Business Associations Outline Fall 2010

Introductory materials:

Obligations entered into by promoters: People forming the corporation (promoters) often find it useful to enter into business arrangements with other prior to the filing of the articles. After incorporation it would be a corporate responsibility, but before incorporation it becomes an issue. You cannot be an agent for a non-existent principle but you can be for an undisclosed principle.

Is promoter personally liable?: Restatement 326 has the rule: “Unless otherwise agreed, a person who, in dealing with another, purports to act as agent for a principal whom both know to be nonexistent or wholly incompetent, becomes a party to such a contract.” Whether promoter will be liable turns on the intent of the parties.

If third party parts with payment before the corporation is formed then a contract is formed and promoter can be liable. This is because part performance suggests that a contract is in existence. Otherwise it could just be considered an offer that is not accepted until the corporation is formed. If the contract speaks of the corporation as the party it leads toward a finding of no promoter liability. Some statutes provide that someone who acts on behalf of a corporation knowing that it is not formed yet is personally liable.

Defective Incorporation and ultra vires: For exam assume the corporation has no defects. Corporations are authorized to incorporate for any lawful purpose. The ultra vires doctrine will not be tested on except for charitable contributions.

Charitable contributions: The general rule is that a reasonable amount of money can be given away. Usually charitable work is consistent with economic objectives because it makes the corporation look good, but even if it’s not it’s generally accepted as ok. When making decisions the corporation can consider other constituencies, like the employees and the community, and not just the shareholders. In the old days charitable contributions could be considered ultra vires but not anymore.

Corporate risk-taking: The primary goal of the corporation is to make money. Corporation and shareholder interests sometimes are not aligned because shareholders can diversify and therefore may want the board to take more risks. Corporations have obligation to obey the law, however, if violating it could make them more money.

Corporate governance structure:

Choice of law: Under the internal affairs doctrine the legal relationship between bodies within the corporation is governed by the law of the state of incorporation.

Shareholders: They are the owners of the corporation. They have power to elect the directors and also the power to remove the directors for cause. Modern trend is to let them remove the directors without cause, which reflects more of a principal-agent view. Some statutes provide for this and also the bylaws and certificate of incorporation can allow it as

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well. We don’t need to know different approaches to when board members can be removed without cause. Shareholders can amend the bylaws and they also vote on major organic changes like mergers.

Board of directors: The most fundamental rule is that “the Board shall manage.” In practice the board delegates a lot of management to the senior officers in the corporation. The ALI reflects this by explicitly stating the senior executives shall manage with the board overseeing them and setting their compensation.

Situations of tension between shareholder and director rights:

Board interfering with shareholder right to vote: If the Board is doing something that is interfering with the shareholders right to vote the court will apply strict scrutiny to the board decision to make sure it is fair. The board must have a compelling justification. An example is if the board is acting in good faith to avoid a situation that will be disastrous to the corporation, like if an insurgent group is misleading shareholders into accepting a merger and will pillage the company.

Shareholders interfering with Board’s right to manage: Shareholders cannot adopts by-laws that conflict with the certificate of incorporation or statutes. They can use by-law amendments that don’t conflict to limit the Board’s power, however to what extent they can do this is an open question. If they used the by-law amendments to take significant management power away from the board it would be problematic.

In Fleming the court decided it was ok for the shareholders to pass a by-law amendment that required shareholder approval for any “poison pills.” These poison pills made it harder for third parties to acquire the corporation and thus have the effect of perpetuating the incumbent board in power.

Authority of individuals to bind the corporation:

In general: The ALI says actual management, subject to board monitoring, is done by officers. The board has statutory authority to manage, but the officers do not. The statutes give the board the power to give officers authority with resolutions, but in the absence of any resolutions the general law of agency applies. Also it is hard to draft resolutions that would apply to every situation.

Actual authority: An agent has actual authority to act and bind the principal if the principal’s words or conduct would lead a reasonable person in the agent’s position to believe that the principal so wishes the agent to act. If the agent has actual authority and acts within the scope of that actual authority the principal is bound. The principal is bound even if the third party was unaware that she was dealing with an agent, i.e. in the case of an undisclosed principle. The agent is also bound, as a general rule, in situations where she acts for an undisclosed principle.

There are two types of actual authority, express and implied: Express actual authority constitutes the things expressly delegated, while implied actual authority are powers implied from the words used, the customs, and the relations of the party. Example: If P tells

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A to sell a piece of land in a jurisdiction where it is the custom to include a warranty of title, A has implied actual authority to insert into the deed of trust usual covenants of title.

Apparent authority: The agent as apparent authority in dealing with a third party if the third party reasonably believes that the agent has the authority to act. Often the position of the agent, such as a bank teller for example, will carry with it the appearance of apparent authority. If the agent has apparent authority and acts within the scope of that authority the principal is bound. The agent can be personally liable to the principal is situations of apparent authority as well.

Authority of president in a close corporation: If the president has been acting absolute authority over the corporation’s affairs, and the board has never questioned, altered, or rejected his decisions, the president will have extremely wide actual and apparent authority.

Authority of president in non-close corporations: The general rule is that presidents have the apparent authority to bind the company to contracts in the usual course of business but not to contracts of an extraordinary nature. Reflecting the modern view that the officers manage the company with little hands on oversight of the board, the only things deemed extraordinary are those that significantly change the structure of the business or the structure of control over the business. The president of course may have even wider actual authority if the board gives it to him.

Mechanics of shareholder voting:

Quorum: The default is that you need a majority of the shareholders present to decide something. The by-laws can specify that the number required is higher but usually it is actually made lower because it is hard to get half to participate. Sometimes the certificate can also require different levels to reach a quorum depending on whether thing being voted on is fundamental or not.

Election of directors: They are elected by plurality, meaning they don’t run for specific seats. There are two different kinds of voting, straight and cumulative.

Straight voting: A shareholder can cast, for each candidate for election, a number equal to her shares. For example if the shareholder owns 100 shares of X corporation, and all seven director positions are up for election, the shareholder can cast a total of 700 votes but cannot cast more than 100 votes for any candidate. Under straight voting a minority shareholder or faction can never elect a director over the opposition of the majority. This is because if the minority owned 50 shares of corporation X, he would be only be able to cast 50 votes for his candidate while the majority shareholder with 100 shares could cast 100 votes for all of her favorite candidates.

Cumulative voting: Under this regime, a shareholder can cast for any single candidate, or for two or more candidates, a number of votes equal to the number of shares she holds times the number of directors up for election. Public policy is to allow minority shareholders to get some representation on the board, and get fresh ideas in the boardroom.

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Legal issues involving cumulative voting:

Staggering elections: This impedes effectiveness of cumulative voting. Some laws require at least 3 directors to be up for election in any vote so cumulative voting will have some effect.

Removal: Can usually happen if majority shareholders vote to remove, but this would undercut effectiveness of cumulative voting. Many state laws address this and say if the votes against removal would be enough to get the director elected then you can’t remove him.

In general: It used to be more that cumulative voting was a guaranteed right but now it is considered just an option.

Limited liability/Piercing the Corporate Veil:

Generally: The general rule is that there is no liability for individuals for the liabilities of the corporation. This encourages investment and risk-taking. However, in the interests of preventing fraud and promoting equity individuals can be liable in some situations.

Rule statement: “There is such a unity of interest and ownership that the individuality, or separateness, of such person and corporation has ceased, and that the facts are such that an adherence to the fiction of the separate existence of the corporation would, under the particular circumstances, sanction a fraud or promote injustice.”

There are no cases where shareholders at giant corporation like GM have been held personally liable. The court will have to decide that the shareholders are abusing the corporate process, which happens mostly in closed corporations. However, the general rule is that you can’t join the shareholders of a close corporation in the suit against the close corporation.

Fraud: If the there is fraud taking place it is an easy case for piercing the veil. Fraud can be hard to establish though. Also if the shareholder doesn’t commit the fraud it doesn’t seem fair to hold the shareholder liable.

Factors: No single factor is determinative. The courts will weigh the factors, and some will give more weight to certain factors. Courts will only pierce the veil if they decide, in their equitable discretion, that they want to disregard the general rule.

Corporate formalities: Include having an office, meetings, filing taxes, keeping records, maintaining separate bank accounts (it’s ok to siphon the money away from sub to parent as long as records are kept showing it’s the subs money). This is especially important for a wholly owned subsidiary. The corporate formality requirement is sometimes only raised if the lack of corporate formalities caused the injury. Courts do not make close corporations follow formalities.

Adequate capitalization: Courts may find that a company engaged in behavior that exposes it to liability should have adequate cash or insurance to account for those risks. Some courts may find that insurance is not sufficient, and cash is needed, but the

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distinction is meaningless for other courts. It can be hard to draw the line and say when enough cash is enough. Also problematic if the company has the amount of insurance required by law. Is it really fair to pierce the veil if they are following the insurance requirements? When the company started is a factor, because if the economy, rather than choice, causes the corporation to have inadequate assets then less likely the veil is to be pierced. Also highly relevant is the type of business being engaged in. In parent-sub relationship inadequate capitalization on its own might be enough.

Commingling: This is related to corporate formality, in the sense that it is not keeping the bank accounts separate. Also if you’re just using all the corporate money for yourself you are abusing the corporate form.

The problem with the two factor approach: Some courts articulate two factors for piercing the veil. 1) A unity of interest such that the separate personalities of the corporation and the individual (or the other corporation) no longer exists and 2) adherence to the separate nature of corporation would sanction a fraud or promote injustice.

Laz has problems with the second prong, saying if corporation can’t pay and first prong is satisfied second is automatically satisfied. This is because in a contract case the corporation would be unjustly enriched because they wouldn’t have to pay and in a tort case it would be an injustice because the innocent injured person would be unpaid. So a better way to state the two part test would be if there is a connection between the harm and the wrong (no formalities, inadequate capitalization, etc.). We may say that a contract creditor should have investigated the assets and make-up of the corporation but this is not very practical.

Stockholder informational rights:

State v. Federal standards: Federal rules only apply to Section 12 (very large) corporations. The federal standard is more burdensome for the corporation. Delaware and other states still keep the shareholders mostly in the dark. Congress thought the state informational rights rules were too spotty and inconsistent. Under state law, for instance, regular reporting is not common.

State laws: States require that shareholders have a proper purpose for requesting inspection of books and records. In Delaware the burden in on the shareholder to show that he has a proper purpose. “Proper purpose” means reasonably related to the interests of the shareholder. I.e. information that is needed to decide how to vote, whether to buy or sell, or needed to solicit proxies for challenge to incumbent board. You only get the documents that are related to your proper purpose.

It is difficult in Delaware and other states to get timely access. In the Seinfeld case the court said that suspicion of improper activity is not enough; so the shareholder has to get third party information somehow to constitute credible evidence. In Pillsbury the court said that although the shareholder had other motives, his proper purpose for wanting to

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solicit proxies meant that he could get access to books and records. However Pillsbury was a Minnesota case applying Delaware and the Delaware Supreme Court repudiated it.

Federal law: Section 14 of the 1934 act makes it illegal to violate the SEC rules. Rule 14a deals with content of proxies for section 12 companies for both transactional and periodic disclosures. The federal proxy rules have a broader application than the state statutes on the issues of timeliness and scope of the information.

14a9 makes it illegal to make any proxy solicitation or statement sent to shareholders as a means of proxy solicitation, which “at the time and in light of the circumstances under which it is made, is false or misleading with respect to any material fact, or which omits to state any material fact necessary in order to make the statements therein not false or misleading or necessary to correct any statement in any earlier communication with respect to the solicitation of a proxy for the same meeting or subject matter which has become false or misleading.”

Private right of action under the proxy rules: The rule and the statute do not explicitly say there is a private right of action but in the Borak case the Supreme Court says there is. Court says that it is necessary to have private right of action to supplement private enforcement. They analogize to antitrust law, although the antitrust statutes specify that there is a private right of action.

Requirements: For a private plaintiff to recover there must be material misstatement or omission and there must be causation. There is no established standard on what state of mind (scienter) is required. The SEC does not need to show causation.

Causation requirement:

1) Transaction causation: There must be an essential link between the process and the outcome. This is an objective test. You only need to prove that the process of soliciting proxies was essential to maintaining the outcome, which is a mathematical test. If the action could not have moved forward without the proxies then there is transaction causation. If it would have moved forward anyway there can be no private right of action under the proxy rules but there could be a claim for breach of duty. You do not need to show that individual shareholder relied on the statement as reliance is presumed if misstatement or omission is material.

2) Loss causation: This is whether misleading statements actually caused damage to the plaintiff. For example if the false statement of material fact caused a merger to be approved that turned out to be hurt the company there would be loss causation. If the merger helped the company and the stock price there would be no loss causation. For loss causation a consideration of other causes of the damage to the plaintiff need to be considered. Private plaintiffs need both transaction and loss causation to get damages.

Materiality requirement: For there to be a violation of the proxy statements, the omission or misstatement must have been material. Something is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to

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vote. This can be question of law if it is really clear or in a close case it can be a question of fact.

Statements of reasons, opinions, or belief as violations: These can be violations even though whether they are considered “facts” is somewhat ambiguous. Coming from a director these are material because directors are supposed to know what they are talking about and shareholders will put a lot of emphasis on what they are saying. These statements are considered factual because (1) they actually believe what they are saying and 2) because it is coming from the directors it has to do with the underlying truth of the subject-matter for which the opinion is offered.

Scienter: The Supreme Court has refused to address this issue. The Second Circuit held that negligence sufficed. The Eighth Circuit decided that strict liability was not enough because it was “too blunt a tool” to prevent the deceptive practices that Congress sought to prevent with section 14a.

Shareholder Proposals:

Rule 14a8 is the shareholder proposal rule. Designed to give shareholders that meet certain easy to satisfy requirements the opportunity place materials in the corporate proxy materials that are used at the annual meeting at the corporation’s expense. The goal behind this is to facilitate communication among the shareholders and between the board and the shareholders. Also raises issues that might not otherwise get raised and promotes corporate democracy. The corporation can ask the SEC for permission to exclude a proposal on the grounds it falls into an exception. If the SEC agrees it will issue the corporation a no-action letter, which assures the corporation that the SEC will not take legal action against the corporation if the proposal is not included. Individuals have a private right of action against a corporation if the individuals proposal is not included.

Proposals that Corporation does not have to include:

1) Relevance: If the proposal relates to less than five percent of the company’s assets and earnings for the most recent year and is not otherwise significantly related to the companies business it does not have to be included.

2) Management functions: The proposal does not have to be included if it relates to the company’s “ordinary business operations.”

There can be difficulty in applying “ordinary course of business” and “otherwise significantly related to the company’s business” exceptions. In Roosevelt case proposal related to the timing of the phasing out of certain chemicals. It raised important health issues but was deemed to be in the ordinary course of the company’s business because the company was already phasing the chemicals out and the proposal just suggested a slightly faster time frame.

Things like testing animals, fur coats, and television content seem ordinary in one sense but also raise important policy questions. This area is litigated a lot and the SEC spends a lot of time on it

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3) Improper under state law: In order not to run afoul of the board shall manage rule the shareholder should put his submission in the form of a recommendation and not a direction to the board. The shareholders can’t suggest things that would make the Board violate any of their state law duties. For example the board has to be able to exercise discretion when deciding whether to reimburse election expenses for challengers to board of directors. If the challenger had interests that were adverse to the company the board would violate its fiduciary duty by reimbursing them. Any proposal needs to provide for a “fiduciary out.”

4) Election of directors: The old rule didn’t allow proposals that related to nominating directors or how that procedure was to be undertaken. However, under Obama new rule came out that if a shareholder has had enough stock for a long enough time he can make such proposals.

5) Personal grievance; special interest: This one is vague, but if the proposal only benefits you or is to address a personal grievance or claim against the company or any other person it can be excluded.

Proxy contests:

If the corporation is required by law to give information then those expenses are paid for from the corporate treasury. The issue that these rules address is who has to pay for expenses incurred for trying to get support to vote to keep an incumbent in power on the board. Also an issue arises as to whether insurgent groups should be reimbursed for their expenses.

General rule: The board can spend corporate funds as long as the expenditures are reasonable and proper. The by-laws can set reimbursement levels. This reflects the policy that sometimes the incumbents need to spend corporate money to fend off challengers for the good of the corporation. The directors must believe, in good faith, that it is necessary to spend this money for the good of the corporation. By-laws that dictate that the directors must reimburse insurgent challengers are invalid because they don’t let the board use their discretion not to reimburse such insurgents if the reimbursement would not be in the best interests of the company.

Partnership Law:

Generally: Partners are personally liable for tort and contract claims that occur during the ordinary course of the partnership business. This is the most significant difference between partnership and corporation law. Partnerships are mainly contractual, as opposed to corporations which are governed mostly by statutes. The statutes in partnership law are just fall-back rules.

Defining a partnership: A partnership is an association of two or more persons to carry on as co-owners of a business for profit. There is also a four part definition that some courts use to determine whether a partnership has formed:

1) an agreement to share profits

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2) an agreement to share losses 3) a mutual right of control or management of the business 4) a community of interest in the venture.

An explicit partnership agreement can, however state that the partners will not share losses and that they won’t share in the management or control. Whether individuals have formed a partnership in the absence of an explicit agreement is an objective test that depends on the factors above, and no formalities are required.

Entity theory v. aggregate theory: Under the revised act partnerships are considered entities. However this does not change the fact that partners are individually liable for partnership obligations. The only real practical effect of this is on joinder and naming party issues.

Miscellaneous rules governing partnerships: These are default rules, all of which can be altered by agreement. 1) All partners have equal rights in management and conduct of partnership business. If an impasse is reached an option would be to dissolve the business or there could be a claim for breach of duty. 2) All partners have to consent to somebody becoming a partner. Somebody can transfer their economic rights in the partnership without consent of the other partners, but they can not transfer their governance rights. 3) Voting is not based on proportion of ownership, as every partner gets an equal say. 4) One partner can’t hire somebody over the objection of the other partner. If the other partner acquiesces to a hiring it is ok. 5) Partners share equally in profits and losses, regardless of the amount of capital contributed. 6) Partnership agreement under RUPA is quite broad, and can conclude oral statements and course of conduct evidence. 7) A partner has a right to be consulted on something even if his vote is not needed.

Authority of partners: UPA says that a partner is an agent of the partnership “for apparently carrying on in the usual way of business of the partnership of which he is a member.” There is controversy in this rule with regards to whether it refers to the course of business of the partner’s firm or the course of business of other firms in the same line of business in the locality.

RUPA clarifies this ambiguity, going with the definition of business of the kind carried on by the partnership. So we look to what a third party would think a person in the partners line of business would have authority to do. The partnership will not be bound of the third person had notice that the partner did not have the authority to bind the partnership on a matter. New rule in RUPA allows partnerships to file something in real property office saying a partner lack authority to transfer property. In case where partner binds the partnership by use of his apparent, but not actual, authority, the partnership will not have a claim against the third party but may have a claim against the partner.

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Liability for partnership obligations: This is the most significant difference between partnership and corporation law. Individual partners are liable if partnership and insurance are insufficient to cover the obligation. Partners are jointly and severally liable. The partnership property must be exhausted before the individual partners can be gone after.

Fiduciary duties in the partnership: Partners owe a duty of care and loyalty to the other partners and the partnership. The duty of good faith is implicit in these. The relationship is similar to that of a trustee and a beneficiary. A failure to disclose something to your partner can be a breach of duty. Like the Salmon case, where the court said “not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior.”

While the relationship can be altered by written agreement, the duty of loyalty and some of the informational rights can not be taken away. Also the reduction of duties can not be manifestly unreasonable. In determining whether limitation of duties is reasonable, courts will look out for overreaching in making the agreement, such as where one partner has more bargaining power than the other.

Close Corporations:

Generally: Close corporations’ shares are not publicly traded, there are a small number of shareholders, and they are often characterized by owner-management and restrictions on the transferability of ownership interests. In many ways close corporations resemble partnerships, which are also typically characterized by a small number of owners, owner-management, and restrictions on the transferability of ownership interests. Also, like partnerships, close corporations are mostly contract based, and in the absence of a contract partnership principles will be fallen back on. Shareholders in a close corporation owe a duty of care to each other.

Planning Devices: When forming a close corporation individuals can agree to follow certain procedures and be bound in certain ways. This is similar to a partnership agreement. Basically we want people to have the protection of limited liability with the flexibility of a partnership. Usually if there is planning we do not fall back on general fiduciary duty concepts, as those concepts are usually only fallen back on in the absence of planning or with inadequate planning.

1) Voting arrangements at the shareholder level: There are two general types: In the first the parties agree to vote in a certain way during the term of the contract, for example they may agree to vote for each other as directors. In the second type, the parties agree to vote their shares as a unit. These shareholder agreements are generally valid. An exception is if a private benefit, a.k.a. side payment, is given to a party in exchange for his vote. This is a reflection of the broader principle in corporate law that a shareholder may not sell his vote. The same rules on voting arrangements apply in all kinds of corporations.

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Enforcement of voting arrangements: These agreements are usually specifically enforceable as long as the agreement itself is enforceable, because money damages are usually an inadequate remedy.

2) Agreements controlling matters within the board’s discretion: These can raise issues because they can infringe upon the Board’s responsibility to manage the corporation. In Delaware these provisions are ok even if they so infringe and they have the effect of making the shareholders the Board. If the certificate conflicts with something that the shareholders agree to regarding the Board the certificate can be reformed. Basically these agreements are valid even if they interfere with the Board’s power to manage, because the shareholders become the de facto Board.

3) Supermajority voting and quorum requirements at the shareholder and board levels: The shareholders can specify in the certificate that a certain number of votes will be necessary to make any changes. These provisions are enforceable and the Board or a majority of shareholders cannot simply alter them. For example, in Sutton the certificate had an agreement that required unanimous approval for amendments to the certificate. Even though 70 percent of the shareholders wanted to amend the certificate they could not. This reinforces the idea of flexibility. If the shareholders in a close corporation want to require a certain number of votes to do things at the shareholder and board level they should be able to do so.

4) Restrictions on the transferability of shares and mandatory sale provisions: The general rule is that these are enforceable if they are reasonable and conspicuous. Problems only come up when a shareholder doesn’t think he is getting a good value for his stock.

There are three basic types of restrictions: 1) First refusal: Prohibits the sale of stock unless the shares have first been offered to the corporation, the other shareholders, or both, on the terms offered by the third party. This is the least restrictive and is thus almost always upheld. 2) First options: Prohibits a transfer of stock unless the shares have been first offered to the corporation, the other shareholders, or both, at a price fixed under the terms of the option. The restrictiveness depends on the difference between the option price and the fair price. Courts will often uphold these even if the option price is much lower than the fair price with the justification that the agreement was fairly entered into. These option price cases raise the tricky issue of deciding what the fair price of the stock actually is. 3) Consent restraints: Prohibits a transfer of stock without approval from the board or the shareholders. These are the most restrictive and in some states are not valid. Usually held invalid if they are denying consent for an arbitrary reason.

B) Mandatory sales provision: Under these agreements the corporation or the remaining shareholders are given the opportunity to purchase a shareholder’s stock if a given circumstance occurs, even if the shareholder does not want to part with his stock. A common contingency is if the shareholder is terminated from his position. Courts generally enforce these even if the buy-back price is lower than the actual value of the stock.

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1) The question of bad faith termination: Courts are often faced with situations where an employee is fired just before a higher buy-back price is triggered. In general, the courts will enforce the contract and give the fired individual the price provided for in the contract. The reasoning is that if the parties planned on an issue they should not be able to complain to the court when there planning is carried out. So in these cases courts generally find no breach of fiduciary duty. Sometimes the courts will re-form the deal on a finding of bad faith on the part of one of the parties. So there is no real clear answer in these types of cases but planning on an issue is a strong reason to enforce it as long as nobody has been taken advantage of in making the contract.

5) Arbitration: The parties can agree that arbitration will be turned to in certain situations. There is an argument that this infringes on the board shall manage model but this is a weak argument as the board shall manage can be infringed upon by agreement in many other ways.

Dispute resolution:

1) Dissolution for deadlock: Traditionally if the corporation was at a deadlock a court would order dissolution. This is a legal concept, in contrast to liquidation which is an economic concept. This is a drastic remedy, and courts are reluctant to use it to break up a profitable company. Usually the parties will work it out some way by selling to each other or to a third party. The parties can also use dissolution as a planning device, for example by providing that they can dissolve the corporation at will or upon the happening of some event.

2) Provisional directors and custodians: These devices allow a third party to come in and fix the situation, and are a less drastic remedy than dissolution. A custodian becomes the operator of the business, which is not a remedy to be used often because the company is being turned over to a stranger. A provisional director is not as intrusive, as he just comes in to break the deadlock. The criticism of this is that the parties have bargained for a right to veto action, and brining in a provisional director to break a deadlock frustrates that right.

3) Dissolution for oppression: Oppressive conduct has to be more than disappointment. Reasonable expectations have to be defeated. This is an objective standard. Expectations can change over time. A shareholder who is himself culpable in some way should not be able to benefit from this concept. Some statutes require a certain level of stock ownership before an action can be brought. The remedy the court grants will be tailored to the situation. For example, they can force dividends if that was the reasonable expectation of the parties. Also a buyout could be ordered. The point is for the court to fashion relief that fits the wrong without blowing the whole corporation up.

4) Fiduciary duty in close corporations: The shareholders owe a duty of care and loyalty to each other. These are less protective generally than the oppression statutes. Generally these only need to be fallen back upon when there is no planning and the oppression statutes don’t apply or there is no oppression statute.

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5) Valuation issues in close corporations: There is no open market so it’s difficult to decide what a fair share price is. A majority block will be worth more because of “control premium.” Lack of marketability makes the stock worth less. If there is a dissolution there is no lack of marketability because everybody gets a pro-rata share. Main methods for measuring value: 1) Market value: This is what the stock is trading for on the open market. However, in the case of close corporations there is no open market for the shares. The less trading there is in a stock the more difficult it will be to determine market value. 2) Earnings based: The per share earnings of the corporation is calculated and then multiplied by a number that takes into account the prospective financial condition of the corporation and the risk factor inherent in the corporation and the industry. 3) Net asset value: All the assets of the corporation are added to together and then divided by the number of stocks. These methods can be weighed/combined against each other in varying proportions. The control premium also needs to be considered. The main point on valuation is that it is difficult to say with any certainty exactly what a corporation’s stocks are worth. The parties will get their own experts to come to the conclusion that they want.

Limited partnerships, Limited Liability Partnerships (LLP), Limited Liability Limited Partnerships (LLLP), and Limited Liability Companies (LLC)

Limited partnership: A limited partnership is a partnership that has one or more general and limited partners. A limited partnership is admitted to the partnership as a limited partner pursuant to the partnership agreement. A certificate of limited partnership must also be filed.

Power to bind partnership: A limited partner does not have the power to bind the partnership as a general rule. However, the partnership can give the limited partner the authority to bind it if it wants to. Also

Liability of limited partner: Under the older version of the statute (RULPA) a limited partner would be liable if they participated in the control of the business. There were many things enumerated that did not count as controlling the business, so “control” was narrowly defined. Under the 2001 act a limited partner is not liable even if they do exercise control. The drafters wanted to give the limited partner as much of a liability shield as a corporate shareholder.

Fiduciary duty of general partner: The general partner owes a fiduciary duty to the limited partner. Delaware allows this duty to be eliminated by agreement, although the general partner must still act in good faith. The uniform act says that fiduciary duties can be expanded or diminished but does not go as far as Delaware, which says that they can be completely eliminated.

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Limited Liability Partnerships: The main difference between this and a regular partnership is that the general partners are shielded from personal liability.

Limited Liability Limited Partnership: An entity under which the liability of the general partners in a limited partnership is limited.

Limited Liability Company: Combines the limited liability characteristic of a corporation with the flexibility of a partnership. There are two “flavors.” Member managed LLCs, which are managed by the members (similar to shareholders), and manager-managed LLCs, which are managed by managers who may or may not be members. Members are shielded from liability unless conditions for piercing the veil are satisfied. States are highly variable on how some issues are resolved regarding LLCs. For example, in some places you can bring derivative suits and in some places you can’t. Since there is not much case law on LLCs people starting a big business usually go for a corporation because there is more certainty.

Duty of Care:

Generally: With the grant of legislative power to manage to the board comes with the duty of care. Relates to how the management exercises its oversight duties. The standard is one of ordinary negligence: A director breaches her duty of care when she does not use a degree of skill and care that an ordinary person would use in like circumstances. The standard is “gross negligence” in Delaware but there is debate about whether the word “gross” actually adds anything to the standard. Some think it is “gross” because it occurs in high stakes context.

Business judgment rule: This is not found in the statutes, but is rather a judicial interpretation of the statutes. When the directors are well-informed when making a decision it is rare that they will be found to have breached their duty of care. This reflects the policy choice that risk is necessary in business and the directors will make decisions that turn out bad for the company. We don’t want to impose “hindsight liability” on them. If the shareholders don’t like management’s judgments they can just sell their stock.

The business judgment rule comes down to process v. substance. If the director has employed the proper process the decision will not be a breach of duty if there is a rational basis for it. If the business judgment rule does not apply the transaction must have been “entirely fair,” and courts will often put the burden on the directors to prove this.

Requirements for business judgment rule to come into effect: 1) Must be an affirmative decision. (So a failure to take action does not qualify for protection under the business judgment rule). 2) The director must have informed himself to an extent he reasonably believes appropriate under the circumstances. 3) The decision must have been made in good faith, and 4) the director must not have a financial interest in the subject matter of the decision.

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Failure to do anything: A director must have at least a rudimentary understanding of the corporation. There is no such thing as a “dummy director.” If you are a named director you need to keep up with what is going on with the corporation. I.e. you can’t be like Ms. Pritchard. A failure to become or be informed is a failure to exercise proper process and thus the business judgment rule can not be used as a shield in these cases.

Director oversight: The duty of care includes the duty to inquire when the circumstances would alert a reasonable director to the fact that such an inquiry is needed. Directors must also have in place reasonable system for monitoring the business.

Causation requirement: In case of non-feasance, like with Ms. Pritchard, we ask what would have happened if she would have done the right thing. Whether the culpable act or non-act was a substantial factor in the harm is the standard. In some states if a breach is shown the burden shifts to the director to show that there is no proximate cause.

Exculpatory provisions: In response to cases like Van Gorkom, where directors got saddled with huge liability for breach of duty claims, the Delaware legislature passed a statute that allowed corporations to put provisions in their certificate that limits monetary liability for breach of duty claims. These only apply to directors, and not officers, and they do not shield for injunctive relief. Basically a response to high insurance premiums for director liability insurance. Also a policy choice that we want people to be directors. The directors have the burden of raising the exculpatory provision as an affirmative defense.

Response to exculpatory provisions: The Delaware courts have decided that good faith is part of the duty of loyalty, so if the director is not acting in good faith or is breaching his duty of loyalty the exculpatory provision will not protect him. This seems to contradict the statute in Delaware, which list good faith separately from loyalty. Other states treat the duty of good faith as something separate altogether or as being part of the duty of care.

What is required to show director acted in bad faith: Practically speaking, the Delaware exculpatory provisions law and the court’s interpretation of it has meant that plaintiffs plead their cases as violations of good faith under the duty of loyalty, rather than breach of duty claims. Realistically however, the director is breaching his duty of care as well if he is not acting in good faith.

Standard for bad faith: A director breaches his duty of good faith if he acts with intentional disregard of his duty. Even if he is reasonably informed the business judgment rule will not protect him if he knowingly disregards his duty to the corporation. This is a higher standard than gross negligence. Directors cannot knowingly violate the law and be acting in good faith. I.e. giving illegal campaign contributions.

Duty of Loyalty: Generally: This is the more traditional duty of loyalty field, as opposed to just pleading bad faith claims under the duty of loyalty to circumvent the exculpatory provisions. In these transactions the director has a pecuniary interests, so the business judgment rule can not

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apply because the director can not use his best judgment. Also applies if a close relative would benefit.

Self-Interested transactions: This is where the director is standing on both sides of the transaction. Like he is selling or buying something from the corporation. Don’t forget that when the board is deciding whether to approve of one of these transactions they must exercise reasonable care. If it is an awesome deal they could be liable for turning it down. The interested director is also subject to his duty of care. Also fair price does not always equal reasonable. Sometimes the corporation won’t even need whatever they are deciding whether to buy. Why interested transactions are allowed: The old rule was one of absolute voidability, but now they are ok in some circumstances. This comes from the recognition that sometimes it is in the corporation’s best interest to enter into these deals. Sometimes directors are great managers but they also have personal assets that would be of great benefit to the corporation. So a balance is struck to where we allow these transactions but only if certain conditions are met.

Cleansing techniques and their effect on the standard of review and the burden of proof: For proper cleansing we must always make sure that all the material facts are actually being disclosed and that the people doing the approving (shareholders or directors) are actually disinterested. The ALI says if there is not proper disclosure the director breaches his fiduciary duty even if the transaction is otherwise fair. It could be argued that this is implicit in all the state statutes.

1) Disinterested director approval: This method of cleansing can be problematic in the sense that it brings up the “I’ll scratch your back if you scratch mine” problem. Courts can and will guard against this by making sure that the other directors are actually exercising independent judgment when deciding to approve of a self-interested transaction of one of their co-directors. The disinterested directors are subject to the duty of loyalty and care when making these decisions, and if there decision to approve does not satisfy the business judgment rule the cleansing will not be effective. a) Delaware: The burden shifts to the plaintiff to prove that the transaction does not meet the business judgment rule. b) California: The burden is on the plaintiff to prove that the transaction is not just and reasonable (basically a fairness standard which is harder to meet than the business judgment rule). c) ALI: The burden shifts to the plaintiff to show that that the transaction is not just and reasonable (basically a fairness standard which is harder to meet than the business judgment rule).

2) Disinterested shareholder approval: Again we must make sure that all the material information is actually communicated to the shareholders and that a majority of disinterested shareholders approve. Also, like with disinterested directors, the ALI says that if the interested directors does not disclose all material facts to the shareholders he

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will violate his duty of loyalty even if the transaction is otherwise fair. And this same standard is probably implicit in the other statutes. a) Delaware: The burden shifts to the plaintiff to show waste. Waste is even harder to show than violation of the business judgment rule. Must show no reasonable person would have been willing to make the deal. b) ALI: The burden shifts to plaintiff to show that there is waste. c) California: The burden shifts to plaintiff to show that there is waste. In all of these situations there is always the issue of whether the court will actually let an unfair transaction stand.

3) No cleansing: The general rule in all jurisdictions for our purposes is that the burden is on the director to prove fairness. He must also disclose all material facts before undertaking the transaction.

Compensation: The default rule is that the board fixes compensation and is able to grant stock options. A director has the duty to prove the fairness of his pay if there is no cleansing. If the directors approve it is business judgment standard and if shareholders approve it is a waste standard, and in each of these cleansing situations the burden is on the plaintiff. Even if fairness is required to be proved it is very hard for a plaintiff to win one of these lawsuits. Putting a value on somebody’s employment is tough. Cases involving deceiving the shareholders as to the value of stock options are more likely to succeed because the board is not acting in good faith.

Corporate opportunity doctrine: A person getting an individual opportunity through their contacts with the corporation. There are three related issues under this doctrine: 1) Competing with the corporation: like if you work at a golf club company and you go into business selling putters. 2) Use of corporate assets. Like using the corporate jet for personal use. 3) Taking advantage of opportunity of information gained through one’s role in the corporation.

Different from self-interested transaction because the director is not buying or selling anything from the corporation. The basic question to ask is does the corporation have a better equitable claim to the property. There are no statutes on this subject and the states vary a lot on their approaches.

Different tests for determining whether there is a corporate opportunity:

1) Line of business test: If the opportunity is closely associated with the existing business of the corporation then it will probably be deemed a corporate opportunity. This test can be difficult to apply because a corporation may want to expand to other areas and it may be a very diverse company. The golf course case illustrates the difficulty because the company was in the golfing business but it wasn’t really good for the company if houses were built around the course. An element of this test is also whether the corporation could afford the opportunity, but including this as an element would create conflict of interest because the director won’t try her hardest to get financing for the project.

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Line of business also raises problems with and relates to competing with the corporation if the fiduciary gets involved in the same business as the company he works for. A low level employee will be more likely allowed to just quit his job and start competing with the company if he learns of an opportunity outside of the scope of his employment. In contrast, a director of officer is likely to be required to turn over the information because his duty to the corporation is more demanding. The ALI puts a more demanding duty on officers than directors because officers are involved in the day to day management of the corporation. Thus if a director learns of an opportunity within the line of business of the corporation, but learns of it outside of the scope of his duties and without the use of corporate property it will not be deemed a corporate opportunity. However, if the same thing happened to an officer it would be deemed a corporate opportunity.

2) Fairness test: There is no principled standard to this test. We let the trier of fact look at all the circumstances and decide whether the opportunity really belonged to the corporation.

3) Official capacity test: If the director or officer learned of the opportunity in the course of their capacity as an agent for the corporation it will probably be deemed a corporate opportunity. The fiduciary would not have likely even got the information if it weren’t for his position and/or the person telling them the information did so because the third party knew the fiduciary’s position. In this situation the fiduciary is basically using corporate property (the information) for his own benefit.

Cleansing through disclosure: The fiduciary can take the corporate opportunity after making full disclosure to the corporation and then having them reject the opportunity. If a disinterested board rejects the opportunity pursuant to the business judgment rule the fiduciary can pursue the corporate opportunity. If the shareholders reject or ratify the taking of the opportunity the fiduciary can go ahead with it as long as the waste standard is satisfied. Corporate opportunity is not defined in the ALI beyond the above tests, but we can give it a broad definition to effectuate the purpose of getting disclosure in close cases.

Competition with the corporation: Generally directors and officers can not advance their own pecuniary interests by competing with the corporation. However, the ALI does allow it in some limited circumstances, such as when: 1) The benefits to the corporation are outweighed by any harm. Like if the prestige or expertise of the director helps the company to a degree that it tolerates the competition. 2) There is no reasonable foreseeable harm to the corporation from such competition. (In this sense competition is given a narrow meaning. Presumably, if the two companies each sold beer in different states they would not be competing although arguably you could say that they were. 3) The competition is authorized by the board after full disclosure in a way that satisfies the business judgment rule. 4) The competition is authorized by the shareholders after full disclosure in a way that satisfies the waste standard.

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Note on combinations of three related loyalty issues: Three principles of fiduciary duty overlap in this area: 1) corporate opportunity, 2) use of corporate assets and 3) competition with the corporation. Any combination could be present in any one case. For example all three would be present if a director learned of an opportunity in his official capacity as a director, the opportunity was in the line of business of the corporation, and he started competing with the corporation.

If a director learned of an opportunity on her own that was in the line of business of her corporation, she would be using a corporate opportunity (because it is in the line of business of her corporation and she should have offered to them first) but would not have used corporate assets to get the opportunity. Whether she violated the competition principle would depend on whether she resigned from her position. Finally, if the director inherits a business that is in the same field as her corporation she would not have used corporate assets or taken a corporate opportunity but she would be competing with the corporation unless she resigned.

Duties of controlling shareholders: A shareholder can be a controlling shareholder even if he has less than 50 percent of the shares because there can be de facto control because of the dispersion of the other shares. Whether he is a controlling shareholder is a question of fact. Controlling shareholders do owe a duty of care and loyalty to the corporation. A challenger to these transactions must show that the controlling shareholder got something that the minority did not. The scope of protections in close corporations is broader because the reasonable expectations of the minority can not be defeated.

Standards of review for transactions between the controlling shareholder and the company: 1) The transaction is ok if the controlling shareholder can show that it is fair. 2) Disinterested shareholder cleansing: If, after disclosure, the disinterested shareholders approve of the transaction, it is ok unless the plaintiff can prove waste. 3) Transactions in the ordinary course of business: In a case of a transaction between the controlling shareholder and the corporation that is in the ordinary course of business, the party challenging the transaction has the burden of proof to show that the transaction was unfair. No cleansing is needed.

Standards of review for shareholder using corporate opportunities: 1) The taking of the corporate opportunity is ok if it is fair to the corporation. If there is no cleansing the controlling shareholder has the burden to prove that the transaction was fair. 2) Disinterested shareholder cleansing: If the disinterested shareholders approve of the transaction after full disclosure then the transaction is ok unless the plaintiff can prove waste.

Mergers: In Delaware the controlling shareholder has the burden of proving entire fairness even if there is cleansing by disinterested shareholders. This is different from ALI which puts the burden on the plaintiff to prove waste if disinterested shareholders approve.

Sale of control: There are no restrictions on who you can sell a control block to or any procedures you have to follow.

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Exceptions: 1) Foreseeable looting: If there are factors—such as excessive purchase price, buyers wanting immediate transfer, liquid assets—that would put the seller on notice that the corporation might be harmed they have a duty to investigate. Absent facts to put a reasonable person on notice there is no general duty to investigate. 2) Naked sale of corporate office: This is a breach of duty because you can’t sell something that actually belongs to the corporation. It is ok if the transfer of office accompanies a sale of voting control. This makes sense because nobody would want to buy a control block without being able to put who they wanted on the board.

Insider trading:

Background: After the crash of 1929 Congress decided it needed to supplement the weak state law in this area in order to improve investor confidence that they were trading on a level playing field. Under the old state decisions courts decided that there was no duty to disclose the knowing of material non-public information when selling on impersonal stock exchange.

Section 10b: Makes it illegal to employ “in connection with the purchase or sale” of a security any “manipulative or deceptive device or contrivance” in contravention of the SEC rules. The Court has decided that this language makes 10b an anti-fraud statute and therefore requires intent. Even if the rules can be read to go further, no violation of 10b can occur without the requisite scienter. This has been criticized because it seems to go back to the common law which Congress was trying to supplement by creating these laws. Of course Congress can change the standard if it wants to. 10b, unlike 14a, applies to all securities, not just section 12 corporations.

In connection with requirement: Courts have interpreted this very broadly. However a private plaintiff must be a buyer or a seller. Potential buyers are not included. The fraudulent statement or failure to disclose does not have to relate to value. For example, if somebody deceived somebody into entering an option contract with no intent to honor it this would be a violation because an option to purchase stock is a security.

Public disclosure: An insider or other person with a duty to disclose or abstain from trading can began trading when there has been an effective public disclosure.

What constitutes scienter: An intent to deceive, manipulate, or defraud satisfies the scienter requirement. Courts have found that recklessness is enough also. The problem is that the courts have not settled on one definition of reckless: One definition that a lot of courts follow, however, is this: “Extreme departure from the standards of ordinary care, and which presents a danger of misleading buyers or sellers that is either known to the defendant or is so obvious that the actor must have been aware of it.”

1) Heightened pleading requirements regarding scienter: The PLSRA, which Congress created to try to rein in private actions, imposes higher pleading standards for 10b5 cases

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than the FRCP require. Plaintiff must plead facts that give a “strong inference” of scienter. The inference of scienter must be at least as compelling as any competing inference, and the courts must consider opposing inferences. This heightened standard does not apply in SEC actions.

Distinction between using information to trade and merely possessing it: The rule says you trade on the basis of inside information when you are aware of it. This is separate from the issue of scienter because you may not have scienter if you are aware of the information but you think it has already been publicly disclosed.

What constitutes fraud in silence case?: There must be a duty to disclose before non-disclosure can constitute fraud and be a violation of 10b. A duty to disclose does not come about from mere possession of the material. Insiders and temporary insiders owe a duty to the corporation. But this leaves lots of holes, for example if somebody trades on insider information but only trades in a different company that he does now owe a duty to. Misappropriation theory and tippee liability fill in gaps that this standard may create.

Material fact requirement: To be a violation the fact traded on must be material. The standard is the same as the proxy rules, which is would a reasonable person attach importance to the information when deciding to trade.

1) Soft information: When applying the would standard to information is not certain to come true (like a merger) we balance the probability and magnitude. The higher the probability and the magnitude the more likely the fact is material and vice versa. In the context of mergers we can look at the size of the respective companies, how far along discussions are, and whether higher ups in the corporation are involved in the discussions.

Causation requirement: Only private plaintiffs must prove causation and damages. The SEC can bring an action for relief even if there is no causation or damages.

1) Transaction causation: The defendant’s violation of 10b must have caused the plaintiff to enter into the transaction. In other words, the plaintiff must show that but for the fraudulent statement the plaintiff would not have entered into the transaction. In a non-disclosure case plaintiff must show that if the information was disclosed it would have assumed significance for a reasonable shareholder. So in non-disclosure cases causation and reliance fold into each other. Even if statement is material however, the defendant can rebut transaction causation by proving that plaintiff would have done the same thing had he known all the material facts.

Individual reliance is not needed in every case because of shortcut of fraud on the market theory. There is presumption that the market absorbs all material information so if something is withheld or falsely states the market price will not be correct. The defendant can rebut this by showing that plaintiff already knew all the material facts or that they already had an agreement to sell.

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2) Loss causation: Defendant’s wrongful act must have also been the cause of the plaintiffs loss. Can be equated to proximate cause, in the sense that the loss must have been a foreseeable result of the violation. Unlike with transaction causation, plaintiffs have the burden of showing loss causation. Other causes of the plaintiffs’ loss must be ruled out.

Tippee/Tipper liability: This is one of the ways in which the duty to disclose or refrain from trading expands outside of traditional insiders. If the tipper has a motive of personal gain then both the tipper and the tippee are liable under 10b. If there is no motive for personal gain then there is no fraud. A tippee only inherits an insider’s duty to the shareholders if the tipper has made the information available to the tippee improperly. To be liable the tippee must know or should have known that there was a breach. If the tipper is not breaching his duty then the tippee will not be liable on a tippee theory because there is a break in the chain. He could be liable on a fraud on the source theory or temporary insider theory however.

“Personal gain” is defined very broadly. Thus if the tipper is just giving a gift or trying to increase his reputation it will be considered personal gain even though he won’t necessarily be making money. Conversely, is somebody is just rambling on and you don’t have a relationship of trust and confidence with that person you could trade on the information. The rambler may have breached a state duty of care however.

Temporary insiders: People brought into the company to do specialized work, like lawyers and consultants, who gain access to private information through their contact with the company. These individuals take on a fiduciary duty to the company and they are thus held to the same standard as traditional insiders.

Misappropriation theory: This closes a big loophole for people who obtain non-public material information through a relationship of trust yet do not have a fiduciary relationship with the company they trade in. The seminal case was O’Hagan where the defendant learned the information through his role as a lawyer, yet he owed no duty to the company that he traded in.

Defendants are liable under this theory if they breach a duty to the source of the information. This is known as “fraud on the source.” Even though the defendant is not trading in the stock of the source of the information the trading is still done “in connection” with the fraud.

When does trader breach duty to the source?: There is a violation when the relationship is one where there is an expectation of trust, such as with lawyers, doctors, and employers. Also applies when somebody has agreed to keep something confidential or has pattern of sharing confidences with an expectation of confidentiality. A good example of the distinction is between the driver for a car service that somebody always uses and with whom there is an understanding of confidence vs. a random cab driver.

Curing through disclosure: In O’Hagan the Court stated that O’Hagan could have escaped liability under 10b if he would have disclosed to his law firm because there would no

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longer be a fraud. Court says that although one could escape liability in this way it is not an easy out for people because there life would essentially be ruined.

Rockladge distinction: The 1st circuit decided that if the wife had disclosed to her husband that she was going to trade it would cure the fraud with respect to tipping her brother, but not with respect to her inducing her husband to tell her information. The distinction with O’hagan was that there was nothing to show that he joined the law firm with the intent of fraudulently inducing them to give him private information so he could trade on it.

Liability for short-swing trading under 16b:

Generally: This is a strict liability statute that is exclusively enforced by private parties. This law deals with potential abuse, rather than actual abuse, thus the strict liability. The policy behind it is there is such potential for abuse we just don’t want people to undertake the activity specified in the statute. Some innocent activity will be swept in but the policy behind the rule outweighs this harm. Also we want to incentivize people close to the corporation to own corporate stock but it is not positive behavior for them to be undertaking quick in and out trading.

What is covered: If a director, officer, or any shareholder of more than 10 percent of any class of stock buys stock in that company and sells it within six months they have to disgorge all the profits they make. We focus on the function of the individual, not just on their title. Any holder of a security in the company can sue to enforce this.

Computation of when a profit is made: If you can match up any trades within a six month period where the sale price is higher than the purchase price the difference must be disgorged.

Example: Date Action Amount Price 2/1 Purchase 1,000 $30 3/1 Sale 1,000 $25

4/1 Purchase 1,000 $20 5/1 Sale 1,000 $15

In this situation we can match the $20 purchase on 4/1 with the $25 sale on 3/1 because they are within six months of each other. It doesn’t matter that Defendant didn’t actually make a profit. He will have to disgorge $5,000.

Narrow exception to liability under 16b: One Supreme Court case created an exception to liability when an unorthodox involuntary transfer forced the defendants to sell there stock.

Return to the common law: State law is much more protective than it was back on 1933. Misuse of confidential information could be actionable as a breach of duty and could also be

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misuse of corporate assets. On the exam we could state that there could be a state law claim as well as a violation of 10b or 16b.

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