against both of the contending parties, thus furthering the basic purpose of the Williams Act

b. Whether the Indiana Act violates the Commerce Clausei. Principle objects of the dormant commerce clause are statutes that discriminate against

interstate commerce1. the fact that the burden of a state regulation falls on some interstate companies

does not, by itself, establish a claim of discrimination against interstate commerce

2. statutes may be invalidated that adversely may affect interstate commerce by subjecting activities to inconsistent regulations

ii. Choice of Law issue1. The law of the State of Incorporation governs a corporation’s “internal affairs”2. many states have adopted “anti-takeover” statutes to protect local interests

a. See also Del. Corp. Law §203 – law applies if a bidder acquires at least 15% of a target’s stock; thereafter, the bidder may not engage in a business combination with the target for three years

b. Exceptionsi. Should a bidder acquire 85% or more, ban will not apply

ii. Should a target board approve a tender offer or business combination before a bidder acquires 15%, ban will not apply

iii. Should a target board approve a merger after the bidder acquires its 15% threshold state and 2/3 shareholders approve the merger, ban will not apply

VII. Proxy Regulation and Shareholder Inspection Rightsa. Proxy Fights

i. Governed by Exchange Act §14(a) – in general, it is unlawful to solicit proxies ii. SEC Rules

1. 14a-1 through 14a-9: Generally provides for three objectives to be accomplished in proxy solicitation:a. Full disclosure of all material information to the shareholders being solicitedb. Prevent the use of fraud in solicitationc. Provide for shareholder solicitation

iii. Private Actions for Proxy Rule Violations: Basically there is an implied cause of action for proxy solicitation violation in the SEC §14(a) under §27

1. JI Case v. Borak: JIC submitted a merger proposal to shareholders. Management also solicited proxies in support of the merger. Borak contended the solicitations were false and misleading. Issue was whether private parties have an implied right under §27 to bring suits for violations for §14(a) for both derivative and direct causes of proxy violations. Court held Yes – although §14(a) does not make express reference to private causes of action, one of its chief purposes is protection of investors. Therefore, it is implicit in this purpose that private parties may bring a cause of action for private relief.

iv. In suits to enjoin voting of proxies, proof of material misstatements or omissions is sufficient causation1. Mills v. Electric Auto-Lite: Shareholders brought derivative suit to enjoin EAL from voting proxies it had

solicited to approve a merger. The proxy materials did not contain certain material disclosures about the merger, and the merger was effectuated and ratified by 2/3 shareholder vote (made with proxy votes). Issue was whether, if plaintiff proves that the proxy solicitations contained material misstatements or omissions, plaintiff has additional burden of proving reliance on the contents of the proxy materials. Court held No – where there is a finding of materiality a shareholder has made sufficient showing of causal relationship between the violation and the injury, and need not demonstrate causal relationship between the misstatements/omissions and the decision to permit proxy voting/injury.


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a. Since the merger had already taken place, the court remedy depends on the interests of the parties, and the court must determine whether setting aside the merger would be in the best interests of the shareholders as a whole

b. Shareholder Proposalsi. SEC Rule 14a-8

1. Relating to situations in which a company must include a shareholder’s proposal in its proxy statements when the company holds a shareholder meeting.

2. Has certain procedural requirements that must be met before a shareholder’s proposal must be considered for inclusion by the directors in the proxy statement

a. If procedural requirements are met, company may still exclude shareholder proposals when:i. The proposal’s would be improper subject for action by shareholders under state law;

ii. The proposal would cause the company to violate state, federal, or foreign law;iii. Would violate proxy rulesiv. The proposal is merely a personal grievance or represents a “special interest” (i.e. a

personal interest of the shareholder)v. If the proposal is “irrelevant” (i.e. relates to operations that account for less than 5% of

company’s assets)vi. The company lacks power or authority to implement the proposal

vii. The proposal deals with matters relating to company’s ordinary business operationsviii. Proposal relates to election of board members

ix. Proposal conflicts with company’s proposalx. The company has already implemented the proposal

xi. Proposal is duplicative of another proposal already submitted for the same meetingxii. If the proposal has already been submitted within preceding 5 years and was

subsequently rejectedxiii. Proposal relates to dividend amounts

b. Company must submit reasons for excluding proposal to the SEC 80 calendar days before release of proxy statement

3. If company plans on including proposal, must submit a copy of the statement to proponent of the proposal to ensure it accurately reflects shareholder’s proposal

ii. Lovenheim v. Iroquois Brand (Proposal Exclusion based on Relevance: 14a-8(i)(5)): L wanted his proposal included in proxy statement. Company refused to include the proposal because it related to operations that account for less than 5% of IB’s total assets. Issue was whether IB should have been enjoined from excluding the proposal. Court held Yes – the 5% standard was an objective standard, and that the SEC has stated that proposals should be included despite their failure to reach that threshold if a significant relationship to the issuer’s business is demonstrated on the face of the resolution or supporting statements. In light of the ethical and social significance of L’s proposal, L demonstrated a likelihood of success on the merits.

iii. NYC Employees’ Retirement System v. Dole Food Company [Proposal Exclusion based on Ordinary Business Operations (14a-8(i)(7)), Relevance (14a-8(i)(5)) and Power to Effectuate (14a-8(i)(6))]: NYCERS is public pension fund owning stock in Dole. NYCERS submitted proposals about health care at Dole. Dole argued it was not required to include the proposal under the “ordinary business operations,” “insignificant relationship,” and “beyond power to effectuate” exceptions. The SEC permitted Dole to exclude the proposal. NYCERS brought suit to have proposal included. Issue was whether the proposal could be excluded under those exceptions. Court held No

1. Under 14a-8(i)(7): NYCERS showed that the proposal did not relate to the ordinary business operations, but rather it related to which national health care policy Dole should participate in, which would have a significant financial impact on Dole. Therefore, the proposal did not fall under the “ordinary business operations” exception, and should not be excluded on those grounds.

2. Under 14a-8(i)(5): since Dole’s annual health insurance constituted more than 5% of its income, this exception was not available.

3. Under 14a-8(i)(6): this exception allows a company to exclude a proposal if the proposal deals with a matter beyond the registrant’s power to effectuate. Because the proposal called for commission of a research report on national health insurance proposals, and does not ask for Dole to attempt to influence selection of health care proposals or engage in political lobbying, it is not a matter beyond Dole’s power to effectuate.

iv. Austin v. Consolidated Edison Company of New York: Shareholders of CEC sent proposal for a corporate resolution endorsing changes in the company’s pension plan. CEC submitted to SEC to exclude proposal because it dealt with the company’s day-to-day operations, and it was designed to further the personal interests of the proponents. SEC granted CEC’s request for exclusion. Issue was whether the Court should require company to include the proposals. Court held No – pension proposals fall under the exception dealing with the ordinary business operations. Further, even though this fell under the business operations exception, it still would have been excluded because A had an available forum for collective bargaining on pension plans as a member of the union. It is not an issue that should be brought up in a shareholder vote.

c. Shareholder Inspection Rightsi. See Del. Corp. Code §220(b) and Rule 14a-7

ii. State Ex Rel. Pillsbury v. Honeywell, Inc. (Minn. 1971)1. lower court ordered a judgment denying all relief prayed for, i.e. the opportunity to inspect corporate records


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2. Del.Code.Ann. tit. 8 §220 – the outcome of the case rested upon whether or not petitioner has a proper purpose germane to his interest as a shareholder; here, the shareholder must prove the proper purpose

a. This was not demonstrated here; it may be shown that a shareholder with a bona fide investment interest, and may be appropriate when shareholder has a bona fide concern about the adverse effects of abstention from profitable contracts on his investments

b. P’s only purpose in getting shareholder list was to communicate with other shareholders to elect a new board; the right to inspect corporate records is not “absolute;” requires demonstration of a proper purpose

iii. Sadler v. NCR Corporation (2d Cir. 1991)1. P-stockholder demanded a list of record shareholders and a list of beneficial owners of shares who do not

object to disclosure of their names2. HOLDING – NY Law authorizes production of the shareholder and other lists in the circumstances of this

case, and application of NY Law does not violate the Commerce Clause3. RULE

a. §1315(a) – permits any NY resident who for six months has been a stockholder of record of a foreign corporation doing business in NY, or who holds or acts for those who hold 5% of any class of outstanding shares to require the corporation, on 5 days’ written notice, to produce ‘a record of its shareholders setting forth the names and addresses of all shareholders, the number and class of shares held by each, and the dates when they respectively became the owners of record

Corporations Outline

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