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AGENCY

INTRO TO AGENCY

Start with burden and requirements before moving on to the elements.

Agency : the relation which exists where one person acts for another. The relationship which results from the

o (1) manifestation of consent by one person to another that the other shall

The manifestation by or attributable must somehow reach the agent; otherwise the agent has nothing to

consent to.

When it reaches it might not be direct

o (2) act on his behalf and subject to his control, and

The control need not be total or continuous and need not extend to the way the agent physically performs, but

there must be some sense that the principal is “in charge.”

o (3) consent by the other so to act.

Look toward the outward manifestations. Words & conduct can evidence consent

o Authority: Restatement of Agency (Second) § 1; Gorton v. Doty

o This test was used in Gorton v. Doty –Idaho

There could be an attempt to avoid the relationship by establishing a Gratuitous Bailee relationship.

There was Consent by handing over the car

Doty manifested control over the football coach by making the condition that only he should drive the car. NOTE: There need not be consideration to create agency.

§1. Agency; Principal; Agent

(1) Agency is the fiduciary relationship 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 so to act.

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

How to Prove Agency

o The existence of an agency relationship is a question of fact. Botticello v. Stefanovicz

o Burden of Proof: The person alleging agency and resulting authority has the burden of proving it exists. Mills Street

Church v. Hogan

“Agency cannot be proven by a mere statement, but it can be established by circumstantial evidence,

including…

the acts and conduct of the parties such as the continuous course of conduct of the parties covering a

number of successive transactions. Mills

o REQUIRED: “[t]he relationship of principal and agent must necessarily involve some matter of business, but only that where one undertakes to transact some business or manage some affair for another by authority and on account of the latter, the relationship of principal and agent arises.” Gordon v Doty

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o NOT REQUIRED: It is not essential to the existence of authority that there be a contract between principal and agent

or that the agent promise to act as such, nor is it essential to the relationship of principal and agent that they, or

either, receive compensation. Gorton v. Doty

o CANNOT: When an agreement considered as a whole, establishes an agency relationship, the parties cannot

effectively disclaim it by consent. (i.e. disclaimers) Murphy v. Holiday Inns, Inc.

o Parties may try to disclaim an agency in a contract. While courts will take the disclaimer into account, the decision is

not dispositive – circumstances might require otherwise.

Agency relationships are in three principal forms

o 1. The relation of principal and agent

o 2. The relation of master and servant

o 3. The relation of employer or proprietor and independent contractor.

Other Possibilities for Formation of Agency

o Control & Liability of Creditors - Debt

A creditor who assumes control of his debtor’s business may become liable as principal for the acts of the

debtor in connection with the business. Restatement (Second) of Agency § 14 O, comment a (1958); Jenson

Farms v. Cargill

i.e. creditor might become liable for debtor’s debts to other creditors.

C. is lending money to W. to finance business. Debtor-creditor relationship. Also

buying the grain.

If management taken over; directs what contracts may not be made

Assuming de facto control turns relationship into principal-agent

Creditors’ interference with internal affairs

Cmt. a: A security holder who merely exercises a veto power over the business acts of his debtor by

preventing purchases or sales above specified amounts does not thereby become a principal.

o Marriage

Marital status cannot in and of itself prove agency. Botticello v. Stefanovicz

o Joint ownership of land

Mere fact that land is jointly owned does not make one agent for another. Id.

TYPES OF AUTHORITY

Actual Agency ( Authority ) §§ 14 & 26 :

o Authority §7

Authority is 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.

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o Creation of Authority; General Rule; Restatement (Second) of Agency § 26: Authority to do an act can be

created by written or spoken words or other conduct of the principal which, reasonably interpreted, caused the agent

to believe that the principal desires him to act on the principal’s account

Elements

Objective manifestation by the principal

o Can reach directly or indirectly

o Silence & Acquiescence

Agent’s reasonable interpretation of that manifestation

o Objective standard

o § 33. General Principal of Interpretation: An agent is authorized to do, and to do only, what is

reasonable for him to infer that the principal desires him to do in light of the principal’s

manifestations and the facts as he knows or should know them at the time he acts.

o Also look to §34 for some circumstances that are considered when interpreting whether there is

authority.

Leads the agent to believe that it is authorized to act for the principal

NOT REQUIRED: It is irrelevant what a third party may or may not know.

An agent can have actual authority even though at the time of the relevant occurrence the third party

neither knows nor has reason to know the extent of the agent’s authority.

DISCLOSURE OF THE PRINCIPAL:

It does not matter whether the principal is disclosed, partially disclosed, or undisclosed.

o There are Two types of Actual Authority: Expressed & Implied

“Actual authority” means authority that the principal, expressly or implicitly, gave the agent. Lind v.

Schenley Industries, Inc.- Ky.

Express Authority: A clearly expresses to B.

Implied Authority : Implied Authority is actual authority circumstantially proven which the principal actually intended

the agent to possess and includes such powers as are practically necessary to carry out the duties actually delegated. Mill

Street Church of Christ v. Hogan

Hogan hired his brother for a painting job.

o §35. When Incidental Authority is Inferred: Unless otherwise agreed, authority to conduct a transaction includes

authority to do acts which are 1) incidental to it, 2) usually accompany it or 3) are reasonably necessary to

accomplish it.

o FACTORS TO CONSIDER (From Mills):

AGENT’s REASONABLE BELIEF: In examining whether implied authority exists, it is important to focus

on agent’s understanding of his authority

It must be determined whether the agent reasonably believes because of past or present conduct of the

principal that the principal wishes him to act in a certain way or to have certain authority. Mills

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PRIOR SIMILAR PRACTICES: Existence of prior similar practices is one of the most important factors.

(objective)

SPECIFIC CONDUCT OF PRINCIPAL: Specific conduct by the principal in the past permitting the agent to

exercise similar powers is crucial.(subjective)

NATURE OF TASK: The nature of the task or hob may be another factor to consider, because implied

authority may be necessary in order to implement the express authority.

o BURDEN: Person alleging agency and resulting authority has burden of proving it exists.

May be Proven by circumstantial evidence

Manifestations to Third Persons Apparent Agency ( Authority ) §§ 8 & 27 :

o General Principles: Its all about protecting the 3rd party

The power derives from the appearance of legitimate authority; the doctrine exists to

protect third parties who are misled by appearances

An agent’s intent is immaterial. A person with apparent authority can bind the apparent

principal to a K even if the person does not intend to benefit the apparent principal and

even if the person is lying about being authorized.

o R2nd § 8. Apparent Authority: Apparent Authority is 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 persons. Restatement (Second) of Agency § 8; Lind

o The power derives from the appearance of legitimate authority; the doctrine exists to protect third parties who are

misled by appearances.

R2nd §8 Comment B – Apparent Authority applies in creation when 1) statements are made directly from P

to 3P; or 2) statements made by others to a 3P traceable to P. (Advertising, Publications included)

R3rd §2.03 Comment C – Same thing as above really.

o R2nd § 27. Creation of Apparent Authority: General Rule: (Except for the execution of instruments under seal or

for the conduct of transactions required by statute to be authorized in a particular way) Apparent authority to do an

act 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.

o R3rd § 2.03 – Apparent Authority – 3P reasonably believes the actor has authority to act on behalf of P and that

belief is traceable to P’s manifestations.

o Test – Elements of Apparent Agency

(1) Is there a manifestation by the principal;

Focus on the actions, communication to find manifestation – can be written or oral. §27

Made directly to the 3rd party or to the community in general (advertising) (Billops v. Magness)

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Placing a person in a position where such authority would be presumed (370 Leasing v. AMpex) Manifestation can reach third party by intermediary

Seems to be enough if the principal gives someone a title such as “district manager.” – Authority by

position (Lind)

Acquiesence/silence???

The statements of the apparent agent cannot give rise to apparent authority????

o Is there an exception to this if at the time the agent made the manifestation statement, the agent is

1) actually authorized to act for the principal, and 2) while actually authorized, accurately

describes the extent of its authority??? What is the source for this?

(2) Which reaches the third party; and

(3) Which Causes a Reasonable belief by the third party as to the agent’s authority.

Is it within the realm of believability?

Relying on someone in a titled position can operate as a reasonable belief to a manifestation made.

(370 Leasing Corp v. Ampex Corp.)

An agent has the apparent authority to do those things which are usual and proper to the conduct of

the business which he is employed to conduct. (370 v. Ampex).

o SALESPERSON: A salesperson binds his employer to a sale if he agrees to that

sale in a manner that would lead the buyer to believe that a sale had been

consummated. 370

o ***An agent for an undisclosed principal can never have apparent authority. For a partially disclosed principal it

might be possible, but it would be difficult.

o Apparent Authority is not actual authority, but the authority the agent is held out by the principal as possessing. It is

a matter of appearances on which third parties come to rely. Hogan, Lind v. Schenley

Uncertainty as to whether third person must change position based on this.

“Apparent authority” arises when a principal acts in such a manner as to convey the impression to a

third party that an agent has certain powers which he may or may not actually possess” Lind

o POLICY: Usually, The principal is the one who should be held responsible, because they are in control of the

circumstances

Employer in the best position to reign in the agent’s action

Look at the decision in Lind, Since Schenley allowed its agents to hold themselves out as having

this authority, then they should pay for the results of not keeping them under control

o An agent has apparent authority sufficient to bind the principal when the principal acts in such a manner as would

lead a reasonably prudent person to suppose that the agent had authority he purports to exercise (reasonably believe).

o Cases

o Lind v. Schenley – (liability on the theory of apparent authority) Factors showing actual agency:

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Manifestation of principal to 3rd person – defendant’s VP and general sales manager told Lind he would be appointed assistant to Kauffman, and to see him for his new duties.

Reasonable to believe principal’s manifestations of consent – it was reasonable that Kauffman would be given this authority because he was Lind’s superior.o The fact that Kauffman did not in actually have such authority is irrelevant for actual agency.

o 370 Leasing Corp. v. Ampex – (liability found on apparent authority, but looks more like inherent) Factors indicating apparent authority to bind the company:

Kays was employed as a salesmen and it is reasonable to believe that a salesman can bind his employer to sell. – Inherent Authority.

Nothing suggested Kays did not have this power. – Inherent or Apparent Authority. Principal agreed with Joyce that he would only have to deal with Kays. The limitation on Kays authority to sign the contract was never communicated to Joyce.

o Billops v. Magness – (apparent agency found via advertising, etc.) Factors indicating apparent authority (franchisor liable as master):

Manifestation to the guests, which guests relied upon, where those made indirectly via advertising. Based on the physical environment and management of the hotel, a reasonable person would have no

reason to know that he was dealing with anyone other than the Hilton Corporation. Franchisor held the right to control such things as: advertising; office procedures; cleaning and

inspection; minimum standards; staff procedures; standards for booking group meetings; franchise was required to keep detailed records; franchisor maintained right to enter premises and inspect.

Guests expressed reliance on the Hilton name and the quality it stands for.

Inherent Agency ( Authority ) § 8A

o Inherent power performs two important functions: It holds a principle responsible for (1) certain unauthorized acts of

an agent who the principal has entrusted with ongoing responsibility, and for (2) certain false representations of an

agent or apparent agent.

o §8A Inherent Agency Power: Inherent agency power is a term used in the restatement of this subject to indicate the

power of an agent which is derived not from authority, apparent authority 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.

o Limitations in the Restatement: §§ 194, 195, infra

General Agent – a agent authorized to conduct a series of transactions involving a continuity of service (R2dA §3(1))

§ 194 – Acts of General Agents: A general agent for an undisclosed principal authorized to conduct

transactions subjects his principal to liability for acts done on his account, if usual or necessary in

such transactions, although forbidden by the principal to do them

Special Agent – an agent authorized to conduct a single transaction or a series of transactions not involving continuity of service (R2dA §3(2))

§195- Unauthorized Acts of Special Agents: Undisclosed principal who entrusts an agent with

management of business is subject to liability to third persons with whom the agent enters into

transactions usual in such businesses and on principal’s account, although contrary to directions of

principal.

§195A Unauthorized Acts of Special Agents: A special agent for an undisclosed principal has no

power to bind his principal by contracts or conveyances which he is not authorized to make unless:

o (a) the agent’s only departure from his authority is

(i) in not disclosing his principal, or

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(ii) in having an improper motive, or

(iii) in being negligent in determining the facts upon which his authority is based, or

(iv) in making misrepresentations; or

o (b) the agent is given possession of good or commercial documents with authority to deal with

them.

o Test:

(1) Is it within the custom of a person in the position?

Not focusing on speech or acts

It is a different sort of factual determination.

(2) Third party has to have a reasonable belief that the person is acting within the scope of the position.

o Scope of Inherent Agency:

Even if the agent is going beyond the scope of given authority, he continues to have authority to bind the

agreement as long as he is within the general scope of his position; the importance is custom. Kidd. v. Edison

In Kidd, the agent offered a full concert to singer and the issue was whether or not the agent had the

authority to do so.

It makes no difference that that the agent may be disregarding his principal’s specific directions, secret or otherwise, so long as he continues to act within the larger field measured by the general scope of the business entrusted to his care.

It was customary for agents in this industry to have the power to offer full concert tours and therefore Kidd was justified in believing that the company would be bound.

o Policy:

Not beneficial to change what people rely on. It would be unfair to upset the idea of what such relationships

consist of…

The idea of using an agent is supposed to be situation where the third party is entitled to rely on the agent, not

go check what is allowable according to the principal.

Protection of 3rd party creditors

Allows for delegated powers to avoid constant recourse to principal and assures public that contracts are

binding (Kidd v. Thomas)

Principal should be bound by minor deviations or disobedience of agent

Contractual Relations With Third Parties – (inherent above)

o Disclosed Principal

A principal is disclosed when the third party has notice of the principal’s existence and identity at the time of

the transaction. §4(1)

Under these circumstances the agent acting in the transaction is not a party to the contract in the absence of

special facts, like expressly agreeing to be a party or guaranteeing the contract.

o Partially Disclosed Principals § 4(2) – Personal Liability

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If the other party [to a transaction] has notice that the agent is or may be acting for a principal but has no

notice of the principal’s identity, the principal for whom the agent is acting is a partially disclosed principal.

§4(2); Atlantic Salmon A/S/ v. Curran

§ 321: Unless otherwise agreed, a person purporting to make a contract with another for a partially disclosed

principal is a party to the contract.

The duty rests upon the agent, if he would avoid personal liability, to disclose his agency, and not upon

others to discover it. Atlantic Salmon A/S v. Curran

An agent can be on the hook if they do not let a party know that he was an agent.

o Undisclosed Principals §§ 194, 195 :

A principal is undisclosed when the third party is unaware that the agent is acting for a principal. The

assumption that the third party is making is that the agent is a person contracting on his own behalf. Under

these circumstances that agent of course is a party to the contract

§ 194: Undisclosed principal is liable for acts of an agent done on his account, if usual or necessary in such

transactions, although forbidden by principal.

§ 195: An undisclosed principal who entrusts an agent with the management of his business is subject to

liability to third persons with whom the agent enters into transactions usual in such business and on the

principal’s account, although contrary to the directions of the principal.

In Watteau v. Fenwick, the hotel was transferred, the former owner was still general manager and his name

was still on the hotel. Using inherent agency, the undisclosed principals were liable for the payments owed

to suppliers from whom general manager ordered goods without permission. No apparent agency because the

plaintiff could not have held out such authority because of undisclosedness.

Policy: not allowing: we want to keep the wheels of commerce turning; we want to encourage people to act

as creditors.

Do not want people to hide behind agents.

Difference between Apparent and Inherent

o Apparent: you need to look at principal communication to the third party that the agent is entitled to bind: turns on

what kind of manifestation was made to the third party

Focus on aspects-communication of dealing: where is the manifestation?

o Inherent: customary usage that that person is entitled to bind the principal

Doesn’t look for speech or action, but rather what someone in that position normally has the authority to do.

Not manifestations, but custom

o Both characterizations have the following in common:

Both have to have a reasonable belief

o Nogales Service Center v. Atlantic Ritchfield Company- NSC (P) alleged that an agent of ARCO (D) had

agreed to certain pricing concessions, an agreement that the ARCO agent contended that he had

not been authorized to make

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A principal can be bound by a general agent based on his position as such, even if he lacks express or

apparent authority for the commitment at issue, so long as the 3rd party would reasonably believe the agent

has the authority to bind the principal.

Usual and customary is the language of inherent authority.

In apparent agency, you look for the principal communicating in some way to the third party that the agent is

allowed to carry out business on its behalf. In inherent agency, the general manager or agent title carries with

it the customary usage that the agent is authorized to carry out specific acts.

Both require that the third party reasonably believe that the agent has authority to carry out the acts.

What proof is required for apparent and inherent agency?

Apparent agency turns on manifestations of the third party with respect to the agent.

Inherent agency turns on what is authority is customary for agents in the same position to have.

Ratification: § 82 : The affirmance/affirmation (look to §83) 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. .

o §83. Affirmance

Affirmance is either

(a) a manifestation of an election by one on whose account an unauthorized act has been done to treat

the act a authorized, or

(b) conduct by him justifiable only if there were such an election.

o The impact of saying there has been a ratification is to place the person in the position of being willing to do the act

in question.

o Test - express

(1) acceptance of the results with an intent to ratify

principal affirms by making a manifestation that, viewed objectively, indicates a choice to treat the

unauthorized act as if had been authorized

If a purported principal attempts to ratify only part of a single transaction, then either the entire

transaction is ratified or there is no ratification at all??????

(2) full knowledge of all the material circumstances

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(3) agent has to have purported to act for the other Botticello

If the original transaction was not purported to be done on account of the principal, the fact that the principal receives its proceeds does not make him a party to it.

o NOT RATIFICATION: Mary observed the plaintiff occupying and improving the land, received rental payments

from the P from time to time, knew that she has an interest in the property, and knew that the use, occupancy, and

rentals were pursuant to a written agreement she had not signed. Botticello

o Ratification requires acceptance of the results of the act with an intent to ratify, and with full knowledge of all the

material circumstances. Botticello v. Stefanovicz

o Cmt. f: If the original transaction was not purported to be done on account of the principal, the fact that the principal

receives its proceeds does not make him a party to it.

o Limitations

A situation where there would be an unfairness to an unsuspecting third party

o Problems:

Arise where there may not have been an express ratification. Such situations can be found where the

affirmance is implied.

Estoppel § 8B – Change of Position :

o (1) A person who is not otherwise liable as a party to a transaction purported to be done on his account, is

nevertheless subject to liability to persons who have changed their positions because of their belief that the

transaction was entered into by or for him, if

(a) he intentionally or carelessly caused such belief, or

(b) knowing of such belief and that others might change their positions because of it, he did not take

reasonable steps to notify them of the facts.

o (2) An owner of property who represents to third persons that another is the owner of the property or who permits

the other so to represent, or who realizes that third persons believe that another is the owner of the property, and that

he could easily inform the third persons of the facts, is subject to the loss of the property if the other disposes of it to

third persons who, in ignorance of the facts, purchase the property or otherwise change their position with reference

to it.

o (3) Change of position, as the phrase is used in the restatement of this subject, indicates payment of money,

expenditure of labor, suffering a loss or subjection to legal liability.

o Works to cause a principal to be liable for an agent where otherwise the principal would not be liable.

o Pleadings and Proof:

There has to be some kind of creating on the part of the principal a situation giving rise to an appearance that

the other party relied on

This is similar to the manifestations made by the principal that are required for apparent agency. A situation allowed by an employer where a third party acts in reliance, or changes position due to

the acts of an impostor. Hoddeson v. Koos Bros.

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o In Hoddeson, customer went to a furniture store, representative met her, took her order and

money. After goods didn’t arrive, she couldn’t identify him and had no receipt. Estoppel was

used by the court – the duty of the proprietor also encircles reasonable care and vigilance to

protect the customer from loss occasioned by the deceptions of an apparent salesman.

Reasonable Belief

There needs to be a reasonable belief on the part of the third party that the alleged agent has authority to act for the principal.

Reliance/Change of Position

Look to §8B (3) for definition

Giving something of value: includes paying money

Simply signing a contract would not suffice for reliance.

Agent’s Liability on the Contract § 321: Principal Partially Disclosed

o Unless otherwise agreed, a person purporting to make a contract with another for a partially disclosed principal is a

party to the contract. 321; Atlantic Salmon A/S v. Curran

o Atlantic: seafood suppliers delivered fish to the D. D signed docs as agent of “Boston Intl Seafood

Exchange, Inc.” Suppliers didn’t get paid, and are suing him as an individual. BISE at the time

of the King did not really exist.

It was not sufficient that the exporters (plaintiffs) might have had the means, through a

search of the records of the city clerk, to determine the identity of the purchaser's principal.

Actual knowledge was the test. It was the purchaser's duty (Defendant), if he wanted to

avoid personal liability, to disclose his agency. The purchaser's use of trade names or

fictitious names was not a sufficient identification of the alleged principal so as to protect

him from personal liability.

TYPES OF AGENCY RELATIONSHIPS & LIABILITIES

Principal – Agent

o principal responsible for the acts of his or her agent.

o The existence of agency may be proved by circumstantial evidence which shows a course of dealing between two

parties. Gay Jenson Farms Co. v. Cargill, Inc.

When an agency relationship is to be proven by circumstantial evidence, the principal must be shown to have

consented to the agency since one cannot be the agent of another except by the consent of the latter. Id.

o Buyer-Supplier distinction

One who contracts to acquire property from a third person and convey it to another is the agent of the other

only if it is agreed that he is to act primarily for the benefit of the other and not for himself. Factors

1. He is to receive a fixed price for the property irrespective of price paid by him. (emphases added).

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2. He acts in his own name and receives the title to the property which he thereafter is to transfer.

3. He has an independent business in buying and selling similar property. Restatement (Second) of

Agency § 14k (1958); Cargill

ANALYSIS: Is an Employer liable for the Employee’s tort?

o Was there an employee-employer/master-servant relationship?

If yes, was it within the scope of the employee’s employment?

Exceptions under 219

If no, was the person an independent contractor?

Employer-Employee/Master-Servant Relationship § 2

o Respondeat Superior § 219

Under the doctrine of respondeat superior, a “master” (employer) is liable for the torts of its servants

(employees) committed while acting in the scope of their employment.

A master-servant relationship exists where the servant has agreed (a) to work on behalf of the master and (b)

to be subject to the master’s control or right to control the “physical conduct” of the servant (that is, the

manner in which the job is performed, as opposed to the result alone. Restatement (Second) of Agency § 1 &

2.

Control: Question of fact: decision will turn on the evidence.

Physical control of employee’s actions

o Courts will look at whole relationship; factors to determine whether control was present- day to

day control. It does not have to be actual control; The right to control will be enough. §2

Purchase of product, Rent, Operator Compensation, Reports, Hours of Operation, Payment

of Expenses (utilities), Subordinate employees, Duration (ability to terminate), Appearance

of station

Control of premises (with franchise agreement)

Right of inspection & suggestion seems to show principal-agent, but in Hoover, it wasn’t

dispositive.

If contract : scrutinize the terms of the contract

o does it go far enough ?

Disclaimer Clauses : what the parties try to call something is not necessarily be persuasive to a court.

Just because you are trying to disclaim liability does not mean that it will not be a master-servant

relationship. The control will still be important.

o Courts look at economic realities…look to indicators of physical control

This area of law is not concrete

o Restatement § 219 – When Master is Liable for Torts of His Servants

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219: (1) A master is subject to liability for the torts of his servants committed while acting in the scope of

their employment. Servant has to be acting within scope

(2) NOT Liable when acting OUTSIDE of the scope of the employment unless…

o (a) the master intended the conduct or the consequences

o (b) the master was negligent or reckless, or

o (c) the conduct violated a non-delegable duty of the master, or

See Arguello

o (d) 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.

Scope of Employment – This will often be an issue in Respondeat Superior Cases

§ 228 (1): General Statement [of Scope of Employment Doctrine] Conduct of a servant is within

the scope of employment if, but only if:

o (a) it is the kind he is employed to perform;

o (b) it occurs substantially within the authorized time and space limits;

o (c) it is actuated at least in part, by a purpose to serve the master; AND

A servant’s conduct is not within the scope of employment if it is…to little actuated by a

purpose to serve the master.

o (d) if force is intentionally used by the servant against another, the use of force is not

unexpectable by the master

§ 228(2) provides that “conduct of a servant is not within the scope of employment it is it different in

kind from that authorized, far beyond the authorized time or space limits, or too little actuated by a

purpose to serve the master.

§ 229 Kind of Conduct within Scope of Employment

o To be within the scope of the employment, conduct must be of the same general nature as that

authorized, or incidental to the conduct authorized. § 229(1)

Incidental goes a long way it is known that occasionally an employee will transgress.

Thus, an act can be within the scope of employment even though

(i) the master has expressly forbidden the act

(ii) the act is tortious

(iii) the act constitutes a minor crime See 231 cmt. a

In determining whether or not the conduct … is so similar to or incidental to the conduct

authorized as to be within the scope of employment, the following matters of fact are to be

considered:

Factors that can be used to figure out what falls under scope of employment: From Wagner,

Look at Arguello v. Conoco for the first five

o (1) the time, place and purpose of actions

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The event occurred during store hours, while the employee was working, and during her regular course of work (selling gas, processing a credit car transaction, using the store’s intercom).

o (2) similarity to acts which the servant is authorized to perform

While Conoco did not specifically authorize her to abuse people, the employee was in the course of her normal function

o (3) whether the act is commonly performed by servants

o (4) the extent of departure from normal methods

The acts were certainly outside the normal methods of conducting a gasoline sale at a Conoco station.

This does not take it out of the scope of the employment simply because the act was not condoned by Conoco. This was an intentional action and employers can be found liable for their employee’s intentional torts.

o (5) whether the master would reasonable expect such act would be performed

A jury could decide that it did not matter that Conoco did not anticipate that their clerks would act in this manner.

o Others from the Restatement § 229

o (c) the previous relations between the master and the servant;

o (d) the extent to which the business of the master is apportioned between different servants;

o (e) whether or not the act is outside the enterprise of the master or, if within the enterprise,

has not been entrusted to any servant;

o (h) whether or not the instrumentality by which the harm is done has been furnished by the

master to the servant;

o (j) whether or not the act is seriously criminal.

Characteristic of the Activity:

This area of the law unsettled. All courts do not follow restatement.

Bushey Foreseeability Analysis

o Sailor’s actions were not so unforeseeable as to make it unfair to charge the government with responsibility It was foreseeable that crew members crossing the drydock might do damage, negligently

or even intentionally, such as pushing a Bushey employee or kicking property into the water

o Where the activities of the “enterprise” do not reach into areas where the servant does not create risks different from those attendant on the activities of the community, there is not liability.

o Here, the sailor came into a closed area where his ship was, which the Government required that he be able to do, and he committed an act which was “not shown to be due entirely to facets of his personal life.” The risk that seamen going and coming from the ship might cause damage to the drydock is

enough to make it fair that the D bear the loss. Depends on what facts can be adduced, what factors can be brought in.

*** Being an agent does not immunize a person from tort liability. A Tortfeasor is personally liable,

regardless of whether the tort was committed on the instructions from or to the benefit of the

principal.

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An injured party may not go after the agent because the injured party may not have a good chance of

collecting a substantial amount from the agent. The principal probably has deeper pockets, so the

chance to collect might be greater.

§ 220: Servant Defined: An agent is a servant if the principal controls or has right to control the

agent’s “physical conduct in the performance of the agency services.”

Servant v. Independent Contractor

o § 220 Definition of Servant

o A servant is a person employed to perform services in the affairs of another and who with respect to the physical

conduct in the performance of the services is subject to the other’s control or right to control.

o In determining whether one acting for another is a servant or an independent contractor, the following matters of

fact, among others, are considered: (***No single factor is determinative)

(a) the extent of control which, by the agreement the master may exercise over the details of the work;

(b) whether or not the one employed is engaged in a distinct occupation or business;

(c) the kind of occupation, with reference to whether, in the locality, the work is usually done under the

direction of the employer or by a specialist without supervision;

(d) whether the employer or the workman supplies the instrumentalities, tools, and the place of work for the

person doing the work;

(e) the skill required in the particular occupation;

(f) the length of time for which the person is employed;

(g) the method of payment, whether by the time or by the job;

(h) whether or not the work is a part of the regular business of the employer;

(i) whether or not the parties believe they are creating the relation of master and servant; and

(j) whether the principal is or is not in business.

Test: whether the employer has the right to control the details of the work.

Independent Contractor: someone acting on behalf of principal; control is different than master-servant

§2(3) : An independent contractor is 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. He may or MAY NOT be an agent.

Agent : one who has agreed to act on behalf of another, but not subject to the principal’s control over

how the result is accomplished.

o Authorizing one to buy materials on your credit

Non-Agent : one who simply enters into arm’s length transactions with others. NON SERVANT

AGENTS???

o Employee/Servant v. Independent Contractor Cases

Humble Oil v. Martin

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M was injured when a car rolled out of a service station owned by H, sought to hold H liable for the

station operator’s (Schneider) negligence. S was the franchisee, H was the franchisor.

HOLDING: a party may be liable for a contractor’s torts if he exercises substantial control over the

contractor’s operations

Humble was liable because Martin was found to be an employee, not to be an independent contractor.

Humble was responsible for operation of the station which it owned, along with the principal products

sold under the Agency Agreement.

o Factors where the IC relationship broke down and master-servant relationship was formed. Where Humble Oil: exercised day to day control over operations, controlled hours of operation, could terminate the contract at will, (Schneider could not), required Schneider to make reports, paid 75% of utilities, owned premises, and had general financial control.

o Question of relationship is usually one of fact; contrary evidence cannot be give conclusive

effect.

Hoover v. Sun Oil Company

Hoover sought to hold franchisor Sun Oil responsible after he was injured in a fire at a service station

franchise operated by Barone.

HOLDING : a franchisee is considered an independent contractor of the franchisor if the franchisee

retains control of inventory and operations.

o The test in such a situation is whether the franchisor retains the right to control the details of the

day-to-day operations of the franchisee. A franchisor’s control or influence over the results alone

are insufficient to establish a P-A relationship.

Barone, who operated the store, retained day to day control and had the risk of loss or gain. –

Found to be an independent contract, so Sun was not liable.

*** Note – the fact that an agreement is termed a franchise agreement does not insulate the parties from an

agency relationship.

o Non-Delegable Duties

A principal has certain obligations to a third party which it cannot evade by virtue of the fact that it is acting

through an agent. Regardless of the care the principal uses in selecting, informing, training, and supervising

the agent, the principal remains on the hook until and unless the agent properly performs the delegated tasks.

I.E. maintaining safe premises. Arguello (court does not accept argument that Conoco has nondelegable

duty not to discriminate.)

o Statutory Claims

Arguello v. Conoco, Inc.

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Court held that the duty not to discriminate is not a non-delegable duty, instead a plaintiff must

establish a close connection between the employer and the third party who engages in the intentional

discrimination.

No Agency was found

o Intentional Torts

Restatement § 231: A servant’s acts “may be within the scope of employment, although consciously criminal

or tortious,” but the comments to that section indicate that “serious crimes” are outside the scope. Manning v.

Grimsley.

Plaintiff was a spectator at a baseball game and was injured by a ball thrown by a pitcher. Pl was

seated in bleachers in right field and was in a group of hecklers. Pitcher looked directly at the

hecklers on several occasions. He threw a ball while looking at the plate that came at a 90 degree

angle from the mound into the hecklers and hit the Pl.

Ct says to recover for an assault under Mass law, P must show emp’s assault was in response to P’s

conduct which was presently interfering w/ employer’s ability to perform duties successfully. Court

found that heckling fans constituted conduct. The conduct was w/ pupose to rattle the employee so he

couldn’t’ perform duties. It wasn’t retaliation for annoyance, but a response to a continuing conduct

that was interfering w/ his ability to pitch. Employer was liable, since employee by throwing ball was

working in furtherance of master.

Also look to §228 (1)(d)

Principal can still be liable. In the past there was a “motivated at least in part to serve the master.” More

recently, forseeability tests have been applied.

o Liability for Torts of Independent Contractors

Generally the rule is non-liability, however there are THREE EXCEPTIONS (Majestic Realty Associates,

Inc. v. Toti Contracting Co.):

The plaintiffs, a building owner and a tenet, are suing the defendants, a construction company and the New

Jersey parking authority, because a building being torn down by the construction company fell onto the

plaintiff’s building and damage the property. The construction company did not use the generally accepted

method for tearing down the building since it was in close proximity to other buildings. There is also

testimony of the wrecking ball operator saying that he screwed up..

THREE EXCEPTIONS FROM MAJESTIC CONTROL: Where the potential principal retains control of the manner and means of the doing of the

work which is the subject of the contracto Even though it is independent contractor relationship, the contractee is exerting control over the

independent contractor making the relationship more like master-servant.

o This is really a master-servant relationship and not truly an independent contractor relationship INCOMPETENT K’R: Where the principal retains an incompetent contractor

o The court discusses whether a party without insurance is considered to be incompetent. This was not decided in this case.

o Lack of financial responsibility such as inadequate insurance could be.

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NUISANCE PER SE: Where the activity contracted for constitutes a nuisance per seo For something do be a nuisance per se, it must be inherently dangerous/ ultra-hazardous activity

Something is inherently dangerous if it necessarily requires the creation during its progress of a condition involving a peculiar risk of harm to others unless special precautions are taken, if the contractor is negligent in failing to take those precautions.

o Franchise: “License agreement”

Franchisor enters into contract with a franchisee, allowing use of corporate logo, name, system of doing business

in exchange for payments from the franchisor (usually royalties).

The franchiser controls the distribution of goods and/or services through a contract which regulates the activities

of the franchisee, in order to achieve standardization.

The fact that an agreement is a franchise contract does not insulate the contracting parties from an agency

relationship.

Sun-Oil; Holiday Inn; Humble Oil

Apparent Authority in a Franchise Agreement

(1) manifestation

o A sign holding yourself out to the public via a sign might be enough…Billops

(2) reasonable belief

o Cases

Murphy v. Holiday Inns, Inc.

FACTS: The plaintiff, Murphy, is suing because she slipped and fell on the property owned by Betsy-Len, the franchisee. Holiday Inns was the franchisor. Murphy is arguing that there is a master-servant relationship between Betsy-Len and Holiday Inns and that Holiday Inns can be held liable for torts committed by Betsy-Len (Restat. § 219).

If a franchise contract so regulates the activities of a franchisee as to vest the franchisor with control

within the definition of agency, a principal-agent relationship arises even if the parties expressly deny

it.

o Even though franchisee relied on Holiday Inn for ads, appearance, training, methods of

operation, - these were only for protection of good name.

o The court does not find the name of the document (“License Agreement”) or the disclaimer to be

persuasive. The court is not going to be convinced by the labels given to the relationship by the

parties. Instead they are going to look at what is actually going on.

o The system-wide standardization is not enough to make the relationship a master-servant

relationship, there has to be actual day-to-day control

Factors showing a lack of day-to-day control, thus no master-servant relationship under franchisee-franchisor relationship focus of the franchise agreement is to keep standardization amongst the franchisees,

not to control their daily operations franchisor had no power to control the daily maintenance which gave rise to this

accident, franchisee had risk of profit/loss, franchisee fixed their own rates and business expenses,

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franchisee hired and fired employees, determined employee wages or working conditions, set standards for employee skills or productivity, supervise employee work routine, or discipline employees.

TORT LIABILITY AND APPARENT AGENCY: Billops v. Magness Construction Co.

Magness is doing business under the name Brandywine Hilton Inn. Billops books a party at the

Brandywine. On the day of the event, the Brandywine manager gets belligerent with the plaintiff and

wants more money. The situation gets ugly.

Apparent authority in franchise context : manifestations by the principal that create a reasonable belief

in a 3rd party that the franchisor is the party with whom he is dealing, will lead to the same legal

consequences as those that result from an actual agency relationship (Billops v. Magness)

Were there manifestation on the part of the principal to the third party and a reasonable belief on

behalf of the third party ?

o The sign using the name and log of Hilton Hotels was considered a manifestation satisfying the

requirements of apparent authority.

o There must be a reasonable belief that the agent is so authorized to act. Billops group thought

they were getting a first rate hotel for their first class affair.

FIDUCIARY OBLIGATIONS OF AGENTS

§ 387 General Principle [Duty of Loyalty]:

o Subject to and in accordance with the rules stated in §§ 388-398, 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.

§ 388 Duty to Account for Profits Arising Out of Employment:

o Unless otherwise agreed, an agent who makes a profit in connection with transactions conducted by him on behalf of

the principal is under a duty to give such profit to the principal.

§ 404 Liability for Value for Use of Principal’s Assets:

o An agent who, in violation of duty to his principal, uses for his own purposes or those of a third person assets of the

principal's business is subject to liability to the principal for the value of the use. If the use predominates in

producing a profit he is subject to liability, at the principal's election, for such profit; he is not, however, liable for

profits made by him merely by the use of time which he has contracted to devote to the principal without violation of

his duty not to act adversely or in competition with the principal.

o Reading v. Regen – Officer used uniform to smuggle goods – he owed the money earned to the crown because he

was representing the service: using the uniform for his benefit. There is a fiduciary duty to the crown. His position as

an officer played a predominant role in his obtaining the money, so he should be accountable to the master.

“If a servant takes advantage of his service and violates his duty of honesty and good faith to make a profit for himself, in the sense that the assets which he has control, the facilities which enjoys, or the position which he occupies, are the real cause of his obtaining the money as distinct from merely affording the opportunity for getting it, that is to say, if they play the predominant part in his obtaining the money, then he is accountable for it to his master.”

It is because he got it solely by reason of the position which he occupied as a servant of his mastero REMEDY: The court makes note of the fact that the crown did not lose profits because of their agent’s actions.

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They require the remedy of disgorgement (turning over of the money) because there were no actual damages to the principal. Also, this gives an incentive to agents not to make secret profits.

Definition:

o You are in a special relationship with another party and you are to put your interests above those of the other.

Duty of Loyalty

o The Agent is obliged to prefer the principal’s interests over its own and to act “solely for the benefit of the principal

in all matters connected with the agency.” § 387

o Duty of loyalty applies regardless of the role of the agent

o Unless otherwise agreed, an agent may not benefit from its efforts on behalf of the principal.

o An agent has a duty to safeguard the principal’s confidential information and not to use that information for the

agent’s own benefit or others. Such information may include any information that is not generally known and that

either carries an economic benefit for the principal, or if were released could damage principal

Trade secrets, customer lists, unique business methods, business plans

o There is a duty to disclose to principal

o Unless otherwise agreed, the agent has a duty not to compete with the principal in any manner within the scope of

the agency relationship

o No acting for others with conflicting interests

o General Automotive Manufacturing Co. v. Singer

Moonlighting

o This is allowed. See Reading, 82 for facts…. Gambling Case

o Reading case is different from cases where the service merely gives the opportunity of making money No use of position or assets to make money, but you can moonlight (play poker or something like that)

Duty of Care

o Duty to discharge obligations in a prudent, careful manner. You have to act with the same degree of care as if you

were acting in your own business.

o Ordinary negligence standard

o An agreement between the principal and agent can change the amount of care owed by the agent

Duty to Disclose/Provide Information

o If an agent possesses information and has reason to know that the principal may need or desire the information, the

agent has a duty to provide the information to the principal.

Rule Against Secret Profits

o § 389: Acting as Adverse Party Without Principal’s Consent: Unless otherwise agreed, an agent is subject to a

duty not to deal with his principal as an adverse party in a transaction connected with his agency.

o Ex: Principal asks agency to sell property, but agent buys property for himself without knowledge – putting self

interest first. The problem here is that the agent will try to buy for less without principal’s knowledge that he or she

may have gotten more. This is a Conflict of Interest

o The agent has the obligation not to made secret profits. Enrichment can be violation when not specifically agreed to

by the master.

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o Disgorgement remedy: preventative remedy

o Restatement sections 387, 388

Conflict of Interest : This underlies the duty of loyalty and fiduciary duty

o To avoid: follow a duty to disclose

Competing Against Principal

o Duty of Loyalty to Act Solely for the benefit of the employer : In General Automotive Co. v. Singer, Singer kept

orders for himself that he thought the company could not handle.

By failing to disclose the reason the contracts were turned down (informing GAM could have given them the opportunity to contract it out themselves, increase capacity, or turn it down) to the principal and by making secret profits, Singer violated his duty of loyalty to GAM and had to turn over the profits.

an agent who draws business away from his principal for his own enrichment is liable to the principal for his

profits therefrom.

An agent has a fiduciary relationship to his principal and a fiduciary owes a high degree of loyalty to

the principal, and part of this duty is not to do anything to the principal’s economic detriment.

An agent who “moonlights” or otherwise engages in activities that draw profits away from the

principal does precisely this.

o The title of an activity does not determine the question whether it was competitive but an examination of the nature

of the business must be made. General Automotive Mfg. v. Singer

Whether an employee’s side work constitutes a breach of fiduciary duty depends on many variables, including the position of the employee and the closeness of the side work to the type of economic activity of the principal.

Obligations to Principals after Termination of Relationship

o § 396: Using Confidential Information After Termination of Agency: Unless otherwise agreed, after the

termination of the agency, the agent:

(a) has no duty not to compete with the principal;

(b) is subject to a duty to the principal not to use or disclose to third persons, on his own account or on

account of others, in competition with the principal or to his injury, trade secrets, written lists of names, or

other similar confidential matters given to him only for the principal's use or acquired by the agent in

violation of duty.

The agent may use general information concerning the method of business of the principal and the

names of the customers retained in his memory, if not acquired in violation of his duty as agent.

(c) has a duty to account for profits made by the sale or use of trade secrets and other confidential

information, whether or not in competition with the principal;

(d) has a duty to the principal not to take advantage of a skill subsisting confidential relation created during

the prior agency relation.

Short Version of (b)--After termination of agency, A has a duty not to use...in competition with the P or to

his injury...trade secrets, written lists of names, or other similar confidential matters...

o There is a limited continuing duty to the relationship

o Soliciting Customers – Town and Country House & Home Service, Inc. v. Newberry

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Facts: Certain employees of T&C (P) left, formed a competing company, and utilized customer lists, style of

doing business, and pricing they had obtained from their former employer. T&C sued for unfair competition.

“[E]ven where a solicitor of business does not operate fraudulently under the banner of his former employer,

he still may not solicit the latter’s customers who are not openly engaged in business in advertised locations

or whose availability as patrons cannot readily be ascertained but “whose trade and patronage have been

secured by years of business effort and advertising, and the expenditure of time and money, constituting a

part of the good will of a business which enterprise and foresight have built up.”

This case focused on the nature of the information that was taken – the secrecy and the confidentiality of

the information.

Trade secret: has the principal expanded effort and incurred expense to obtain or create the

information? Does the principal derive economic advantage from the information not being generally

known?

Impermissible action by agent which will constitute a breach fiduciary duty : Solicitation of his former employer’s customers whose trade and patronage have been secured by

years of business effort and advertising and the expenditure of time and money, o i.e. such customers are not openly engaged in business in advertised locations nor can their

availability as patrons be readily ascertained.o A customer list , insofar as it contains information not readily available to the general public, is a

trade secret. Former employee may not steal a confidential list in preparation to compete.

Here, a client list was protected as such customers could not be obtained by merely looking up names in a directory, but rather were screened from among many households who declined such services.

Such customers were screened at considerable expense and effort, without which their receptivity and willingness to do business with this type of service could not be known.

Default Rules : one that applies in the absence of an agreement of the parties. o GAM v. Singer: Because the parties did not agree in advance, disgorgement of the profits to the owner is the defaulto Default rules do not apply in the case of a mandatory rule. Mandatory rules cannot be changed, whereas default rules

can be changed by contract. Remedies for Breach of Duty

o Damages

o Disgorgement

o Rescission

PARTNERSHIPS

CREATION OF PARTNERSHIPS AND OTHER GENERAL INFORMATION

Uniform Partnership Act

o This is a model law: In practice this is not adopted in all states, but rather states have enacted statutes that are very

similar.

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o In general, there must be a business relationship whose participants intend the kind of arrangement that the law calls

a partnership. The participants must agree to that arrangement, either expressly or by their conduct.

Definition: UPA § 6(1) - A partnership is an association of

o Two or more persons

o to carry on as co-owners a business

o for profit.

PROFIT REQUIREMENT: For participants in a business to be partners they must have the right to share in

the business’s profits. It is not necessary that the business actually have profits, and profit sharing is not

irrefutable evidence of partner status, but the right to share whatever profits exist is a necessary precondition

to being a partner.

LOOK TO FENWICK

Sharing in revenues does not satisfy the profit-sharing prerequisite

Business’s revenue (or proceeds, receipts, or gross income) consists of the money the business takes

in

Business’s profit equals the amount of its revenue, less the amount of expenses the business has

incurred in generating that revenue

Having a share of profits tends to produce a different attitude than having a share of revenues.

Someone with a share merely of revenues tends to focus on making sales, worrying little about the

rest of the enterprise. For someone who shares profits, in contrast, sales (and revenues) are only part

of the equation; a profit will exist only if the whole business is functioning well.

Determining is there is a partnership

o Restatement Rules for Determining Existence of Partnership § 7

1) Except in §16 (partnership by estoppel) persons who are not partners as to each aren’t partners to 3rd

persons.

(2) Joint tenancy, tenancy in common, tenancy by the entireties, joint property, common property, or part

ownership does not of itself establish a partnership, whether such co-owners do or do not share any profits

made by the use of the property.

3) Sharing of gross returns does not of itself establish partnership, whether/not persons sharing have

joint/common right in property from which returns are derived.

4) Receipt by person of share of profits of business is prima facie evidence that he is partner in business,

but no such inference shall be dawn if such profits rcv’d in payment:

a) as debt by installments/otherwise,

b) as wages of employee or rent to landlord

c) as annuity to widow/rep of deceased partner

d) as interest on loan, though amt of paymt vary w/ profits of business

e) as consideration for sale of good-will of business or other prop by installments/otherwise

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*** Those who share profits tend to view their economic fate as linked with the fate of the enterprise as a

whole. As a consequence, they will wish to involve themselves in controlling the enterprise and will tend to

see the enterprise as belonging in part to them.

o In General :

Courts will look at actual relationship

Courts will look through form to substance. Substance of relationships will be looked at to make a

determination. Just because there is a disclaimer doesn’t mean anything.

Employee/Employer or Partner Relationship? Court’s determination from Fenwick v. Unemployment

Compensation Commission

The UCC (D) determined that a written agreement fixing compensation between

Chesire and her employer, Fenwick (P), owner of the United Beauty Shoppe, did not

make her a partner to the shop.

Where the agreement describes the relationship as one thing, it will be termed another if all of the facts and circumstances lead to that result. o Other factors determining P include:

(1) Intent of Parties: Intent of the parties, as evidenced through the totality of the written agreement, (this was only a financial agreement b/t the parties);

(2) Right to share profits: Sharing of profits (prima facie evidence of P under UPA §7(4)), unless received in payment as wages to an employee;

(3) Obligation to share losses ; (4) Control of Partnership property : Ownership and control of P property and business,

(she contributed nothing and had no control over business decision); (5) Share of Administrative Power: Power in administration, (she had no management

control); (6) Language of the agreement (i.e. terming it a P) is not conclusive and given little

deference when the totality of the circumstances indicate otherwise; (7)Conduct of the parties towards 3 rd persons, (she was held out to others as a receptionist

and not a partner); (8)Rights on dissolution, (her right of dissolution would have been exactly the same as if

she had quit employment).o Fenwick’s secretary wanted raise so they entered agreement purporting to be a partnership. After

they changed the terms her duties were basically the same, she gave no capital investment, had

no control, no management, she took on no liability and at dissolution no rights. Profit sharing

was not enough.

o The default rule about sharing of losses is that everyone is jointly liable. Since Chesire does not

share in the losses, it is unlikely that there was a change in her status after the “Partnership

Agreement” was signed.

Partnerships by term and Partnerships at-will §§ 31(1) a & b

o At will – § 31(b) If the partners have not agreed to continue the partnership until the end of some particular term or

undertaking, then each partner has the power and the right to cause dissolution at any time simply by withdrawing,

resigning, retiring, or otherwise making known his, her or its expressed will.

One partner can terminate by express notice as long as there is no bad faith. See Page v. Page

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***At-will is the default 31 a & b

Sometimes the determination is not clear because sometimes that there is an implied term. Also – fiduciary

duty does play a role in these partnerships. One partner cannot freeze out the other; there must also be

compensation is such a situation. Doctrines of fairness and good faith apply.

o Term – 31(1)(a) - Partnership for a definite term

Court will look to intention of the parties

Joint and Several Liability § 15

o (a) All partners are jointly and severally liable for everything chargeable to the partnership under sections 13 and 14

– should be acting in the scope of the business

13 Partnership Bound by Wrongful Act

14 Partnership Bound by Partner’s Breach of Trust

o (b) All partners in a partnership are jointly and severally liable for the debts of the partnership

o Lender or Partner? Martin v. Peyton, Nabisco v. Stroud – NY

Martin: Martin, a creditor of the brokerage firm KNK (P), claimed that investments made by

Peyton and his associates in KNK made them partners in the firm. PPF transferred money

to KNK, question: was this an investment or a loan? If investment, then they are investing

to carry on as co-owners. KNK is going to take securities and use them as collateral on a

bank loan

The question was whether or not there was a loan or something else which would create a partnership. The

transaction looked like a loan, but courts will look beyond form to substance.

What makes it look like a loan? Form of the documents Lent securities Take collateral for their loan PPF can inspect the books (this is like Cargill, lenders want to have some

control over what’s done)What may make it look like a partnership?

Whatever KNK did with the securities, they had to consult “trustees” (PPF) Veto power 40% share in profits PPF can replace partners in the firm if they become unhappy with the way it is

run Possible partnership because the lender consulted with trustees, had the right to inspect books, veto power,

profit sharing, control…

Control was important, and is often the deciding factor – in this case, different from Cargill, there

was no mechanism to use control mechanisms.

The court decides that this is a lender and not a partnership relationship. This was an extremely close case and really could have gone either way.

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CARGILL: This case is different from Cargill because in that case control was enough to convert the grain operator into an agent. What is the difference here?o Cargill actually exercised strong control in the Cargill case whereas here there was a right to

control on the part of PPF but there was no mechanism under the agreement which would have allowed PPF to exercise their right to control.

Partnership by Estoppel § 16

It is possible for a person to have partner-like liability for an enterprise’s obligations without truly being a partner.

If ◙ a person represents itself as being a partner in an enterprise (or allows others to make the representation)

And ◙ A 3 rd pty reasonably relies on the representation and as a result does business with the enterprise

Then ◙ the person who was represented as a partner is personally liable on the transaction, even though that person is not in fact a partner AND others who have either made or consented to the representation are bound by the person’s acts.

If ◙ a partnership exists, and ◙ all the partners make or consent to the misrepresentation of a person’s status as partner, Then ◙ the partnership is liable on the transaction, and

◙ the partners are each liable under the ordinary rules of partner liability—i.e. UPA §15

If ◙ a partnership exists, but ◙ not all the partners make or consent to the misrepresentation, Then ◙ the partnership is not liable, and

◙ those partners who made or consented to the misrepresentation are jointly and severally liable on the transaction

If ◙ no partnership exists, Then ◙ those who made or consented to the misrepresentation are jointly and severally liable on

the transaction.

§16 UPA 1914. Partner by Estoppel.

(1) When a person, by words spoken or written by conduct, represents himself, or consents to another

representing him to any one, 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 the knowledge of the apparent

partner making the representation or consenting to its being made.

(a) When a partnership liability results, he is liable as though he were an actual member of the

partnership.

(b) When no partnership liability results, he is liable jointly with the other persons, if any, so consenting to

the K or representation as to incur liability, otherwise separately.

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(2) When a person has been thus represented to be a partner in an existing partnership, or with one or more

persons not actual partners, 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, with respect to persons who rely upon

the representation. Where all the members of the existing partnership consent to the representation, a

partnership act or obligation results; but in all other cases it is the joint act or obligation of the person acting

and the persons consenting to the representation.o Policy : to protect creditors who extend something of value to the partnership because they are mistaken to the nature

of the partnership. The idea is not to protect creditors in general.

o **When person, by words spoken/written OR by conduct, represents self, OR consents to another representing him

to any one, as Partner in an existing partnership OR w/ 1/more persons not actual partners, he is liable to any such

person to whom such representation has been made, who has, on faith of such representation, given credit to

actual/apparent partnership… Young v. Jones

This means that they are jointly and severally liable.

o *** Reliance will be important

o In Young v. Jones, TX investors deposited $550,000 in a South Carolina bank on the basis of an

audit letter issued by Price-Waterhouse—Bahamas regarding the financial statement of SAFIG.

The financial statement turned out to be falsified, and Plaintiffs lost the deposited money.

Two elements by estoppel: Representation : a partner who represents himself or permits another to represent him to another as a

partner in an existing P, or with others not actual partners, he liable…o There were brochures saying PW was holding itself out as a P globally.

Reliance : …to any such person to whom such a representation is made who has, on the faith of the representation, given credit (reliance) to the actual or apparent relationship.o Young did not see these brochures before making the investment, therefore he could not have

relied upon them; there is no evidence that Young relied on any act or statement by an PW-US partner indicating the existence of a P with PW-Bahamas.

Although Y alleges that PW holds itself out as an international accounting firm, he can point to nothing concrete that should hold the various affiliated entities liable for the acts of others.

A Partnership is implied by law when one or more persons represents themselves as partners to a 3rd party who relies on that representation.

Persons who are not partners as to each other are not partners as to 3rd parties. Rules Determining Rights & Duties of Partners § 18

o Rights & Duties of Partners in relation to partnership shall be determined, subject to any agreement between them,

by following rules:

(a) Each Partner shall be re-paid his contributions, whether by capital or advances to partnership prop &

share equally in profits & surplus remaining after all liabilities, including to partners, are satisfied; AND

must contribute towards losses, whether capital/otherwise, sustained by partnership according to his share in

profits.

(b) Partnership must indemnify every P in respect of payments made & personal liabilities reasonably

incurred by him in ordinary & proper conduct of its business, or for preservation of its business/prop.

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(c) Partner, who in aid of ‘partnership makes any payment or advance beyond amount of capital which he

agreed to contribute, shall be paid interest from date of payment or advance.

(d) Partner shall receive interest on capital contributed by him ONLY from date repayment should be made

(e) ALL PS HAVE EQUAL RIGHTS IN MGMT & CONDUCT OF PARTNERSHIP BUSINESS

(f) No Partner entitled to salary for acting in partnership business, except that surviving P entitled to

reasonable compensation for his services in winding up partnership affairs

(g) No person can become member of partnership w/out consent of all partners

(h) Any difference arising as to ordinary matters connected with partnership business may be decided by

majority of partners; but no act in contravention of any agreement between partners may be done rightfully

withoutout consent of all partners

FIDUCIARY DUTIES IN PARTNERSHIPS

o RUPA § 404 General Standards of Partnership – Fiduciary Standards

(b) Duty of loyalty, account to partnership, refrain from dealing with adverse party and competing

(c) Duty of Care: refrain from negligent, reckless, intentional misconduct, knowing violation of law.

o Rendering Info – UPA § 20

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 the legal representative of any deceased partner under

legal disability.

See Meehan v. Shaughnessy

o Partner Accountable as a Fiduciary UPA § 21

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 or from any use by him of its property

No taking business opportunities from the partnership without consent.

o Cases

Meinhard v. Salmon – Lead Case Establishing the Duty

Salmon brought Meinhard in for financial support, S did all the work, they split the profits, S made a

deal with another but didn’t include M. Court found that there was a breach of fiduciary duty in this

action. S should have let his partner know that there was a chance to expand the old lease.

Cardozo’s Famous Quote: “Joint adventurers, like copartners, owe to one another, while the

enterprise continues, the duty of the finest loyalty. Many forms of conduct permissible in a workday

world for those bound by fiduciary ties. A trustee is held to something stricter than the morals of the

marketplace. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard

of behavior.” Duty is like that of a trustee

Joint adventurers (partners) owe to one another the highest fiduciary duty of loyalty while the enterprise is ongoing, and the duty is “relentless and supreme”.

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A partner may not appropriate for himself, in secrecy and silence, an opportunity that should have belonged to the P. o The partner that learns of the opportunity must at the very least disclose this opportunity to the

other partner(s) so that all partners will have an opportunity to compete. Factors indicating a duty to a partner:

o Partner in control of the partnership as the manager, was charged with the duty of disclosure.o Failure to disclose deprived another partner of the opportunity to compete. o The distinction here is the subject-matter of the lease and whether it is an extension of the first

lease or something distinct and removed from the first lease. Bane v. Ferguson – Fiduciary Duties of Partners After Dissolution

Former partner loses pension because former firm dissolved and merged with former firm.

HOLDING: the fiduciary obligations owed by members in a partnership to one

another do not flow to former partners, whose withdrawal terminates the partnership

in relation to that partner.

No relief here, the partner was not fiduciary of former partners.

UPA (1914) § 9(c) provides that “unless authorized by the other partners…one or more but less than all the partners have no authority to: Do any…act which would make it impossible to carry on the ordinary business of the partnership.”o The purpose of this statute is to make negligent partners liable to the other partners and not

someone with whom the conduct business. Bane ceased to be a partner when he retired.

o “A partner is a fiduciary of his partner, but not of his former partners, for the withdrawal of a partner terminates the partnership as to him.”

Even if the Ds were a fiduciary, the business-judgment rule shields fiduciaries from

liability for mere negligence in the operation of a firm.

o Business-judgment rule : doctrine relieving corporate directors and/or officers

from liability for decisions honestly and rationally made in the corporation’s best

interests.

Meehan v. Shaughnessy – Grabbing & Leaving, Limits of Fiduciary Duty, “Utmost good faith & loyalty”

Leaving partners were leaving firm and secretly planned and organized departure. The fiduciaries

may plan to compete with the entity to which they owe allegiance provided that in the course of such

arrangements they do not otherwise act in violation of their fiduciary duties. They can prepare

logistics, client list, take employees.

There were violations cannot lie, contact clients without giving them the option of staying with old

firm, solicit clients on old firm’s letterhead. They were unfair in the manner which they

communicated with other former clients – violation of UPA § 20. Duty to Disclose

*** Important – you can provide by the partnership agreement that it is ok to take a business

opportunity. Partnerships should plan in advance for such situations – especially for break ups.

HOLDING: A partner has an obligation to provide true and full information of all

things affecting the partnership to any partner. §20

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o §20 UPA, 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.

o MB were entitled to make logistical arrangements such as signing a lease,

obtaining financing, and drawing up lists of clients in order to establish their firm

o MB committed no breach of duties to PC during last several months with the

firm with regard to their handling of cases or changes in workload

o MB did breach their duties by unfairly acquiring consent from clients to remove

cases from PC

o Through prep for obtaining clients consent, secrecy, and substance and method

of their communications with clients, MB obtained an unfair advantage over

former partners in breach of their fiduciary duties

Lawlis v. Lightlighter & Gray- Expulsion, Limits of duty

Alcoholic partner was voted out of partnership. There was a contract that stated he could be thrown

out for any reason – “no cause,” which he signed. The fiduciary duty was overridden by the contract.

When a partner is involuntarily expelled from a P, his expulsion must have been in good faith for a

dissolution to occur without violating the P agreement.

o Where the remaining partners in a firm deem it necessary to expel a partner under a no-cause

expulsion clause in a P agreement, the expelling partners are deemed to have acted in good faith

if their conduct does not cause a wrongful w/holding of money or property legally due the

expelled partner.

o The executive committee had the right to expel plaintiffs without stating a reason or cause

pursuant to the P agreement, and as such, there was not breach of any fiduciary duty.

*** Compared to Cardozo’s view, this case has a more limited view of the fiduciary duties owed. It

appears that in Lawlis, the fiduciary duty can be waived by contract.

PARTNERSHIP PROPERTY

o Partnership Property UPA §8

1) All prop originally brought into partnership stock or subsequently acquired by purchase or otherwise, on

acct of partnership, is partnership property

2) Unless contrary intention appears, prop acquired with partnership funds is partnership property.

3) Any estate in real prop may be acquired in partnership name. Title so acquired can be conveyed only in

partnership name.s

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o UPA §24 – Extent of Property Rights of P

Prop rights are

1) rights in specific partnership property

o the partnership tenancy possessory right of equal use or possession by partners for partnership

purposes.

o You can use the property but only in connection with the business

2) interest in partnership

o share of profits/surplus (retained profits not paid out)

3) right to participate in mgmt

o partners are supposed to have equal rights

o UPA §25 Nature of P’s Right in Specific Partnership Property

(1) Partner is co-owner with other Partners of specific partnership property as tenant in partnership

(2) P has = right with other Partners to possess specific partnership prop for partnership purposes; but no

right to possess such prop for any other purpose without consent of his Partners

o UPA §26 Nature of P’s Interest in Partnership.

P’s interest in partnership is his share of profits & surplus & same is personal prop

o UPA §27 Assignment of P’s Interest

(1) conveyance of P’s interest does not dissolve partnership & does not entitle assignee any mgmt rights but

merely entitles assignee to receive profits

(2) upon dissolution assignee is entitled to assignor’s interest

o UPA Transfers

A transfer of partnership – the organization is treated as an aggregation of assets

A transfer of property – the organization is treated as an entity

o Cases

Putnam v. Shoaf

Putnam wanted to sever relations in her indebted partnership. She paid Shoaf to assume all

obligations and to take over her shares. Shoaf found out that old bookkeeper was embezzling and

received $69k in judgment. Putnam wanted her share, but court denied because she contracted away

her rights.

A partner owns no personal specific interest in any specific property or asset of the P and may only convey an undivided interest in the value/deficit of the P. The P owns the property or asset. o I.e. when a partner sells his interest, he sells every interest and all rights he may have had,

including all future causes of action. o All Putnam had to convey was the net value of the partnershipo She had no specific interest in any possible lawsuits which she could separately

convey or retaino She only intended to convey her interest in a share of the profits and losses of the

company UPA §24 The property rights of a partner are:

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o (1) rights in specific P property (P tenancy possessory right of equal use or possession by partners for P purposes)(possessory right does not exist absent the P),

o (2) interest in the P (i.e. his share of the profits and surpluses, and the same is personal property), and

o (3) right to participate in mgmt.

PARTNERSHIP RIGHTS IN MANAGEMENT

o ADD SECTION FROM CRL OUTLINE

o UPA § 18 (e) – equal rights : All partners have equal rights in management and conduct of partnership business

This is a default rule – you can change the equal rights and still have a partnership, but there will be a limit to

the way this is proportioned.

o UPA § 18 (h) – majority controls – Any difference arising as to ordinary manners connected with partnership

business may be decided by majority of partners; but not act in contravention of any agreement between partners

may be done rightfully without consent of all partners.

This is a default rule ! - important

problem with deadlock situation

Nabisco v. Stroud

o § 9 – Ordinary Business Matters – The acts of the partner must be within the actual or apparent scope of his

authority to bind the partnership.

o Cases

Nabisco Biscuit Company v. Stroud

Stroud and Freeman entered into general partnership to sell groceries. The purchase and sale of bread

were ordinary and legitimate business of partnership. Stroud stated that he would not be responsible

for any additional bread; Freeman ordered anyway. Stroud was stuck with the bill.

Stroud liable for debt Each partner is an agent of the partnership, equal management cannot be

aggregated without agreement § 18(a) & (h). Stroud could not restrict the power and authority of

Freeman to order bread because such an action was an ordinary matter with the partnership business

and within its scope. Partners are jointly and severally liable under UPA § 15 – here the purchases

bound the partnership and Stroud.

The acts of a partner, if performed on behalf of the partnership and within the scope

of its business, are binding upon all co-partners.

o Giving notice to a creditor that you don’t want to be personally liable doesn’t cut

off your personal liability, have to go through procedures for how decisions are

made in the partnership. It is a rule of majority voting.

o If a majority of the partners disapprove of a transaction before it is entered into,

then they may escape liability for whatever obligations the transaction ultimately

incurs.

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o F’s acts were entered into on behalf of the partnership, were within the scope of

its ordinary business, and probably conferred a benefit upon both F and S as

partners

o Default rule to take into consideration: §9 (a partner is an agent of the

partnership for purposes of the partnership business)

*** To avoid the problem they could contract to have a third party control this or give one partner a

controlling share to avoid such a problem.

Day v. Sidley & Austin

Day was managing partner of D.C. office. As a result of merger, Day became Co-managing partner.

Day sued because he was told that no one would be worse off after merger. There was no breach here:

Day contracted away his management rights to the Executive Committee so there was no need for

unanimous consent of all partners.

Partners have a fiduciary duty to make a full and fair disclosure to other partners of all information that may be of value to the Partnership. Day v. Sidley & Austino There is not a fiduciary duty to disclose the type of information handled by an executive

committee involving an action, the concealment of which does not produce any profit for the offending partners or any financial loss for the P as a whole, i.e. changes in the internal structure of the firm. Day v. Sidley & Austin

*** What is probably most important about this case is its illustration of the rule of partnership law

that partners are free to make any agreement that suits them, without concern about niceties if

partnership theory, and its illustration of contract law – “You made your bed, now lie in it.”

o The court says that executive committees have rights to conduct the business of the firm without being required to reveal all information to other partners

o The court points out that even if Day had not voted to approve the merger, he did not have veto power over the decision and the decision could be made by a majority vote.

DISSOLUTION OF PARTNERSHIPS

In General

o The disassociation of any partner causes dissolution of a UPA partnership

o Dissolution does not end the partnership but instead puts the partnership into a period of winding up

o The eventual end of a partnership is not necessarily the end of a partnership’s business

o Under the UPA, a partner always has the power (but not necessarily the right) to dissolve the partnership.

Dissolution UPA § 29

o Defined in 29: The dissolution of part a partnership 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.

o A partnership dissolves when a partner leaves (technically)

At the time of exit by one partner, a new partnership is created consisting of the remaining partners

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o This can be changed; some agreements state that a partner can leave without dissolution of the partnership

UPA § 30 - Partnership NOT terminated by Dissolution

o Partnership continues until winding up of partnership affairs complete

(1) Selling off the business in parts

(2) Sell the whole things as ongoing concerns

o Partnership has business affairs that it has to wrap up after dissolution including payments to partners, suppliers

etc…

o This is different than the next section which deals with dissolution

o The practical effect of this section is that one partner may try to buy the business for himself. There is difficulty with

respect to this because of problems with determining the value/worth of the business.

This can cause fairness problems because the party who wants to buy the assets will want to pay the lowest

price, but this results in a reduction in funds available for distribution – i.e. the party not purchasing the

business will not receive as much money.

Appraiser coming in can solve the problems

o One party cannot pick the better accounts of the partnership-

o It is permissible for partners to buy all the assets and start a new partnership --

UPA §31 – Causes of Dissolution

o Dissolution caused by

1. Without violation of the agreement between the partners,

a. by the termination of the definite term or particular undertaking specified in the agreement,

b. by the express will of any partner at anytime when no definite term or undertaking is specified, -

i.e. any partner can withdraw, resign, retire

c. by the express will of all the partners who have not assigned their interests or suffered them to be

charged for their separate debts, either before or after the termination of any specified term or

particular undertaking,

d. by expulsion of any partner if provided for in the agreement.

2. In contravention of the agreement: by the express will of any partner at any time—this gives any partner

the power to dissolve the partnership in contravention of the agreement. The party who dissolves the

partnership must accept the consequences for his actions.

3. By any event that makes the business of the partnership unlawful.

4. By the death of a partner.

5. By the bankruptcy of a partner.

6. By court decree under section 32.

o *** The power to dissolve cannot be eliminated by agreement.

o When a partner is involuntarily expelled from a business, his expulsion must have been “bona fide” or in “good

faith” for a dissolution to occur without violation of the partnership agreement.

Lawlis v. Knightlinger & Crap.

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UPA § 32 – Dissolution by Decree of Court – Judicial Intervention

o UPA § 32(1)(d)

makes dissolution by decree of court available on “appllcation by or for a partner” when another “partner

willfully or persistently commits a breach of the partnership agreement, or otherwise so conducts himself in

matters relating to the partnership business that it is not reasonably practicable to carry on business in

partnership with him.”

o UPA § 32(1)

Permits a partner to apply for judicial dissolution when “the business of the partnership can only be carried

on at a loss.”

32(1) Dissolution whenever

(a) A partner has been declared a lunatic in any judicial proceeding or is shown to be of unsound

mind,

(b) A partner becomes in any other way incapable of performing his part of the partnership contract,

(c) A partner has been guilty of such conduct as tends to affect prejudicially the carrying on of the

business,

(d) A partner willfully or persistently commits a breach of the partnership agreement, or otherwise so

conducts himself in matters relating to the partnership business that it is not reasonably practicable to

carry on the business in partnership with him,

(e) The business of the partnership can only be carried on at a loss,

(f) Other circumstances which render dissolution equitable.

o In general

32 is an alternative to what is available in § 31

***New version of UPA does not look to blame, but more economic factors.

Courts are reluctant to decree dissolution without serious misbehavior. Partnership may be dissolved on

application whenever partner guilty of prejudicing business or breaches partnership agreement.

Where there is such a breach of the agreement that it is unreasonable to continue –

The question with this section is what is sufficient for a finding.

Owen v. Cohen

Owen (P), who had entered into an oral agreement with Cohen (D) whereby they contracted to

become partners in the operation of a bowling alley business, sought judicial dissolution of the

partnership.

HOLDING: a ct may order the dissolution of a partnership where there are disagreements of such a

nature and extent that all confidence and cooperation between the parties has been destroyed or where

one of the parties by his misbehavior materially hinders a proper conduct of the partnership business.

o Where there are only minor differences and grievances that involve no permanent mischief, a ct

should not issue a decree to dissolve a partnership

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o One partner cannot constantly minimize and deprecate the importance of the other without

undermining the basic status upon which a successful partnership rests

An aggregate [of separately trivial acts] can destroy all the confidence and cooperation between the

partners

Page v. Page

After the business started by two brothers had suffered losses for the 8 yrs it was in operation, Page

(P) dissolved the partnership by express notice to Page (D), who then contended that the partnership

was for a definite term. This case relates to “at will” partnerships – see above

Partnership may be dissolved by express will of any partner when there is not definite term – a

particular undertaking is specified.

o All partnerships are ordinarily entered into with the hope that they will be profitable, but that

alone does not make them all partnerships for a term and obligate the partners to continue in the

partnerships until all of the losses over a period of many years have been recovered

o The power to dissolve a partnership-at-will by the express will of any partner must, like any other

power held by a fiduciary, be exercised in good faith

o A partner may not dissolve a partnership to gain the benefits of the business for himself, unless

he fully compensates his co-partner for his share of the prospective business opportunity

o If bad faith could be proven, then should get something for business opportunity that he should

have gotten profits from

AT-WILL : The court finds that the partnership was at will and not for a term. The court looks to what the parties intended and finds that there is no evidence that the parties intended to stay together until the recouped their initial development.

§38 – Rights of Partners to Application of Partnership Prop – Liquidation Rights

o (1) When dissolution caused in anyway except contravention P may have partnership prop applied to discharge

liabilities & surplus applied to pay in case net amt

applying to liabilities; whatever is left will pay off creditors

BUT if dissolution caused by expulsion then that P shall receive cash only for net amt due from partnership

o (2) Where there is no consent –

(a) consequences that flow – the right to continue the business. The party who has caused the breach has

certain rights as well as the party who did not caused breach.

(b) Party that did not breach: continue the partnership, have to pay the other partner the interest in the

partnership

Breaching party – has to pay damages for breach of the agreement.

38(2)(c):

G&S Investments v. Belman

§38 UPA. Effect of Dissolution on Partner’s Existing Liability

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(1) When dissolution is caused in any way, except in contravention of the partnership agreement, each partner,

as against his co-partners and all persons claiming through them in respect of 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 section 36(2), he shall receive in cash

only the net amount due him from the partnership.

(2) When dissolution is caused 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,

I. All the rights specified in ¶1 of this section, and

II. The right, as against each partner who has caused the dissolution wrongfully, to damages for

breach of the agreement.

(b) The partners who have not caused the dissolution wrongfully, if they all desire to continue the business

in the same name, either by themselves or jointly with others, may do so, during the agreed term for 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 clause (2aII) of this

section, and in like manner indemnify him against all present or future partnership liabilities.

(c) A partner who has caused the dissolution wrongfully shall have:

I. If the business is not continued under the provisions of ¶2b all the rights of a partner under ¶1

subject to clause 2aII, of this section,

II. If the business is continued under ¶2b of this section the right as against his co-partners and all

claiming thought them in respect of their interests in the partnership, to have the value of his interest

in the partnership, less any damages caused to his co-partners by the dissolution, ascertained and paid

to him in cash, or the payment secured by bond approved by the court, and to be released from all

existing liabilities of the partnership; but in ascertaining the value of the partner’s interest the value of

the good-will of the business shall not be considered.

o Buy-Sell Agreement—courts uphold these even though retiring or departing partner might not get FMV of the

partnership.

Overall these are enforced because they increase certainty, but it is clear cut and easy to administer, the intent

of the parties will be respected.

o Other alternatives

FMV valuation of property interest

Present value formulations

o Cases

Pav-Saver Corp. v. Vasso Corp. – Unilateral breach

When the partnership between PSC (P) and Vasso (D) was wrongfully terminated by PSC the head of

Vasso took over PSC and continued to operate the business.

o Formation of company – agreement to eliminate individual partners. One party was physically

ousted by the other party who took over day-to-day operations.

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HOLDING : When a wrongful dissolution occurs, partners who have not wrongfully caused the

dissolution shall have the right to continue the business in the same names and to receive damages

for breach of the agreement.

o Wrongful termination invokes the provisions of the UPA. There was a wrongful dissolution, so

UPA § 38 applies – under 38(2)(b), the party that did not breach can continue the operation…

o Thus, although the partnership agreement b/t PSC and V provided for a return of the trademark

and patents, such return is not mandated by the statute where wrongful termination has occurred.

Here, the busn could not continue without the patents and the trademark.

Another issue was the ownership rights of patents—parties didn’t contract with respect to these, so

they were not returned.

Default Rule for Losses - § 18a –

o General rule (if not decided to contrary) There will be equal sharing of profits and losses.

o Cases

Kovick v. Reed

Plaintiff approached defendant, proposed that he would provide the funding and defendant would

provide the skill to serve as superintended on kitchen remodels. Reed superintended, Kovacik funded.

The two agreed to share profits – there was no agreement to share losses. They ended up with a loss.

HOLDING: In a joint venture in which one party contributes funds and the other labor, neither party

is liable to the other for contribution for any loss sustained.

o The general rule is that in the absence of an agreement to the contrary the law presumes partners

and joint venturers intended to participate equally in profits and losses of the common enterprise,

irrespective of the amounts contributed, each sharing in the loss in the same proportion as he

would in the profits. However, that presumption applies only in cases in which each party had

contributed capital or was to receive compensation to be paid to them before computation of the

losses or profits. Here, this was not so.

o Where one partners or joint adventurer contributes the $$ capital as against the other’s skill and

labor—hold that neither party is liable to the other for any loss sustained. Upon loss of the

money the party who contributed it is not entitled to recover any part of it from the party who

contributed only services.

o UPA § 40 Rules for Distribution provision that talks about how payments are made, who gets paid first in the

event of a dissolution. – First people that are paid are third party creditors, second people are partners for things

other than capital and profits. Third thing is payment for return of capital contribution. Finally, profits will be

distributed in according to the agreements which the parties have made.

Buyout Agreements

o This is a contract that allows a partner to terminate their partnership interest and in addition be paid out a certain amount of money as compensation for their terminating of the partnership.

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It should permit a partner to exit and be very clear about when the party can exit (exit rights) and sets forth the financial aspects (the value of the partnership interest, when the payments can be made, how the payments can be made)

Buyout agreements fix the parties’ rights before the partnership has broken down and their ability to get fair value for the partnership from each other is going to be difficult.

o Cases

G&S Investment v. Belman

DEATH OF PARTNER: G&S & Nordale were partners. G&S sues for dissolution but Nordale died.

G&S wants to continue partnership and buy out Nordale.

HOLDING : A partnership buy-out agreement is valid and binding even if the purchase price is less

than the value of the partnership interest, since partners may agree among themselves by contract as

to their rights and liabilities.

o N’s conduct was in contravention of the partnership agreement, his conduct affected the carrying

on of the business and made it impracticable to continue in partnership with him

o Partnership agreement provided that upon death, retirement, insanity, or resignation of one of the

general partners the surviving and remaining partners may continue the partnership business, and

that they must purchase the interest of the retiring/resigning partner. Such buyout agreements are

valid and binding.

Assignment and Transfer

o UPA § 27(1): Conveyance of partnership interest does not dissolve partnership, it merely entitles assignee to receive

in accordance with contract profits of which assigning partner would otherwise be entitled

Partner can assign interest, but not rights as partner

Assignee can only become partner with consent of all partners

Assignee not entitled to interfere in management of business, inspect books

Valuing Property Upon Dissolution

o FMV

Law Partnership Dissolutions – Allocating Profits from Unfinished Business

o Rule Against Extra Compensation § 18f

No partner is entitled to extra compensation for services rendered in completing unfinished business. Partners

cannot get extra compensation, they are only entitled to pro-rata shares that arise

Policy no fighting to scramble for files and most lucrative clients

o Cases

Jewel v. Boxer

NO AGREEMENT FOR DISSOLUTION: Four person law firm with no partnership agreement

splits. In the absence of partnership agreement, UPA applies standard rules.

HOLDING : Absent a contrary agreement, any income generated through the winding up of

unfinished business should be allocated to former partners according to their respective interests in

the partnership

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o In the absence of a partnership agreement, the UPA requires that atty’s fees rec’d on cases in

progress upon dissolution of a law partnership are to be shared by the former partners according

to their right to fees in the former partnership, regardless of which former partner actually

provides legal services in the case after the dissolution

Rule against no extra compensation: §18f UPA

Meehan v. Shaughnessy

AGREEMENT FOR DISSOULUTION: Split at firm, but in this case there was an agreement that

provided what would happen. This agreement allowed departing lawyer to take file/client with them

but must compensate firm = fair charge = asset of partnership. The agreement also stated that

departing partners did not get any share of business that remained with old partners…this is a

disadvantage. Departing partners have to share, but are not shared with.

HOLDING : rights provided by a partnership agreement, even though different from those provided in

the UPA, control the method of dividing assets upon dissolution, provided the dissolution is not

premature.

o Here, the partners have fashioned a division method that immediately winds up unfinished

business, allows for a quick separation of the surviving practices, and minimizes the disruptive

impact of a dissolution

Difference between the two cases

In Meehan, they were able to take business, which is different from the default rules. Convenient

formula allows a clean break.

Still need to prove that the old clients knew that there was an option to remain and that the clients did

in fact consent.

There is a bit of a windfall to the former firm in Meehan.

LIMITED PARTNERSHIPS

o In general

Differences from general partnership

Creation: file certificate of limited partnership with state

o Each state has its own Uniform Limited Partnership Act

Types of Partnerships: General Partners and Limited Partners

Personal Liability: Limited Partners are not liable (absent special circumstances), unlike in general

partnerships where general partners are personally liable – must have one general partner.

Limited Partners are passive investors – unlike general partners – management and control

o In exchange for Limited Liability you give up management

Limited Partners share in profits and losses in proportion to capital contributions

Limited Partners may leave without dissolution unlike general partnership, where when one partner leaves,

the entire partnership dissolves

Limited Partners can sell their interests

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Limited and General Partnerships have the same tax treatments – no double taxation because partnership is

not taxed like a corporation

o Cases

Holzman v. De Escamilla

Two partners set up limited partnership & De Escamilla was the general partner. Dissolution occurs,

the two LPs attempt to avoid liability and say that GP was solely liable because of his position.

HOLDING : If a limited partner exercises control over the partnership business, he becomes a general

partner.

o limited partnership is lost if there is participation in or control over the business, these are the

actions of the general partners. Where a limited partner assumes such duties, his protection

ceases; he becomes personally liable for partnership debts just as though he were a general

partner.

The court finds that the two LPs have too much control to be limited partners so they are liable as if

general partners. Even though provision calls them limited partners, court finds them to be general

partners because of the control that was exercised. There is some limited measure that a limited

partner may exercise and still retain limited partner status.

General Partnership Agreements – Handouts

Lawyers often start w/ model Ks & then modify

7 Imp’t Parts of P’ship Agmt:

Term – length of agmt (if no term stated then considered “At WILL”)

o UPA

§31 – Any P may dissolve At Will P’ship w/out violation of p’ship agmt unless Term stated

§32 – when ct may dissolve

Capital – contributions brought by Ps to P’ship

o UPA

§18(a) – Rules Determining Rights & Duties of Ps / requires Ps contribute funds to satisfy

losses in same proportion as would share profits

sharing in profits & losses is equal not in proportion to capital b/c each P has equal

mgmt rights

§40 – Distribution of Funds for Liabilities / 1) creditors / 2) debts to Ps / 3) repayment of Ps’

capital contributions / 4) payment of profits

Management –

- UPA

o §18(e) - = rights in mgmt

o §18(g) – Ps may NOT transfer rights as Ps w/out consent of ALL Ps // Managing Ps delegated power by

K from other Ps

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o §18(h) – majority vote decides disagreements re: daily decisions / unanimous consent needed for

amendments to P’ship agreement

o §9(1) – P is agent of P’ship as to P’ship Business (Actual Agency)

o §§13/14/15 – all Ps jointly & severally liable for act of other P w/in scope of P’ship business & certain

breaches of trust

Title to P’ship Prop – Everything acq’d by P’ship becomes P’ship prop

- UPA

o §26 – P’s interest in p’ship prop is personal prop: real prop / profits / surplus

o §24 – rights of P are 1) specific p’ship prop / interest in p’ship / to participate in mgmt

o §25(2)(a) – P has = right w/ other Ps to possess specific p’ship prop; but NO right to possess such prop

for any other purpose w/out consent of Ps

o §8(1) – all prop brought into p’ship or acquired after is p’ship prop

o §8(2) – prop acquired /w pship funds is p’ship prop

P’ship agmt should state whether real prop owned by p’ship or individual Ps

Upon death of P if real prop was owned by p’ship passes as personal prop // if P owned it would

pass as real prop

Assignment & Transfer

- UPA

o §27(1) – conveyance by P of interest does NOT dissolve p’ship / merely entitles assignee to rcv in

accordance w/ K profits to which assigning P would otherwise be entitled

P can assign interest but NOT rights as P

Assignee can only become P w/ consent of all Ps

A not entitled to: interfere in mgmt of bus. / inspect books

Dissolution

- UPA

o §29 – def of dissolution

o §30 – upon D p’ship NOT terminated until winding up

o §31 – D caused by:

1) W/out violation:

a) termination of definite term of agmt/particular undertaking specified in agmt

b) express will of any P

c) express will of all Ps not assigned interests

d) expulsion of any P from business pursuant to p’ship agmt

3-6 – D caused by any event which makes it unlawful for business of p’ship to be carried on /

death of P / bankruptcy of any P or p’ship / decree of ct (§32)

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Buy-Sell Provisions & Valuation

CORPORATE LAW

Introduction :

o Partnerships v. Corporations

Partnership needs no government involvement, corporations DO

have to file with the state - gives notice to creditors of LLC / who mgrs are / where inc. / where

jurisdiction is

Corporation: as investor=SH in corporation only liable for that interest

Corporation: by-laws = corporate constitution

Process of Incorporation

o Preparation of Cert of Inc

DE Gen. Corp. Law §101 – Incorporators / How Corp. Formed / Purposes

Don’t have to be citizen there / must do 2nd filing where primary place of business is / & “Cert of

doing bus as foreign corp” / DE prestigious & pro-mgmt

DE law governs within the corporation / relationship between SH/Mgr/Ofcr

State law governs issues relating to employment, contract law

§102 – Contents of Cert of Incorporation

name/address/ i.d. of registered agent / purpose / authorized capital structure

registered agent must be able to accept process

file w/ state

§106 – corporation comes into existence when this filed

doesn’t require acceptance/approval

o By-Laws – can contain anything NOT inconsistent with Certificate of Incorporation

# directors / when meet / what SH vote on / control matters of corp

DGCL §109 [94] – By-Laws

(a) may be adopted/amended/repealed by initial directors IF named in cert of inc or board of directors,

may confer this power on directors/governing body

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Players

o DGCL §141 [98] – Board of Directors

(a) source of business judgment rule – business & affairs of corporation managed by

board of dir (BJR is rebuttable presumption – usually rebutted by shareholders)

(b) # of dir fixed by bylaws / majority constitute quorum unless bylaws say different but

never less than 1/3

directors serve until removed/resign

committee of board – sub-group of board which can take action to bind bd of dir

specifically authorized under DE statute (significant in SH derivative litigation)

o DGCL §142 [101] – Officers

Every corporation organized under DGCL shall have

Chosen pursuant to bylaws

o Shareholders

DGCL §211 [123] – Meetings of SH

Required to include where/how often / must be at least annual / main order of business is election of

directors

§212 – [124] - Voting Rights of SH

§216 – [126] – Quorum & Required Vote for Stock Corps

Promoters Liability on Preincorporation Contracts

o Fiduciary Duties: This often arises with self dealing – putting yourself above the Business. Promoters owe duties

among themselves and to the incorporation coming into business.

o Liability of Promoters for Pre-Incorporation activities

Liability on Contract

As a rule, one who contracts with what he acknowledges to be and treats as a corporation, incurring

obligations in is favor, is estopped from denying its corporate existence, particularly when the obligations are

sought to be enforced. Southern Gulf Marine v. Camcraft

By estoppel – Southern Gulf Marine

Personal liability?

o General rule: promoters will be held personally liable unless there is something in a contract that

says otherwise. Rest. Pf Agency § 326

Theories to get to assets - Walkowvszky

o Enterprise liability : ignore separate corporate identities of each of the organizations. The normal rule is that they

wouldn’t be liable for the debts of the other corporations. Enterprise is an exception to this. This doctrine overlooks

separate organization if they are being operated really as a single organization. This would be like the various

corporations that owned only two taxis each in Walkowvszky

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allege defendant was not really maintaining separate identities of the corporation (i.e. disrespecting the corporate form), so all the corporations are seen as one (i.e. commingling of funds, assets, same officer, unspecified records, same phones, same office, etc.) Walkovsky

Must be shown that the corporation is the agent and the shareholder is the principal Seen when a larger corporation conglomerate conducts the business of fragment corporations Going after all the corporation and not the shareholder

Have to show:

No different identities for the organizations – no separate accounts, offices, staff

Show defendant not maintaining separate identity of corporation

o Agency : when one uses control of the corporation to further his own rather that the corporation’s business, he will be

liable for the corporation’s acts, applicable where the agent is a natural person (Walovsky)

One would have to allege that the one agent organization is operating on behalf of alleged principal

organization.

This is an agency theory, so control must be found Show that defendant was using the corporation for his own purpose and not for the existence of the

corporation

This extends to the corporations commercial dealing and negligent acts

o Piercing the Corporate veil

o Cases

Walkovsky v. Carlton

Plaintiff hit by cab owned by company claiming not to have enough cash. Plaintiff sues owner,

Carlton, because he owns 10 cab companies – shows three theories of liability. Listed Above.

Piercing the Corporate the Veil

o Intro

NOTE WELL: First step is to ESTABLISH CORPORATE LIABILITY

This is an exception to general rule of limited liability. A plaintiff must first establish an independent basis to

hold the corporation liable. Having established corporate liability for a tort or breach of contract, if the

corporate defendant has insufficient assets to satisfy a prospective judgment – plaintiff can seek to pierce,

hoping to reach individual shareholders or parent corporations.

This theory is an equitable theory in which the facts of each case are important.

The law of piercing is different from jurisdiction to jurisdiction.

Differences:

o Van Dorn Test ILLINOIS LAW(Sea-Land Services Inc., v. Pepper Source): A corporate entity will be

disregarded and the veil of limited liability pierced when two requirements are met: test is disjunctive

1) there must be a unity of interest and ownership that the separate personalities of the corporation and the

individual (or other corp.) no longer exist

(1) failure to maintain adequate corporate records or to comply with corporate formalities –

meetings/minutes/officers and directors elected/ records kept

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o When there is a lack of corporate formalities, an inference is drawn that the individuals are more

responsible, and should be held responsible. To avoid this inference, shareholders should

document dealings – i.e. keep records

o The fact that a corporation is wholly owned by a single shareholder is not conclusive of an alter-ego situation or even enough to create a presumption. If that individual does not treat the business as separate from his own personal assets, then creditors should not be required to do the same.

o In this Sealand, Marchese is the sole shareholder of all of the corporations except one. He used the assets of the corporation for personal expense, ran all of the corporations out of one office, never held corporate meetings, officers were never elected.

(2) commingling of funds or assets

o does the owner and Corp have one bank account or separate accounts

o there shouldn’t be a blurring of the distinction between the concerns of the corporation and those

of the owners.

(3) undercapitalization/inadequate capitalization

o If the capital is so small compared with the business to be done

o insufficient funds to handle debts of corp or the risk of loss

o insurance for tort claims????

(4) 1 corp treating assets of another as its own

SEALAND: “There can be no doubt that the unity of interest and ownership part of the test is met

here; corporate records and formalities have not been maintained, funds and assets have been

commingled with abandon, PS was undercapitalized, and corporate assets have been moved and

tapped and borrowed without regard to their source.”

NEXT STEP: once this part is satisfied, either sanctioning of a fraud (intentional wrongdoing) or the

promotion of injustice, will satisfy the second element.

2) Circumstances must be such that adherence to the fiction or separate corporate existence would sanction a

fraud or promote injustice.

A showing of fraud might not be necessary in a tort case, where it would in a contract case. – In re

Breast Implant

There is a possibility that undercapitalization might be a form of fraud - Kinney

SEALAND: If mere failure to pay a creditor was sanctioning fraud or an injustice (the claim in this

case), then the two-part test would be collapsed into one element (since everyone is going to sue if

there has been a failure to pay).

o Promoting injustice means something other than a full-fledged fraud. How much less can it be and still satisfy this part of the test? Exactly how courts have defined this or how high the level of fraud has to be is different

from case to case and court to court. 3) - optional - A third prong may apply in certain cases:

If there is a credit investigation and it would disclose that the corporation is grossly undercapitalized,

based upon the nature and the magnitude of the corporate undertaking, such party will be deemed to

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have assumed the risk of the gross undercapitalization and will not be permitted to pierce the

corporate veil.

Sea-Land Services, Inc. v. Pepper Source

Sea-Land, an ocean carrier, shipped goods on behalf of PS. PS then stiffed SL on the freight bill. PS

is now dissolved. Suit brought to pierce the corporate veil – there were other corporations owned by

same person that owned Sea-Land.

No piercing in this case – Sea-Land failed to present any evidence that amounted to the wrongs that

were used in other cases applying “promoting injustice” prong. – Remanded for consideration

o Undercapitalization Theory for Piercing: Kinney Shoe Corp. v. Polan : USE WHEN THERE IS

UNDERCAPITALIZATION BUT NOT ENOUGH FOR SECOND PRONG OF VAN DORN

Kinney brought action against Polan seeking to recover money owed on a sublease between Kinney and

Industrial. Polan was the sole shareholder of Industrial.

Court allowed piercing: Polan invested nothing, the corporation was nothing more than a shell – there was

undercapitalization. Nothing in – Nothing out no protection

Two factors used: “grossly inadequate capitalization combined with disregard of corporate formalities,

causing basic unfairness … sufficient to pierce the corporate veil.”

Polan invested nothing in Industrial. When nothing is invested in the corporation, it provides no protection to

its owner. Gross undercapitalization. Here they include it under fraud, which is different from Sea-Land,

where they put this under the unity of interest prong.

Court allowed KS to Pierce.

o Parent-Subsidiary - USE ALTER EGO and InRE Silicone

The idea of holding a parent company liable for the judgments/debts of subsidiaries.

o Alter ego theory (mere instrumentality )

With an individual, when a court finds that a corporation exists solely to carry out the owner’s agenda,

having no independent reason for its own existence, then the corporation is found to be the mere

instrumentality of the owner.

With a parent and a subsidiary, there may be control by the parent to such a large degree that the subsidiary

has become its mere instrumentality.

The fact that there is a sole owner does not even raise a presumption that there is an alter ego??

In order to avoid the charge of an alter ego, it is important to maintain the appearance of the company: hire

management, have regular meetings

In re Silicone Gel Breasts

TORT CASE: Parent owned 100% of subsidiary (not necessary). Plaintiff wanted to sue Parent

company.

Piercing allowed: subsidiary was so controlled by parent that it was merely an alter ego of major

shareholder (parent company).

Totality of circumstances must be evaluated to determine if alter ego or mere instrumentality

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o Common Board of Directors, name and logo of parent on products, commingling of assets,

sharing of common services (legal/accounting, fraud is not necessary or required for the test.)

When a corporation is so controlled as to be the alter ego or mere instrumentality of its shareholder, the corporate form may be disregarded in the interest of justice (In Re Silicone Gel Breast)

Although the standards are not identical in each state, all jxs require a showing of substantial

domination. Among the factors to be considered are whether:

The parent and the subsidiary have common directors/officers

The parent and the subsidiary have common business depts.

The parent and the subsidiary file consolidated financial statements and tax returnso BM and MEC filed consolidated tax returns

The parent finances the subsidiary

The parent caused the incorporation of the subsidiary

The subsidiary operates with grossly inadequate capital

The parent pays the salaries and other expenses of the subsidiary

The subsidiary receives no business except that given to it by the parent

The parent uses the subsidiary’s property as its own

The daily operations of the two corporations are not kept separateo BM’s legal department did work for MECo BM’s logo appeared on MEC products to give it credibility

The subsidiary does not observe the basic corporate formalities, such as keeping separate books

and records and holding shareholder and board meetings

MEC’s Board of Directors was made up primarily of BM executives. MEC president did

not know that there was a board.o Possibility of tort piercing

Court finds that SJ is not appropriate here because there is a genuine issue of material fact as to whether

piercing should occur.

FRAUD REQUIREMENT: The court rejects the requirement that failing to pierce the veil would be a sanction of fraud.

The court rejects this because it is good enough to find the alter-ego. The court says that they would forgo the second prong in this kind of case because in torts cases, as opposed to contracts cases, many courts would not require a showing of fraud in order to pierce the corporate veil.

DE LAW: Under Delaware law, a finding of fraud is not necessary. Even if fraud was required, a couple of pieces of evidence could rise to the level of a finding of fraud.

o Undercapitalizationo BM was lending their name for use with the product and package inserts. The court says that

simply lending their name to suggest that BM’s financial backing was behind the manufacture was enough to show fraud.

o Direct Liability combining piercing and limited partnership to limit liability

There is a variation of a limited partnership where a corporation will be the general partner. With this form,

no individual is liable for the debts of the partnership

Shareholders cannot be liable for amounts greater than their capital investment

When limited partners step into shoes of general partners the shield of limited liability can be lost – De

Escamilla – but see Frigidaire

Corporation serving as general partner to shield liability – Frigidaire Sales Corporation v. Union Properties

Inc. WASHINGTON LAW

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Frig (P) attempted to hold the limited partners of Commercial Investors generally liable after Comm

breached its K with Frig. Union is a general partnership under CI, and has two limited partners: M

and B. Frig wants to strip M and B of their limited liability and hold them generally liable. M and B

were shareholders, officers and directors of Union

No piercing: When the shareholders of a corporation, who are also the corporation’s officers and

directors, conscientiously keep the affairs of the corporation from their personal affairs, and no fraud

or manifest injustice is perpetrated upon third persons who deal with the corporation , the

corporation’s separate entity should be protected.

partners do not incur general liability for the limited partnership’s obligations simply because they are

officers, directors, or shareholders of the corporate general partner.

o In Washington, parties may form a limited partnership with a corporation as the sole general

partner. To hold that M and B (D) incurred general liability to the limited partnership’s

obligations would require the ct to totally ignore the corporate entity of Union (D), when Frig

knew it was dealing with that corporate entity. Frig knew that Union was the sole general partner

of Comm and that M and B were only limited partners.

o LIABILITY OF SH AND DIRECTORS: “When the shareholders of a corporation, who are also

the corporation’s officers and directors, conscientiously keep the affairs of the corporation

separate from their personal affairs, and no fraud or manifest injustice is perpetrated upon third

persons who deal with the corporation, the corporation’s separate entity should be respected”

In Re Silicone: Direct liability for negligent undertaking. The tort complained of would not have existed had the parent not been involved in the actions of the

subsidiary.o The fact that BM put their name on the product, supported the product, and advertised the

product might support a negligent undertaking claim. BM was somehow negligent in not knowing the full story about the implants when it began

the advertising and allowed MEC to use its name. This is the court’s basis for saying that BM might have engaged in a negligent undertaking.

Shareholder Derivative Litigation

o Terms

Shareholders – owners

Rights include limited voting

o Rights to vote for directors at annual meetings

o Right to vote on fundamental, organic changes in the organization including mergers and sales of

all or substantially all of the assets

Management (these are the agents)

Officers & Directors

Board of Directors

o Runs the show; responsible for the policy making

o Delaware § 141a

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Insider directors

o Planning business policy and have an employment interest

Outsider directors

Holding company – only owns shares of other company – does not operate

Distinguished from operating company

o Intro:

In essence derivative litigation keeps agents in check; it is the way shareholders enforce fiduciary duties.

The way shareholders are able to reign in and contain those agents who act wrongly or in their own

self-interest. Suing the corporation in order to get it to take some action.

The concept was developed in equity – it is an equitable action – not a legal theory- no standing.

Allows shareholder to step into the shoes of the corporation.

The plaintiff-shareholder chooses himself as a representative for the corporation.

Recovery: any recovery in derivative litigation generally runs to the corporation. The shareholder-plaintiff

shares in the recovery only indirectly.

Strike suits – brought to get a quick settlements – often brought for settlement value. Some shareholders may

be tempted to bring suit to coerce a settlement based on the suit’s nuisance value.

State Statutes are ways around these suits

o Security requirements help avoid these suits

o Distinguished from Direct claims

In general, derivative suits have procedural requirements and other requirements such as bond in the form of

security that make these actions difficult for shareholders.

A shareholder may also sue in his personal capacity to enforce his rights as a shareholder – a direct action.

This action is not brought on behalf of the corporation. Fewer requirements when there is a direct suit.

Pleadings : should allege that there was either an injury that was separate and distinct from that

suffered by other shareholders, or a wrong involving a contractual right – such as the right to vote.

Examples: to compel payment of dividends declared but not distributed; to require the holding of a

shareholder meeting; to compel dissolution (but may depend on court in all of these situations).

Flexibility: The Rule from Eisenberg- to distinguish direct from derivative, ask if the actions affected the

rights and privileges of the shareholder. – Is it a claim that belongs to the individual shareholder, or all

shareholders?

The current definition deems a suit derivative only if it is brought in the right of a corporation to

procure a judgment in its favor

If a shareholder can characterize a transaction as diluting voting power, even though the transaction

may also be a fiduciary breach, the suit is direct.

In Eisenberg, the corporation sought to require the plaintiff to post security for expenses, but the

court held that the action was direct because the reorganization deprived the shareholder of “any

voice in the affairs of their previously existing operating company.”

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o The statute in this case requires shareholders in derivative suits to post security in order to bring

the suit.

Eisenberg claims that this is not a derivative suit but an individual direct lawsuit. If it is an individual lawsuit, the statute does not apply and he does not have to come up with the security.

o Keep in mind that this is in NY cases

(a) Derivative : complaint is injury to the corporation, and brought in the right of the corporation to procure a judgment in its favor (impinges upon managerial freedoms of board of directors) (i) Recovery of damages is paid to the corporation (examples)

a. Enjoin D/O’s from breaching their fiduciary duty to the corporation b. Recover from mismanagement of the corporation c. Recover for improper dividends d. Action to compel payment of dividends

(ii) An allegation that mismanagement or self dealing has resulted in a decline in the value of one’s shares, the action is always derivative.

(b) Direct Suit – action brought by a shareholder on behalf of himself and other shareholders as a class, against the corporation, which alleges that the corporation and its managers have interfered with the shareholder’s rights and privileges. This injury is separate and distinct from that suffered by other shareholders or involves a contractual right of a shareholder which exists independently of any right of the corporation (Grimes v. Donald) (i) Posting security not needed : a cause of action that is determined to be personal, rather than derivative,

cannot be dismissed for failing to post security for the corporations costs (Eisenberg v. Flying Tiger)a. Security would not be requires where (direct action) a plaintiff does not challenge acts of

management on behalf of the corporation, rather where he challenges the right if the management to exclude him and other shareholders from proper participation in the affairs of the corporation (i.e. he claims that the defendants are interfering with his rights and privileges as a shareholder)

(ii) Direct : complaint is injury to the shareholder individually (i.e. representative of a class) a. Recovery of damages is paid to shareholders (examples)

i. Compel payment of lawfully declared dividends or mandatory dividends ii. Enforce the right to inspect the books and recordsiii. Protect preemptive rightsiv. Enforce the right to vote on corporate affairs (Eisenberg v. Flying Tiger)

a. Abdication claimv. Proceed against voting trustees vi. Enjoin a threatened wrongvii. Recover from an insider that purchased shareholder’s shares without proper disclosureviii. Recover from a controlling shareholder for wrongful redemption ix. Sue for breach of shareholder agreement x. Compel corporation dissolution

(iii) NON-MONETARY: A non-monetary claim, as opposed to a monetary claim where the money rewarded will go back to the corporation (derivative), suggests a direct claim. Grimes

o Procedural Barriers – provisions that make SH litigation difficult

Statutes requiring security for litigation expenses

Plaintiffs may have to undertake to pay defendants’ costs should the plaintiff lost or abandon the

litigation.

Eisenberg NY see above

Cohen v. Beneficial NJ

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o Posting security: a statute holding an unsuccessful plaintiff liable for the reasonable expenses of the corporation in defending a derivative action and entitling the corporation to require security for such payment is constitutional

Demand requirement : before shareholder can sue corporation, there is a requirement of a demand for the

board of directors to take over litigation & prosecute on behalf of the corporation – this is often statutory

A board’s decision to refuse a demand receives deferential review under the business judgment rule.

If the Board rejects the demand, the shareholder can proceed if it is shown that the demand was

wrongful

Demand requirement does not apply in direct suits

RATIONALE: Rationale of Demand – demand is a recognition that directors manage the business

and affairs of the corporation. Grimes v. Donald

o Demand acts as a form of dispute resolution which may avoid litigation altogether. Grimes

o Relieve courts from deciding matters of internal corporate governance by providing corporate

directors with opportunities to correct alleged abuses. Marx

o Provided corporate boards with reasonable protection from harassment by litigation on matters

clearly within the discretion of directors. Marx

o Discourage suits commenced by shareholders for personal gain rather than for the benefit of the C. Marx

Demand is made Where a shareholder demands that a board of directors take action and that demand is rejected

o Where the court determines that the demand was rejected in the sound business judgment of the board of directors, the suit will be dismissed and the shareholder’s right to continue with the action terminates (Zapata)

However, the shareholder can overcome the presumption by alleging particular facts to show demand was wrongfully rejected (Grimes v. Donald) o See futility factors needed to allege demand was wrongfully rejected

By making a demand upon a board of directors, the shareholder has conceded that the board of directors was in a position to consider and act upon his demand o In effect, making demand is waiver to later argue that demand was excused with respect to other

theories arising from the same circumstance Demand is not made:

Suit will be dismissed, unless the shareholder can determine that demand is excused, i.e. demand upon the BOD would have been futile.

Where demand is properly excused (i.e. futile), the shareholder has the ability to initiate the action on the C’s behalf. Zapatao The rationale here is that the C’s rights would not otherwise be protected. o A determination that demand would be futile essentially says that the BOD are under an

influence that sterilizes their discretion and as such, they are not proper persons to conduct the litigation. Zapata

Demand futility exception

o This is a judicially created exception to the demand requirement

o INAPPLICABLE IF DEMAND MADE: If demand is made upon directors, it is a concession that demand is required. Demand futility cannot later be raised once a demand has been made (and refused).

oo If demand is required and rejected, the plaintiff has to plead with particularity that the refusal was

wrongful.

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o Grimes – Delaware –

Grimes is claiming that there is a particular aspect of the employment contract of Donald, the CEO, that it triggers a very large severance package. Grimes also claims that the board abdicated its duties/powers because they would be wary of enforcing their control over Donald because they would be afraid of triggering the severance package. Grimes also claims waste in the excessive compensation of Donald.

Futility requires particularized allegations – one ground for alleging with particularity

that demand would be futile is that a “reasonable doubt” exists that the board is capable of

making an independent decision to assert the claim if demand were made. Test (This is a

disjunctive test)

(1) A reasonable doubt exists that the board is capable of making an independent

decision to assert the claim if demand were made

(1) Majority of the board has a material financial or familial interest; i.e. the board is

tainted – conflict of interest

o Something at stake- money

(2) A majority of the board is incapable of acting independently for some other reason

such as domination or control

o There is one member of the BOD (often CEO) that they get everyone else to fall

into line – other directors are afraid to voice independent concerns

(3) The underlying transaction is not the product of a valid exercise of business

judgment

o So ridiculously out there that there is not a rational business decision involved.

o Grossly uninformed decision-making

HOLDING FROM GRIMES: If a shareholder demands that the board of directors take

action and that demand is rejected, the board rejecting the demand is entitled to the

presumption that the rejection was made in good faith unless the stockholder can

allege sufficient facts to overcome the presumption.

o Demand having been made as to the propriety of the agreement, it cannot be

excused as to the claim that the agreement constituted waste, excessive

compensation or was the product of a lack of due care

According to Grimes, you should always argue demand futility first

o Marx v. Akers – New York

Complaint needs to allege

(1) Majority of directors are interested in the transaction

o Usually evidenced by a direct financial benefit from the transaction which is different from the benefit to shareholders generally E.g. voting oneself a raise.

o Excessive salary raises will not alone deem the transaction self interested, unless wrongdoing, oppression, or abuse of a fiduciary position is also demonstrated

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o The court found that only three members of the board, and not a majority, were interested in the raising of the salaries. These three were the only three that were employees of IBM Inside directors – a person that is both on the board and has an employment

relationship with the corporation. Outside directors – those people on the board who are not employees of the

corporation. (2) directors failed to inform themselves to a degree reasonable necessary about the

transaction – lack of due care

This relates to the business judgment rule If the board was not informed, it would not make sense to go to them and

argue that they should take over the lawsuit

(3) the challenged transaction was so egregious on its face that directors failed to

exercise their business judgment in approving the transaction

Universal Demand Requirement

Some lawyers take the position that there should be a universal approach that would require

shareholder demand in every single case – does not distinguish in every single case -

No discovery permitted

This is a problem with the reasonable doubt standard – the company will not give you information –

look in public documents, info. on file with government (SEC filings), state records

o Special Litigation Committees of the Board of Directors

Intro

These committees are usually formed by appointing disinterested and often recently appointed

directors to decide whether the suit should go forward.

This is established in corporation law statutes - § 141(c)(2) – an expansion on subsection a.

o Boards can delegate as much of management power as wanted.

o §141(c) a committee can exercise all of the authority of the board to the extent provided in the resolution of the board, and those disinterested directors will act for the board of directors

If such a committee is set up and it determines that the litigation should not continue, then the

corporation can move to dismiss and the shareholder will not be able to continue.

An end run around demand futility?

Business Judgment Rule and special litigation committees

NY Courts – Normally, the decisions made by the committees are given deference under the business

judgment rule. There is a shield, but not a complete shield. Courts will not necessarily look at the

substance of the decisions, but will scrutinize the procedures to set up the committee – at least in NY

courts.

o GENERAL RULE: the business judgment doctrine recognizes that courts are ill-equipped to

evaluate what are and essentially must be business judgments. The rule shields the deliberations

and conclusions of a special committee only if its members possess disinterested independence

and do not stand in a dual relation that would prevent an unprejudicial exercise of judgment.

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o “Business judgment rule does not foreclose inquiry by the courts into the disinterested

independence of those members of the board chosen to make the corporate decision on its

behalf.” Defendants will have to show-

o WHAT THE COURT WILL SCRUTINIZE: Every time a special litigation committee is set up, their decision will not be upheld under the business judgment rule. The court will scrutinize some aspects of the special litigation committee: The procedural aspects of the committee

How the committee is set up (members have to be neutral and not self-interested (Independent)

Good faith efforts to decide whether to pursue the litigation Procedure for the investigation itself (did they do a thorough job in trying to figure out

if pursuing the litigation is in the best interests of the corporation; not half-hearted, pro forma, shallow, nothing more than to protect the directors from a shareholder suit).

The substance of the decision, however, will be shielded by the business judgment rule.o Policy Purposes:

Courts are ill-equipped to decide business matters – often because of a lack of experience.

Auerbach v. Bennet was the important case here: “the substantive aspects of a decision to

terminate a shareholder’s derivative suit … are beyond judicial inquiry.”

Delaware Courts – Decision of special litigation committee also protected by business judgment rule.

Recommendations to dismiss will be treated with suspicion.

o In DE, when demand on the board is excused as futile, the courts listen to the special litigation

committee, but regard any recommendation to dismiss with great suspicion. In Zapata, the DE

SC agreed that there might be “suspicious abuse” by members of the committee asked to pass

judgment on fellow directors. The court established a two-part inquiry into whether a special

litigation committee’s recommendation to dismiss would be respected.

o Analysis in demand excuse case (compared to NY) - Zapata

1) Procedural Inquiry: Formation of the committee will be scrutinized. Defendants should

show that the committee members were 1) independent from the defendants, that there was

an 2) adequate investigation 3) conducted in good faith.

2) Substantive Inquiry: no deference given to decision to dismiss – Court will apply its own

independent business judgment. Judicial review will be broader than what special litigation

committee will do. In a demand excuse case there is a lack of independence from the

board, so the methods will be looked at – concern of bias because CEO will likely be

setting up special litigation committees.

Structural bias: inherent prejudice against any derivative action resulting from the

composition and character of the board of directors.

Zapata Corp. v. Maldanado

o Maldonado (P), a shareholder of Zapata Corp (D), sought to prevent the dismissal

of his derivative action against Z following the recommendation for dismissal by a

corporation-appointed investigative committee. M did not first demand that the

board bring the action, believing that demand would be futile b/c all directors

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were named as Ds and allegedly participated in wrongful acts. The comm. was

comprised of two new directors to investigate M’s allegations and see if Z Corp

should continue the litigation.

Comparing the two jurisdictions (NY & Del):

o For shareholder plaintiffs Delaware is more favorable – Delaware is tougher towards deferring

to the Board of Director’s committees

The Role and Purposes of Corporations

o Intro

Corporations are vehicles for making profits for the shareholders. It is questionable when corporations delve

into other areas.

Intra Vires – actions that are within the power of the corporation

Ultra Vires- actions that are outside the power of the corporation

Corporate Powers and Ultra Vires Acts o DGCL §122

Every corporation shall have the power to sue and be sued...acquire real or personal property and dispose of

same...conduct is business w/n or w/o this state...appoint officers...wind up and dissolve...make donations

for the public welfare or for charitable, scientific or educational purposes...make contracts and

borrow/lend money...pay pensions...buy insurance for its benefit.o DGCL §102(A)(3)

Certificate of incorporation shall seet for the nature of the business or purposes to be conducted or promoted

May simply say 'any lawful act of activity

may contain restrictionso DGCL §124

No act or transfer of property shall be invalid b/c ultra vires but lack of capacity, or power may be asserted:

Shareholder suit to enjoin corp from entering into such act of transfer of property

corporate suit against directors and officers

Suit by state attorney general

o Charitable Giving

Gifts to charity are allowed, but are subject to limitations. Must be in accordance with statutes ( there could

be a $$$ requirement regarding shareholder approval) - Pet charity not allowed only giving to one specific

charity when there are various options

IN order to be legitimate, the gift should be

1) in furtherance of corporate purpose,

2) not made to a pet charity of the board of directors in furtherance of personal rather than corporate

ends,

3) reasonable amount in accordance w/corp’s assets

A.P. Smith Mfg. Co. v. Barlow

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o Company Board of Directors adopted resolution to take part in annual giving to Princeton

University and appropriated $1,500 to Princeton. Stockholders questioned action, corporation

instituted declaratory judgment – trial was held.

o HOLDING: State legislation adopted in the public interest can be constitutionally applied to

preexisting corporations under the reserved power.

Controversy: shareholders might object because the donations are not being used for the benefit of the

shareholders – specific categories of beneficiaries

State Laws which lay out rules for gifts– pg. 275

Delaware law: if it is anonymous, it still might be in the corporate purpose – focuses

Cal. Law: - falls in between – language: “regardless of specific benefit”

NY law: pretty clear that you could make a gift

Penn: broadening the idea of what are the purposes of the business – do not have to focus solely on

maximizing profits of shareholders

o Business Judgment Rule

The business judgment rule assumes the board has wide discretion to make business decisions, including

litigations decisions. The directors, more than shareholders or judges, are better positioned to evaluate

whether a claim has merit

Typically shields board of directors from interference and complaints

Circumstances where the court will say the Board has gone too far –

Fraud

Illegality

Conflict of Interest

o Shlensky v. Wrigley

Shareholders sued Cubs for not installing lights.

The decision is one properly before the directors and the motives alleged in the amended

complaint showed not fraud, illegality or conflict of interest in making of the decision.

CONFLICT OF INTEREST: The shareholder was unable to meet the legal standard when he claimed that the corporation was not following the best interests of the shareholders but the personal interests of Wrigley. There is a legitimate corporate interest in not offending the neighbors of the stadium so

that the neighborhood stays safe and there is goodwill towards the team. The shareholder also fails to show damage to the corporation because he does not prove

that night baseball games would increase attendance and corporate profits. Without a loss, there is no reason to overrule the decision of the board.

Dividends

Dodge v. Ford Motor Co.

o Ford decided to reinvest and not pay dividends. Suit brought attacking the dividend policy and

proposed plan to expand facilities.

o Dividends are not required – there is a likely purpose in putting money back into the company.

Decision to pay special dividend in this case was very rare.

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Del. Corp. Law § 170 tells when dividends can be paid.o Dividends can only be paid out of the profit or surplus of the company and not the capital.

This creates a buffer in case of bankruptcy and prevents instability in the corporation by the lessening of capital.

RULE: Courts of equity will not interfere with the management of the directors unless it is clearly

made to appear that they are guilty of fraud or misappropriation or refuse to declare a dividend when

the corporation has a surplus of net profits which it can, without detriment to its business…(pg 278).

– Dodge v. Ford

FINDING: The court found that there was an arbitrary refusal not to pay the dividends.o Since the board was so dominated by Henry Ford, the decision was made that did not make sense

under the circumstances (where there was huge profitability).o This is not like an isolated gift to charity, this seems to have turned the purpose of the

corporation upside down. Using the money in the way that Ford wishes seems to put the interests of the public ahead of the interests of the shareholders.

LIMITED LIABILITY COMPANIES

Intro

o Limited Liability Company Act – focus on 103,202,203

o These companies are creatures of statutes – every state has a LLC statute. Some are based on uniform statute; others

are different.

o LLC’s allow creation of an entity that as a matter of tax law is classified as a partnership with each owner treated as

a partner, while shielding each of the owners from the automatic personal liability of a general partner.

o Maybe better for closely-held companies

§202 ULLCA: Organization.

(a) One or more persons may organize a limited liability company, consisting of one or more members, by

delivering articles of organization to the office of the Sec of State for filing

(b) Unless a delayed effective date is specified, the existence of a limited liability company begins when the

articles of organization are filed.

(c) The filing of the articles of organization by the Secretary of State is conclusive proof that the organizers

satisfied all conditions precedent to the creation of a LLC.

§203 ULLCA: contents of articles

name, address, whether company is set up for indefinite duration or just for a term of years

whether LLC will be managed by all of the members or manager managed

other things that are not required

§204 ULLCA: amendment of articles

can change the articles

§103 ULLCA: Effect of Operating Agreement; Nonwaivable Provisions

(a) Except as otherwise provided in subsection (b), all members of a limited liability company may enter into an

operating agreement, which need not be in writing, to regulate the affairs of the company and the conduct of its

business, and to govern relations among the members, managers, and company. To the extent the operating

agreement does not otherwise provide, this [Act] governs relations among the members, managers, and

company.

(b) The operating agreement may not:

(1) unreasonably restrict a right to information or access to records under §408;

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(2) eliminate the duty of loyalty under §409(b) or 603(b)(3) but the agreement may:

(i) identify specific types or categories of activities that do not violate the duty of loyalty, if not

manifestly unreasonable; and

(ii) specify the number or percentage of members or disinterested managers that may authorize or

ratify... Characteristics

o General

Organized under state statute other than a corporation statute, allowing LLC to exist as legal person and

providing rules (many default) for structuring, governing, and operating the entity.

LLC comes into organization through the filing of “articles of incorporation” with a specified agency.

Limited information required – names & addresses etc…

Exists as legal entity, separate from owners

Has a full, corporate-like liability shield to protect its owners against automatic, vicarious liability for the

debts of the enterprise.

No protection from shareholder’s own personal conduct.

Westec v. Lanham – DEALS WITH FORMATION OF LLCs

o LLC puts on notice, but not to absolve from liability

o In this case, plaintiff didn’t know that the defendant was representing an LLC – no sufficient

symbol or wording on card that signified existence of LLC.

o Agent fully liable on the contract entered into on behalf of principal if principal is not fully

disclosed. LLC Act’s notice provision was not intended to alter the partially disclosed principal

doctrine- would create a safe harbor for deceit.

Operating Agreements

o Free Transferability

Like a shareholder can sell without corporation folding, same can happen here

o Continuity of Life

Death or disability will not destroy

o Management: LLC allows more flexibility than the corporation in developing rules for management and control.

LLC may be managed by all its members or by managers who may or not be members (two options)

Cannot completely get rid of duty of loyalty

Tax Treatement

o Offers advantageous tax treatment as compared with a corporation

LLC allows greater freedom than a corporation in allocating profit and loss for tax purposes

Corporate taxation is double – partnership tax is single level

Corporations face “double taxation” on any dividends they receive.

Partnerships are not taxable entities – they are “pass through” entities.

Limited liability treatment for the owners and single taxation –

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IRS position Treasury Department adopted “check the box” classification regime – domestic entities will

choose their tax status

IRS says can only have 2 of these to qualify for + tax treatment / if use 3 or 4 then treated as corp

(meaning Double taxation) -?????

o Some of the state statutes say that you can only have two of these, but there has been a change

which is shown below

Change - IRS check box regs. mandate parties to choose b/w corporation & partnership tax

treatment OR

o Default rule – 2 or more member LLC will rcv p’ship tax trtmt (Flow through tax treatment no

double taxation

o Limited Liability Partnership

Uniform Limited Liability Company act (“ULLCA”)

o 103 -

o 202

o 203 – what has to be included in articles

203(c): if any provision of an operating agreement is inconsistent with the articles of organization: (1) the

operating agreement controls as to managers, managers, and members’ transferees; and (2) the articles of

organization control as to persons, other than managers, members and their transferees, who reasonable rely

on the articles to their detriment.

Formationo Filing requirements

Articles of Organization (ULLCA §§202, 203) Operates as a constructive notice requirement, (e.g. to creditors). However, this constructive notice requirement is not entirely sufficient. The A of O only operates as

constructive notice where there is some indication to the 3rd party that he is dealing with an LLC. Westec v. Lahnam

Reinforced by the fact that statute requires that an LLC use the initials “LLC” as part of its name, thus identifying itself clearly as an LLC.o Further, individuals can be personally liable for (1) alleged improper acts, and (2) failure of a

LLC to observe the formalities/requirements relating to the mgmt of its business when coupled with some other wrongful conduct.

A of O must include those things laid out in §203(a). Operating Agreement (ULLCA §103)

Operates like the bylaws of a C. §103(b) lays out those provisions which are not waivable by agreement.

o Parties are free to modify any of the default provisions of the ULLCA except those mandatory provisions of §103(b). Elf v. Jaffari See Below

Freedom to Contract

o Operating agreements drafted by the members determines the governance structures and provides operating rules.

The agreements might cover membership, governance, finance and dissolution.

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o Policy reasons favor freedom to contract – provide members with broad discretion in drafting agreements and to

furnish default provisions when the members’ agreement is silent.

Policies that every court will uphold: tortfeasors are liable, injured parties should be compensated, freedom to

contract should be respected

o Parties can change their agreements to make them different from the standard default

o Default rules of the Operating Agreements :

It is possible to change default rules as long as they are not in direct conflict with the LLC statute – for

example, you cannot get rid of the duty of care.

UCCLS § 103: There are express limitations of what you CANNOT LIMIT by contract

Unreasonably restrict a right to information or access to records;

Eliminate the duty of loyalty , but the agreement may:

o Identify specific types of activities that do not violate the duty of loyalty, if not manifestly

unreasonable

o Specific the number/ percentage of members/ managers that may authorize or ratify, after full

disclosure of all material facts, a specific act or transaction that otherwise would violate the duty

of loyalty

Unreasonably reduce the duty of care

Eliminate the obligation of good faith and fair dealing , but the operating agreement may determine

the standard by which the performance of the obligation is measured, if the standards are not

manifestly unreasonable

Vary the right to expel a member

Vary the requirement to wind up the LLC’s business if an event makes it unlawful to carry on the

business or if a court orders dissolution

Restrict the rights of a third party

Elf v. Jaffari

Operating agreement governs – court gives deference to contract if there are disputes. The operating

agreement does not need to be created at the time the articles or organization is filed. When an

operating agreement is created, either orally, or in writing, the provisions are enforceable.

o Arbitration clauses –

There is a strong policy reason to let parties avoid litigation and have other methods to solve problems.

Elf v. Jaffari

Piercing the LLC corporate veil

o ULLCA §303

(a): Member or manager NOT personally liable for debts, obligations and liabilities of LLC, whether

arising in contract, tort or otherwise (b): The failure of a limited liability company to observe the usual company formalities or requirements

relating to the exercise of its company formalities or requirements relating to the exercise of its company

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powers or management of its business is not a ground for imposing personal liability on the members or

managers for liabilities of the company.

(c)(1)&(2): Members LIABLE for debts, etc if consent in writing and include provision in articleso Kaycee Land & Livestock v. Flahive - WY

Landowner seeking damages against LLC and its managing member.

Because “piercing” is an equitable remedy it was allowed

Will be a fact-sensitive inquiry.

Consider the equitable principles and common-sense principles of corporate veil piercing.

o Tom Thumb v. TLH Properties – MN.

Grocery store case. Hartmann, commercial developer, acting on behalf of TLH makes false promises and the

deal falls through.

Court finds LLC liable. Hartmann not liable because MN law requires fraud and injustice to pierce LLC veil

In absence of state law, ULLCA does not provide what to look for to pierce LLC veil.

Fiduciary Duties

o Those who manage an LLC owe to the entity the fiduciary duties of loyalty and care.

o § 409 – ULLCA – General Standards of Members’ and Managers’ Conduct

(b) Duty of loyalty – avoid conflicts of interests; put interests of LLC above your own (1) Account to the LLC…for any profit, property, or benefit derived by the member in the conduct or

winding up of the business or derived from a use by the member of the LLC’s property, including the appropriation of an LLC’s opportunity,

(2)Refrain from dealing with the LLC…as or on behalf of a party having an interest adverse to the company,

(3) Refrain from competing with the LLC in the conduct of the LLC’s business before the dissolution…

(c) duty of care limited to not engaging in grossly negligent/reckless conduct/intentional

misconduct/knowing violation of law

o Two Types of Management §404 – (a) Member-managed (ULLCA § 404)

(1)The default rule is that “each member has equal rights in the management and conduct of the company’s business; AND”

(2) in any matter relating to the business of the company, a majority must control the decisions of the company.

ULLCA § 203(6) tells you that you must state in the articles of organization what type of management the company will have.

(b) Manager managed company: (1): “each manager has equal rights in the management and conduct of the company’s business”; (2): in any matter relating to the business of the company, a majority must control the decisions of the

company.o McConnell v. Hunt Sports

NHL franchise deal – members form LLC to obtain franchise. One partner kept rejecting deals. Another

partner accepts a deal individually. Operating agreement – plain language – construed to allow competition

between members and LLC so there was no violation of fiduciary duty of care.

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Normally fiduciary duties would preclude competition, but the agreement here specifically allowed such

corporation.

Members of an LLC owe to one another the duty of utmost trust and loyalty, however this duty must be considered in the context of members’ ability to compete with the company, pursuant to the OA. McConnel v. Hunt

You cannot contract around the duty of care or the duty of loyalty as they are included in the §103(b) mandatory provisions – however, the agreement may identify specific types or categories of activities that do not violate the duty of loyalty, if not manifestly unreasonable.

The duty of loyalty can thus be abridged or enlarged by the agreement within the bounds of the ULLCA. Here, there was a provision that allowed competition. McConnell v. Hunt Sports.

Dissolution

o ULLCA § 801 – Events causing Dissolution & Winding up of Co’s Business

(1) an event is one specified in the operating agreement

(2) consent of the requisite percentage of members specified in the operating agreement

(3) even that makes it unlawful to continue the business

(4) application by member/entry of judicial decree

(5) application by transferee/judicial determination

o § 805 – Termination

o § 807 – Notice

o New Horizons Supply Cooperative v. Haack

Haack signed agreement to be responsible for payment of fuel purchased by predecessor. Company

dissolved, she was a partner, had assets, agreed to pay for debts, but didn’t. No articles of dissolution were

filed.

The statue stated that a dissolved LLC could dispose of claims by filing articles of dissolution, and then

proving notice to creditors- however this was never done, so she was liable.

o Exception to LL – §808(d)(2) – member liable to the extent of her proportionate share of the claim or of the LLC’s assets

distributed to the member in liquidation, which ever is less, but no more than the total amount she received in the distribution. New Horizons Supply Cooperative v. Haack

This applies where dissolution was proper under the ULLCA. Where dissolution is improper under the ULLCA, the member will become personally liable.

Another potential for liability: Guarantee – contractual obligation by the member to make good on debts by the LLC – here it would have been oral guarantee.

THE DUTIES OF OFFICERS, DIRECTORS, AND OTHER INSIDERS

In General

o Directors are fiduciaries to their organizations. Because of this relationship, they owe certain duties and must act

according to their duties in certain situations. Some of these situations involve the duty of care, the duty of loyalty,

the duty to keep informed, the duty to act in good faith, the duty to act in a certain manner with respect to corporate

opportunities, duty to disclose, and the duty not to trade on certain information.

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o Most decisions involving such duties are protected under the BUSINESS JUDGMENT RULE which creates a

presumption that limits courts in questioning business decisions. For this reason, the focus of judicial inquiry will be

on the decision making process, not the decision.

The Business Judgment Rule

o This rule is used as a tool to review allegations with respect to directors. The rule limits judicial inquiry and protects

directors who are not negligent in the decision making process. Kamin

o Under this rule, courts will not review a director’s decision even if it is wrong or a poor decision.

o Delaware the rule provides a presumption that in making a decision directors were informed, acted in good faith

and honestly believed that the decision was in the best interests of the organization. Aronson v. Lewis- Del.

o Policy- directors must be able to make business decisions without fear of a lawsuit because shareholders want

something else… Furthermore, courts believe they do not have the expertise to make such decisions and that they do

not have the expertise to make such decisions. There is danger is management has to tip-toe and becomes risk

averse.

o Plaintiff shareholder must overcome the presumption of this rule. Once the burden is overcome it shifts to defendant

directors – at least in Delware.

o If a board action violates the duty of care, cts have held that each director who voted fro the action, acquiesced in it,

or failed to object to it becomes jointly and severally liable for all damage that the decision proximately caused the

corporation.

Management by Board of Directors

DGCL§141(a) - business and affairs of corporation shall be managed by or under the direction of a

board of directors

DGCL §141(b) - board shall consist of one or more members; a majority of total number shall

constitute a quorum; vote of a majority of directors present at a meeting with a quorum present shall

constitute valid board actiono Situations of inapplicability:

Does not protect negligence, prolonged failure to act, irrational decisions, ultra vires actions, conflicts of

interests, fraud, bad faith.

Obligations of Control: Duty of Due Care

o The duty of care is that duty that an officer or director owes to the corporation by virtue of his fiduciary relationship, to act for the benefit of the corporation (Kamin v. American Express NY)

Officer and director actions carry with them a strong presumption that they are in the best interest of the corporation

Board of directors have a duty of care which includes the duty to monitor corporate activities (duty to know what is going on the far reaches of the corporation) In re Caremark DE

o Duty of care can arise in certain situations

Generally, the duty of care arises when there is a decision made in a negligent manner (malfeasance) or when

there is a failure to act where a loss could have been prevented (nonfeasance).

o General Guidelines for the Standard of Duty of Care (from NJ Supreme Court).

IN ORDER TO ESTABLISH THAT THERE WAS A BREACH OF THE DUTY OF CARE

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RULE: Liability of a corporation’s directors to its clients requires a demonstration that: (1) a duty

existed; (2) the directors breached that duty; and (3) the breach as a proximate cause of the client’s

losses.

DUTIES: General Monitoring

A director should have some understanding of the business, keep informed of activities, and attend

some meetings.

Having knowledge of the financial situation of the company is important – i.e. Director should

look at financing statements.

Directors should:o Have A Rudimentary understanding of the business of the corporationo Have a continuing obligation to keep informed about the activities of the

corporationo May not shut their eyes to corporate misconduct and then claim that they did not

see the misconducto Does not require a detailed inspection of day-to-day activities, but rather a

general monitoring of corporate affairs *** It is not necessary to keep apprised of day-to-day activities. Outside directors and inside directors

may have different requirements to the extent.

Negligence

The negligence must be of the gross sort.

There should be some element of causation.

What could be done?

To avoid liability – if director knew of violations through monitoring and made an attempt—

resignation or threat of might eliminate liability.

Francis v. United Jersey Bank (NJ) provides these guidelines- the lesson is that directors need to take their

directorships seriously. It is not enough to have the name and do nothing else. If there are possibilities of not

being able to perform, the Director should not take the job.

o Duty of Care in Delaware -

Two types of duty of DCare cases in DE

Negligence action: would be the type that we examined in Smith and Eisner: duty attached to specific action

Duty to monitor action (In Re Caremark)…did not take proper action, failed to act when they should have

(requirement that they monitor what was going on in all branches of company)

Legal rule that the ct establishes for duty to monitor:

Broad duty: wide: that boards have under DE corp law to set up corporate compliance systemso Smith v. Van Gorkom

DGCL:

§141 (a) (Board of Directors; powers; number, qualifications, terms and quorum; committees; classes

of directors; nonprofit corporations; reliance upon books; action without meeting; removal)

(a) The business and affairs of every corporation organized under this chapter shall be managed

by or under the direction of a board of directors, except as may be otherwise provided in this

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chapter or in its certificate of incorporation, the powers and duties conferred or imposed upon the

board of directors by this chapter shall be exercised or performed to such extent and by such

person or persons as shall be provided in the certificate of incorporation.

§ 141 - GOOD FAITH RELIANCE ON RECORDS AND REPORTS

(e) A member of the board of directors, or a member of any committee designated by the board of

directors, shall, in the performance of such member’s duties, be fully protected in relying in good

faith upon the records of the corporation and upon such information, opinions, reports, or

statements presented to the corporation by any of the corporation’s officers or employees, or

committees of the board of directors, or by any other person as to matters the member reasonably

believes are within such other person’s professional or expert competence and who has been

selected with reasonable care by or on behalf of the corporation.

--in performing their duties, board members may rely on good faith on records of corporation and

on information, opinions, reports, statements presented to the corporation by corporation's

officers or employees

§251 (b) (Merger or consolidation of domestic corporations)

--board of each merging corporation shall adopt a resolution approving an agreement of merger and

declaring its advisability

The board of directors of each corporation which desires to merge or consolidate shall adopt a

resolution approving an agreement of merger or consolidation and declaring its advisability. The

agreement shall state: (1) The terms and conditions of the merger or consolidation; (2) the mode of

carrying the same into effect; (3) in the case of a merger, such amendments or changes in the

certificate of incorporation of the surviving corporation as are desired to be effected by the

merger, or, if no such amendments or changes are desired, a statement that the certificate of

incorporation of the surviving corporation shall be its certificate of incorporation; (4) in the case

of consolidation, that the certificate of incorporation of the resulting corporation shall be as is set

forth in an attachment to the agreement; (5) the manner of converting the shares of each of the

constituent corporations into shares or other securities of the corporation surviving or resulting

from the merger or consolidation and, if any shares of any of the constituent corporations are not

to be converted solely into shares or other securities of the surviving or resulting corporation, the

cash, property, rights or securities of any other corporation or entity which the holders of such

shares are to receive in exchange for, or upon conversion of such shares and the surrender of any

certificates evidencing them, which cash, property, rights, or securities of any other corporation or

entity may be in addition to or in lieu of shares or other securities of the surviving or resulting

corporation; and (6) such other details or provisions as are deemed desirable, including, without

limiting the generality of the foregoing, a provision for the payment of cash in lieu of the issuance

or recognition of fractional shares, interests or rights, or for any other arrangement with respect

thereto, consistent with §155 of this title. The agreement so adopted shall be executed and

acknowledged in accordance with §103 of this title. Any of the terms of the agreement of merger

or consolidation may be made dependent upon facts ascertainable outside of such agreement,

provided that the manner in which such facts shall operate upon the terms of the agreement is

clearly and expressly set forth in the agreement of merger or consolidation. The term “facts,” as

used in the preceding sentence, includes, but is not limited to, the occurrence of any event,

including a determination or action by any person or body, including the corporation.

DGCL§2519(C) - Merger agreement shall be submitted to stockholders for approval;

--majority of shares entitled to vote must approve

--if approved by stockholders, merger agreement is then filed and becomes effective

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DGCL §216 - Majority of share entitled to vote shall constitute a quorum at a stockholder meeting;

vote of majority of those present shall be the act of the stockholders BJ Rule does not apply if directors are UN-INFORMED

Smith v. Van Gorkam

HOLDING: the business judgment rule shields directors or officers of a corporation from liability

only if, in reaching a business decision, the directors or officers acted on an informed basis, availing

themselves of all material information reasonably available.

Business decisions should be informed. Decisions should not be hasty and there should be sufficient

information to make decisions.

Gross negligence was the standard adopted by the court here.

In this case, the protection of the BJR was overruled – the directors were grossly negligent in being un-

informed on Van Gorkom’s role in forcing the sale and establishing the price on the intrinsic value of the

company and for approving the sale after two hours without prior notice or reason to act so swiftly.

The key to the holding was that, because directors did not inform themselves or seek advice, they

could not claim the protection of the business judgment rule for an uninformed judgment

***A board of directors cannot simply direct a negotiated offer as opposed to putting the company up for

auction. It doesn’t have to be a public auction, but there should be aggressive negotiations, and there should

be a fairness opinion…

Should have been evaluation by expert, written and complete info, not hasty, and consideration of

more than one bidder would have been better.

Cannot passively rely on information provided by other directors/officers, outside advisors or authorized committees, but may only rely on credible information provided by competent individuals after taking reasonable steps to substantiate such information. Smith v. Van Gorkom

o Kamin v. American Express Company

o Delaware Law Provisions

§ 141(a): provision that underlies the business judgment rule – sets us a presumption under the BJR. There is

a presumption that duties will be discharged in good faith.

251(b): requires the board to pass a resolution in the context of a merger transaction.

141(e): Provision that allows board members to rely in good faith on the reports and opinions of experts.

Defendants who rely in good faith on experts are entitled to the presumption -

Investment Banking firms may be used here – used defensively to show that there was valuation, or

fairness etc…

102(b)(7): made it possible to reduce fiduciary duty and director liability – has to be done through corporate

amendment – this is a further barrier to plaintiff shareholders

o Shareholder Ratification

o Relying on Experts

Defendants who rely in good faith on experts are entitled to the BJR presumption. § 141(e).

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The directors should be reasonably informed.

Brehm v. Eisner- Del. Case regarding severance package of Ovitz, which was for a lot of money.

o Affirmative Duties of Directors – Monitoring Employees & The Corporate Compliance System

Directors should implement procedures and programs to assist in their monitoring of employees. Directors do

have a responsibility to implement appropriate reporting or monitoring systems.

In In Re Caremark (Del.), There was an indictment for the directors who had been paying the doctors under sham contracts in order to get them to prescribe their drug. This is a disguised kickback and is in violation of federal law. Now there is a derivative action.

the court found that directors have a responsibility to assure that an adequate system exists for

receiving corporate information and reporting, including compliance with relevant statutes and

regulations. Directors can be liable if there is a sustained or systematic failure to exercise oversight

sufficient to indicate a lack of good faith.

Board of directors have a duty of care which includes the duty to monitor corporate activities (duty to know what is going on the far reaches of the corporation) In re Caremark

Even if you do not have notice that criminal conduct may be going on, you still have the duty to monitor/investigate the activities/operations of the corporation o Usually done through compliance programs; written guidelines (manual), centralized lower

officers, education programs o Board of director obligation includes a duty to attempt in good faith to assure that the corporate

information and reporting system, which the board concludes is adequate, exists and that failure to do so under some circumstances may, in theory, render a director liable for losses caused by non-compliance with applicable legal standards

o This is how members of the board of directors protect themselves from being liable to shareholders from criminal offenses of the company

TO PROVE BREACH OF DUTY TO MONITOR: In order to prove that the board of directors breached their duty of care by failing to adequately control their employees, plaintiff must show:o That the board of directors knew or should have known that violations of the laws were occurring

and in either event o That the board took no steps in a good faith to prevent or remedy that situation and o That such a failure proximately resulted in the losses complained of

Duty of Loyalty

o The duty of loyalty generally requires a fiduciary to act in the best interests of the corporation and in good faith.

The duty usually involves a situation in which the fiduciary has a conflict of interest with the corporation.

These conflicts usually involve some sort of self dealing.

The key to understanding duty of loyalty is conflict of interest

***If there a conflict of interest, the BJR does not apply.

DIFFERENT FROM DUTY OF CARE: Policy – The duty of loyalty is different from the duty of care in that

it seeks to prevent directors from acting against the best interests of the corporation or in such a way as to

reap a personal benefit unavailable to other shareholders. Thus the quest is: is the benefit to the corporation?

Bayer v. Beran

Wife of corporate officer hired to do singing commercial. She was qualified and not over-

compensated. There was no violation found here.

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DID NOT MATTER THAT DECISION WAS MADE INFORMALLY: The court found that the expenditure was not unreasonable and that the informality of the decision was not a legal wrong.

o Analysis :

The first step of the analysis is whether or not there is a conflict of interest. Bayer v. Beran.

If the conflict of interest is shown, the BJR no longer applies.

It the party in the transaction has an interest in both companies there will likely be a conflict of

interest and it will have to be shown fair and reasonable. Lewis v. S.L. & E.

Money is not always necessary to show a conflict of interest, intangible benefits can also count as a

conflict of interest.

The initial burden is on the plaintiff, but after satisfaction of this burden, it shifts to the defense to show that

it was fair and reasonable.

Showing that the decision was the best objective decision would help demonstrate this.

If the conflict is established, the director must demonstrate that the corporation gets the primary benefit.

Having the Board get together to approve an action will help the accused director show that the decision was

appropriate. Bayer.

o Delaware Provisions

Delaware code § 141(b) sets forth normal voting procedures for boards of directors for normal Delaware

corporations

Quorum: in order to convene a properly constituted BOD meeting, there needs to be a minimum

number of directors present: a majority is the default in Delaware law

o The number necessary for a quorum can be changed in the bylaws or certificate of incorporation

Number necessary to pass a resolution: a majority

o This number can also be changed

Delaware Code § 141(f) you can also meet through electronic means and also through writing – circulating

resolution among necessary consenting parties.

o Self-Dealing –

When there is self dealing, there will be a burden shift. The party that could normally be shielded by the BJR

now has to show that the decisions they made were ‘fair and reasonable’- Lewis S.L. & E. Inc. NY

BURDEN: where the directors of a corporation are engaged in a transaction with an entity in which

the directors have an interest, the burden of proof rests on the interested directors to show that the

transaction was fair and reasonable to the corporation.

many jurisdictions have statutes that deal with conflict of interest and duty of loyalty.

In Lewis, the statute was § 713

normally the self dealing will arise when there is a conflict of interest

IN CONFLICT IS PRESENT: Steps that should be taken if there are conflicts of interests (From Lewis)

Disclosure of material facts/conflict

Shareholder approval necessary

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The Board or shareholders can vote to pass – has to be a vote of members who have interests –

disinterested directors can sign off

After all of this fair and reasonable occurs?

Disinterested directors can be used to “sanitize” a transaction/agreement in order to avoid liability – this can

be used defensively.

Lewis v. S.L. & E. NY

There were two affiliated corporations. SLE board of director owned LGT. SLE rented land to LGT

for too little rent according to shareholders.Conflict of interest found. Defendants lost because they

didn’t prove that rent was fair and reasonable to shareholders.

Corporate Opportunity Doctrine

o If an investment opportunity is viewed as belonging to the corporation, the corporation should be given the

opportunity to invest in it. A director, having a fiduciary duty, cannot usurp a business opportunity from a

corporation. Corporate Opportunity is related to the duty of loyalty. Various tests exist to determine whether or not

there has been a breach.

o WHERE IMPLICATED: The corporate opportunity doctrine is implicated only in cases where the fiduciary’s

seizure of an opportunity results in a conflict between the fiduciary’s duties to the corporation and the self-interest of

the director as actualized by the exploitation of the opportunity.

o Guft v. Loft Test (Delaware Test) used in Broz v. Cellular Info Systems– The test is conjunctive - Four parts used

together, not one is dispositive

(1) Financial capacity/ability

Does the corporation have the financial ability to undertake opportunity

o CIS did not have the money to buy the license or exploit it (2) Same line of business

If it is a new line of business it is likely not a corporate opportunity

o The opportunity was in the line of business that CIS had been in (3) Interest or expectancy

Would the corporation have an interest or a reasonable expectancy?

o It is unclear whether there was an interest or expectancy because CIS appeared to be changing

the direction of their business and because the CIS board said that they would not be interested in

the opportunity if it was offered at that time

(4) Conflict of interest

Is there a self-interest of the director brought into conflict with the corporation?

o Broz’s interest in acquiring the license for RFBC was not in conflict with CIS because CIS was divesting itself of such licenses and because he did make an informal disclosure to the board.

(Formal Presentation )

You do not need formal presentation to satisfy Gutt v. Loft test.

*** In Broz, there was no violation because the corporation was not financially able.

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*** From this case – the fiduciary can take the opportunity if it was presented to her in an individual

capacity; the opportunity is not essential to the corporation; there is no corporate interest or

expectancy and there is no wrongful use of corporate resources.

o American Law Institute on Corporate Opportunity Doctrine – pg. 383

This test is disjunctive – ?

A director may not take advantage of a corporate opportunity unless:

Director offers the deal to the corporation and discloses the conflict of interest (a)(1)

The opportunity is rejected by the corporation

o Rejection must be fair to the corporation - or satisfy BJR, or not a waste of corporate assets

Disinterested shareholder also required? – ask someone

o Policy There should be opportunities for directors to take advantages of opportunities in their individual capacities

as long as they do not usurp a corporate opportunity. We want to keep the “wheels of commerce” turning.

o Possible ways to get out of problems related to corporate opportunity:

Refusal to deal

Financial inability

o Dominant Shareholders

Intro: there are some circumstances where controlling shareholder will owe fiduciary duties to others

o Ratification

Flieger v. Lawrence- held that where defendant officers, directors, and shareholders of the first corporation

had held a significant interest in the second corporation which was acquired by the first corporation, burden

was on those defendants to show the intrinsic fairness of the transaction, and that defendants met that burden.

The Board of Directors (Δ) won even though they were interested because they demonstrated that the

transaction was fair to the corporation.

RULE: ratification of an “interested transaction” by a majority of independent, fully informed

shareholders shifts the burden of proof to the objecting shareholder to demonstrate that the terms of

the transaction are so unequal as to amount to a gift or a waste of corporate assets.

Delaware Corp. Law § 144: Contract not voidable solely because interested directors involved if:

1) Relationship disclosed to the board and contract is approved by a majority of disinterested

directors; OR

2) disclosure to shareholders – they do not have to be disinterested

3) contract fair to corporation - burden on defendants to show contract is fair.

o Parent-Subsidiary Dealings/Controlling Shareholders

In some parent and subsidiary contexts, the parent corporation has chosen not to own 100% of the shares of

the subsidiary so that there are other shareholders.

In Sinclair v. Levien, DE a derivative action was brought by minority shareholders of subsidiary claiming

that dividend policy was established to favor Parent, Sinclair, that parent had seized corporate opportunities

away from subsidiary, and that a contract between parent and subsidiary was unfairly administered.

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The Supreme Court of Delaware found that as a controlling shareholder, parent was required to meet

INTRINSIC FAIRNESS test whenever a conflict of interest existed. Parent not in violation…

RULE: The intrinsic fairness test should not be applied to business transactions where a fiduciary

duty exists but it is unaccompanied by self-dealing.

o SELF DEALING: i.e. where the parent company receives some benefit to the detriment or

exclusion of the minority shareholders of the subsidiary

Test from Sinclair (Delaware)

SELF-DEALING: Plaintiff must show exclusion from a benefit and detriment – if this is shown

o Detriment is different from standard duty of loyalty issues

The standard of intrinsic fairness will then apply and the burden will shift to the defendant to prove

that the transactions were fair.

o Defendant should show that the transactions were objectively fair

This is the Exception to the Rule that Shareholders do not owe duties to eachother

Corporate Waste

o A waste of corporate assets is not protected by the business judgment rule. The standard means that what the

corporation received in a transaction was so inadequate in value that no person of ordinary sound business judgment

would deem it worth what the corporation paid.

BREAK HERE

FEDERAL SECURITITES REGULATION

Introduction:

o PRIMA FACIE CASE FOR A VIOLATION OF THE FEDERAL SECURITIES LAWS

D sold or offered to sell securities

The D used interstate transportation or communication in connection with the sale or offer of sale

No registration statement was filed with any federal or state regulatory body in connection with the

defendant’s offering of securities p. 418 DORAN

o Policy

Disclosure and fairness is attempted to protect investors and the integrity of the markets.

Protection of consumers

Protection of the market

Honesty in the market

Full & Fair Disclosure

o Issues

Determine if there is a security according to the judicial and statutory definition of security.

Disclosure

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Registration

Exemptions to registration

o Securities Act of 1933

Focused on what is referred to as the primary market for corporate securities – when a company needs to

raise capital and goes to the stock market.

When issuer sells securities to investors

IPO’s

Rule 11 reaches Material Misstatements or Omissions in Registration Statements – Doran & Escott

o Securities Exchange Act of 1934

This act mostly deals with secondary markets – the secondary Markey involves trading securities through

brokers

Investors trade securities among themselves without substantial participation by the original issuer.

§ 10b: “In connection with purchase or sale of securities it is unlawful to use or employ manipulative or

deceptive devices in violation of SEC Rules.”

§ 10b-5: “It is unlawful for any reason by the use of any means (a) to employ any device, scheme or artifice

to defraud, (b) to make any untrue statement of a material fact OR to omit to state a material fact necessary,

OR (c) to engage in any fact, 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.”

o Merit Regulation – the government (SEC) looks at compliance with requirements of statute concerning the

information that is provided by the company. It is a disclosure based system, not merit based.

Disclosure – government wants full disclosure – then the market can decide the right value of the stocks

o Scope and Focus

Disclosure Provisions

Protecting investors policy to give investors as much information as relevant/possible.

Anti-Fraud Provisions

If say something wrong/fail to give all the information

There are both criminal and civil possibilities

Regulation of markets and market professionals

o Securities and Exchange Commission (SEC)

Executive agency charged with administration and enforcement

Delegated authority to make rules and adjudicate matters arising under statute

State Blue Sky laws

Parallel set of regulations at state level.

Definition of Security

o 1933 Act § 2(a)(1) – Laundry List: lists financial instruments that qualify as securities as follows

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

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certificate, … any put, call, straddle, option, or privilege on any security, COD, or group of index

securities…, or, in general, any interest or instrument commonly known as a “security” or any certificate of

interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to

subscribe to or purchase, and of the forgoing…

o In order for fall under the Federal Securities Laws, P has to establish that there was a sale involving securities.

o Great Lakes Chemical Corp. v. Monsanto: Howey Test for security: defines “investment contract” in relation to

“security” definition

In order to establish fraud, the plaintiffs have to establish that there is a security involved here. The plaintiffs are trying to characterize the interest they purchased as a security within the meaning of the statute. GLCC purchased ownership interests in an LLC. What is covered under the federal securities laws is the fraud in sales of securities.

According to the Acts, a security is a stocks and bonds, investment contracts, interests commonly known as securities.o ECONOMIC CHARACTERISTICS: In order for something to fall within the definition of stock,

it has to have certain economic characteristics(From Forman, see below): Members are entitled to share in distributions of cash flow Interests are negotiable and may be pledged or hypothecated Members have voting rights in the company Interests have the capacity to appreciate in value

o LLC: The court finds that even though an LLC is stock-like, it is not what would traditionally be considered stock. Not only does it have to have the five characteristics, it must be traditional stock.

INVESTMENT CONTRACT: Howey stated that “an investment contract for the purposes of the Securities Act means 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 or the promoter or third party” p409

The three requirements for establishing an investment contract are:

1) an investment of money

o This is normally not the problem

2) in a common enterprise – not a specific amount of commonality required, but just some amount

o There are two versions of this that have been developed from federal judicial prudent:

horizontal commonality between investors; or

not possible if there is only one investor

vertical commonality between a promoter and investor. –

This test was used in Great Lakes v. Monsanto

There is no common enterprise because GLCC bought NSC in its entirety and there was no interest in common between the investor and the promoter (Monsanto no longer had an interest in profitability). Since there was only one investor, there was no pooling of funds.

3) with profits to come solely from the efforts of others

o Possibility that if there are active partners, then this is not satisfied.

The availability of ability to fire managers can take it out of this prong.

o LLC relevance: Manager Managed or Member Managed?

There is no presumption that managers are passive, the by-laws and operating agreement

must be addressed

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LLC not security? - Monsanto

o General Partnership: generally active managers, so profits cannot be solely derived from the

efforts of others.

o Limited Partnerships

Typical rule is that these partnerships can be securities.

o Closed Corporation

Traditional stock that has the characteristics of equity is always a security.

o Some courts say that you do not have to be completely passive

o Forman –

The U.S. Supreme Court gave enunciated five of the most common features of stock:

1) Right to receive dividends contingent upon an apportionment of funds

2) negotiability

3) the ability to be pledged or hypothecated

4) voting rights in proportion to the number of shares owned

5) the ability to appreciate in value

The Forman court also stated that the term “any interest or instrument commonly known as a security”

covers the same financial instruments as referred to by the term “investment contract.”

o Landreth - The U.S. Supreme Court held that, insofar as a transaction involves the sale of an instrument called

“stock,” and the stock bears the five common attributes of stock enumerated in Forman, the transaction is governed

by securities law.

The court stated that Howey should only be applied to determine whether an instrument is an “investment

contract,” and should not be applied in the context of other instruments enumerated in § 2(a)(1) of the Act.

“Traditional Stock”

not only does it have to have the 5 characteristics, it has to be “traditional stock.” This ct is talking about

traditional stock, like an equity interest in a corporation

o Not Securities

A commercial transaction is not to be characterized as a security

General Partnerships: there are active investors in these and are deemed not to be investment contracts

because there are not profits derived solely from the efforts of others.

LLC

A pyramid scheme is probably not going to satisfy the requirements of investment contract under Howey.

Fraud in General

o 10(b) & 10(b)(5) are important in this area – you cannot get your case in a federal court unless you satisfy

requirements - See below

o Threshold issues to satisfy in a COA – to go forward you need to show that the interest is a security in the meaning

of the word intended by congress

That the item is a “security”

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Great Lakes v. Monsanto

Supreme Court has spoken on this issue

o Forman: 5 characteristics

o Landreth: “traditional stock”

o Howey – investment contract – 3 elements…insert this

Disclosure & Registration

o Intro

If you want to have a transaction, you have to disclose and registration requirements according to 1933 Act.

This area is one of the most frequent areas where legal malpractice arises.

Congress was focused on disclosure based regulation – after disclosure, the market can decide the prices.

THE REGISTRATION PROCESS

In General

o SEC prohibits the sale of securities unless the company issuing the securities has “registered” them with the “SEC.”

o This is a heavy burden because

Gathering of information is time consuming and expensive. Experts must be hired to audit the financing

statements. Lawyers must be hired to assist. When you hire the lawyer you receive a legal opinion to guide

the transaction – it will state that all legal steps have been taken. This gives basis for malpractice action if

there is a problem. Also, investment bankers will be hired to help issue security.

o Exemptions exist – see below – but generally exempt only the initial sale

’33 Act § 5: Three Basic Rules for Registration

o 1) a security may not be offered for sale through the mails or by use of other means of interstate commerce unless a

registration statement has been filed with the SEC

o 2) securities mat not be sold until the registration statement has become effective

o 3) the prospectus (disclosure doc) must be delivered to the purchaser before a sale

o ***If there is a violation of § 5, § 12(a)(1) imposes strict liability on sellers of securities that involve violations.

The main remedy in such a situation is rescission

’33 Act § 12

o This section creates a private right of action for investors. See below

Exemptions from registration – found in ’33 Act and in some regulations.

o Private Placement Exemption/Private Sale § 4(2): no definition given in the Act. There is an exemption from the

requirement to register if it is a private offering

Doran test- 4 factors, if all, then it is a private offering (5th Cir.)

1) The number of offerees and their relationship to each other and the issuer;o The more offerees, the more likely it is public; # of purchasers not important.

o Typically a small number of offerees is important –

o Focus on offerees, not participants.

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You could still have a non-exempt transaction if it were only offered to one person, but

didn’t provide adequate information.

2) Relationship with each other and insurer

o Sophistication not enough, there must be access to relevant information. Availability means

either disclosure of or effective access to the relevant information.

o LOOK TO SEC v. RALSTON PURINA below

3) size of offering, number of units

o A smaller number of units reflects the notion that there are only a limited number of investors who have the requisite knowledge for exemption.

4) manner of offering – public ad or private contact?

o Personal contact b/t the issuer and offerees from of public advertising or intermediaries such as

investment bankers or securities exchanges

Overall: is the disclosure that Congress had in mind possible?

Ralston Purina test to establish an exemption

(1) access to information of same kind available in SEC document filed in public offering (financial

documents / descriptive info re: co)

(2) Ability to Fend for Him or Her self

Investment sophistication – based on education / net worth / amt of assets NOT enough

NEED enough info

HOLDING From DORAN: Absent findings of fact that EACH offeree had been furnished info about the issurer that a registration statement WOULD HAVE DISCLOSED OR that each offeree had effective ACCESS to such info, the offering is not a private placement

o Other exemptions

TRANSACTION EXEMPTIONS: § 4(1): transactions by any person other than an issuer, underwriter, or

dealer

Transactions by any person other than an issuer, underwriter, or dealer Regulation D provides for safe-harbors that issuers can use to come within the private-placement

exemption.o Depending on how much the issuer intends to raise, there are limits on the number of buyers the

issuer may sell to without having to register There is a requirement that there be an interstate contact involving the security in order for the federal

law to apply.o Any use of electronic or telephonic means of communication constitutes an interstate transaction.o This is a threshold issue.

There is an intrastate offering exemption premised on the idea that all of the people involved in the transaction are located in the same state.

Regulation D: not based on statute, but on an SEC regulation – still has authority

Safe-harbors: this regulation is a safe harbor. This means that if you satisfy all of the requirements set

forth in the statute, you are home-free.

Security Exemptions: There are certain types of securities that are never covered by the federal securities regulations, such

as US Treasury Securities

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Intrastate offering exemption: to have a federal securities violation interstate commerce has to come into play

somewhere

Definition of underwriter: someone who buys the security with a view to reselling it. § 2(11).

Civil Liabilities for Problems in Registration

o Intro

Standing necessary –

Enforcement possible by

SEC

Private Action –

*** Keep in mind that these involve statutory interpretation – courts will look at the policy reasons. The

policy reason is full disclosure – remember the investor needs to decide on full or fair information.

o ’33 Act § 11 & Material Misrepresentation

§ 11 is the principal excess clause of action directed at fraud committed in connection with the sale of

securities through the use of a registration statement. Only registration, not other communications not in the

written statements or prospectus statement.

WHO”S LIABLE: **** If there is a material misrepresentation in the registration statement than

there is a right of action allowed/effective against

o Every person who signed the registration statement

o Every person who was director of issuer and issuer itself

o Defendants include every person named in the statement as someone about to become a director, every expert named as having prepared or certified any part of the statement or as having prepared any report or evaluation used in connection w/the statement, every underwriter involved in the distribution, anyone who has signed the statement, and every director of the issuer at the time the registration statement became effective (including directors who did not sign). Who must sign: issuer, principal officers/directors, and a majority of its board of directors Lawyers who merely drafted the statement are not proper party defendants under §11.

Cannot be used with exempt offering – must be related to registration

No privity requirement

There is lightened pleading for this fraud: No requirement in § 11 for causation or reliance. Whether

or not you got the prospectus statement doesn’t matter

Damages: rescission – the difference between what the security was purchased for and what the

security would have been worth had the information been available.

Requirements necessary for § 11 action

In order to make a claim, a party has to allege that they bought the securities, that they have the

proper defendants, and that there was a material misstatement or omission in the registration

statement (§11) or elsewhere (§12).

Next ask if the D has asserted any Affirmative defenses

Escott v. BarChris – New York – a lead case on § 11

Test for Liability

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o 1) Did the registration statement contain False Statements or omit fact.

o 2) If so, were the facts Material?

o 3) If so, has the defendant established affirmative defenses?

Materiality – a fact specific test

o Info required that goes to matters which the average prudent investor reasonably should know be

fore purchasing registered security

o What average prudent investor would consider important.

o “Material” – those matters to which an average prudent investor ought reasonably to be informed before making an intelligent, informed decision whether to buy a registered security, (i.e. the information must have a sufficient bearing on the condition of the corporation). Escott v. Barchris Const. Corp. (bowling alley) Objective reasonable person standard SEE BELOW

Where to start:

Always start with what a reasonable investor would want to know.

If speculative information use the probability/magnitude test.

The fact that which is falsely stated in a registration statement, or the fact that is omitted when it should have

been stated to avoid misleading, be “material.”

No statutory definition, but likely: Those matters to which an average prudent investor ought

reasonably to be informed before purchasing the security registered. –Would a reasonable shareholder

(investor) consider the statement important in deciding how to vote? - TSC

o An objective inquiry.

Standards depend on factual situations –

o TSC – reasonable investor standard

This standard does not apply perfectly when there is speculative information involved –

like a merger

Merger situation -Basic v. Levinson

3rd circuit test – no disclosure necessary until there has been something like a document that expresses

the intent to merge. Negotiations before this are speculative and do not require disclosure.

2nd circuit test – Not necessarily the signing of a piece of paper – “Probability of magnitude test” =

weight the probably that the merger will occur against the magnitude of the event if the event does go

through – with a merger this is important

The determination of which test to use will depend on the public policy of full disclosure

Hard Info v. Soft Info

Use the probability magnitude when dealing with soft-speculative information.

Speculative information is not yet ripe for disclosure

Something speculative – a misstatement with regard to a speculative statement

o Conclusion of merger is speculative

o Theories are speculative

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Affirmative Defenses for § 11: Defendants not automatically liable – the burden shifts and there is an

opportunity for an affirmative defense by the defendant.

(1) Due Diligence Defense to §11 suits – defendant believes after a reasonable investigation, and that

there are reasonable grounds to believe, that the alleged misstatements are correct and that there are

no material omissions, i.e. did the defendant do enough to assure himself that the info in the

registration statement is correct. Escott v. Barchris Const. Corp

o How to deal with this depends on (a) where the statement is in the document and (b) who the

person is who made the statement.

Reasonable Investigation

“reasonable investigation” – standard is that of a prudent man in the mgmt of his own

business. §11(c) of the 1933 Act

Would it have been important? Or was it speculative?

§11 does not distinguish between new and senior directors.o Newly elected directors and outside counsel cannot rely on statements made by

corporate officers and directors as to the accuracy of statements, rather they must conduct a reasonable investigation of statements’ accuracy (i.e. reviewing corporate documents and speaking w/employees). (Grant & Auslander in Escott)

Where a portion of a statement is created by an expert, a new officer or outside counsel is entitled to rely on its accuracy. (Grant & Auslander in Escott)

Defendants may have imputed knowledge, i.e. if they are involved with the corporation, they should know about the activities of the corporation

Burden to Investigate

Experts

o Typically directors are not directors.

o People not affiliated with the corporation that have specific training are often experts

are able or should be able to give objective opinions.

o See chart

Expertised Non-Expertised

Experts Reasonable belief after

reasonable investigation.

No liability

Non-experts No reasonable ground to

believe statements false

Reasonable belief after

reasonable investigation.

(2) Lost Causation Defense

- get better description

o ’33 Act § 12: private right of action

§ 12(a)(1) – gives liability

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§ 12(a)(2): imposes private civil liability on any person who offers or sells a security in interstate

commerce, who makes a material misrepresentation or omission 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 – ***defendants who conduct a reasonable investigation cannot be held

liable.

Prima facie case – pg. 425

This section does not apply in secondary Market offerings

Difference between § 11 and 12(a)(2) : § 11 only applies to registration statements, § 12 operates with

respect to material misrepresentations or omissions made in written documents or oral communications

used in connection with initial public offerings.

’34 Act – § 10(b)/Rule 10(b)(5)

Comparing with § 11 & 12 no language that says someone has standing in a federal court, but the

courts have interpreted this section to apply to private citizens in addition to the SEC

§ 10b & 10(b)(5) Corporate Misrepresentation/Fraud

o Intro:

This is a “catch all” provision

Although 10b does not specify a private remedy for violations of its rules, 10(b)(5) implies a private cause of

action.

“In connection” requirement is essential – no privity required

Standing: Only actual purchasers or sellers may recover damages in a private 10b-5 action. If the person

didn’t buy or sell, then there is not liability. Blue Chip Stamps v. Manor Drug Stores

***Typically there is no duty of the company to come forth and offer information to the public. This would

be disadvantageous. Need to know how much to say to the public – this is difficult

o § 10b : Unlawful for any person…to use or employ, in connection with the purchase or sale of any security…any

manipulative or deceptive device or contrivance…

Really analogous to fraud

It concerns the “purchase or sale of any security” protects investors who purchase and shareholders who

sell

o § 10(b)(5) (1934): 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 any national securities exchange,

to employ any device, scheme, or artifice to defraud,

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 were made, not misleading, or

to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit

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

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o Requirements for 10b-5 Violation

Material Misinformation

Misrepresentation of material fact, omission of material fact, or remained silent when there was a

fiduciary duty ; Silence is actionable in certain circumstances

TSC RULE from Basic v. Levinson: Materiality and Disclosure

o RULE:

Materiality: an omitted fact is material if there is a substantial likelihood that a reasonable

shareholder would consider it important

Disclosure: there must be a substantial likelihood that the disclosure of the omitted fact

would have been viewed by the reasonable investor as having a significantly altered the

‘total mix’ of information made available

o APPLICABLE: where the impact of the corporate development on the target’s future is clear and

certain

o Standards depend on factual situations –

TSC – reasonable investor standard

This standard does not apply perfectly when there is speculative information involved

– like a merger

Probability/Magnitude Test from BASIC v. LEVINSON

o RULE for merger: Whether a company statement is material, in the context of merger discussions, requires a case-by-case analysis of the probability that the transaction will be consummated and the significance of the transaction to the issuer of the securities.

o materiality “will depend at any given time upon a balancing of both 1)the indicated probability that the event will occur and 2)the anticipated magnitude of the even in light of the totality of the company activity”

o Probability: the fact-finder will need to look to indicia of interest in the transaction at the highest corporate levels This would include: board resolutions, instructions to investment bankers,

and actual negotiations between principles or their intermediarieso Magnitude : fact-finder will need to consider such facts as the size of the two

corporate entities and of the potential premiums over market value No particular event or factor short of closing the transaction need be either

necessary or sufficient by itself to render merger discussions material Materiality and Disclosure

Not all misinformation is actionable. A fact is material for purposes of 10b5 if there is a substantial

likelihood that a reasonable investor would consider it as altering the total mix of information in

deciding whether to buy or sell. Basic v. Levinson

Standards depend on factual situations –

o TSC – reasonable investor standard

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This standard does not apply perfectly when there is speculative information involved –

like a merger

Scienter

The person making the misstatement must have made it with an intent to deceive, manipulate, or

defraud. Ernst & Ernst v. Hochfelder Recklessness can also suffice – strongly suggestive of actual

knowledge

Reliance

Fraud on the Market from Basic

o RULE: An investor’s reliance on material, public misrepresentations may be

presumed under a fraud-on-the-market theory for purposes of a Rule 10b-5

action

o Theory: those who trade on public trading markets rely on the integrity of the stock’s market

price. Efficient Market Hypothesis states that the market price reflects all publicly available

information. This theory assumes that if the truth had been disclosed, investors would not have

traded at the prevailing non-disclosure price.

“where materially misleading statements have been disseminated into an impersonal, well-developed market for securities, the reliance of individual plaintiffs on the integrity of the market price may be presumed” Basic

o Rebuttable Presumption : Defendant can rebut prevent presumption of reliance by either

(1) the challenged misrepresentation did not affect the stock’s price

(2) the particular plaintiff would have traded regardless of the misrepresentation.

“any showing that severs the link between the alleged misrepresentation and either the price received (or paid) by the plaintiff, or his decision to trade as a fair market price, will be sufficient to rebut the presumption of reliance.” Basic

Causation

Damages

Recession, Disgorgement, Cover, Out-of-pocket (most common—difference between purchase price

and true value), Contract…

o Corporate Mismanagement – Mismanagement by corporate officials can violate 10b-5, but only if the

mismanagement involves fraudulent securities transactions that can be said to injure the corporation.

o Cause of Action & Santa Fe A cause of action lies under Rule 10b- 5 "only if the conduct alleged can be fairly

viewed as 'manipulative or deceptive' within the meaning of the statute." A breach of fiduciary duty by majority

stockholders or corporate officers without any manipulation, deception, misrepresentation or nondisclosure violates

neither the statute nor Rule 10b-5; such a violation is actionable solely under state law – Santa Fe

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*** The US Supreme Court stated that there must be an allegation of material misrepresentation or deceit in

the pleadings to state a cause of action.

In a short form merger, minority shareholders were frozen out. Although the minority shareholders alleged

that the majority stockholder's failure to give advance notice of the merger was a material nondisclosure, if

such disclosure had been given, the minority would still have been able to seek relief only through appraisal

in the state courts. Therefore, it concluded that this was not a material nondisclosure within the meaning of s

10(b) or Rule 10b-5. Because no deception of manipulation was shown, the Court held that the suit failed.

o ***Other disclosure: the extent to which companies that already have stock in public hands must continue to make

available even though there is not another offering.

1934 Act contains the periodic information requirements.

Periodic reports filed with the SEC will be included with the annual 10k or 10q filed with the SEC.

Integrated Disclosure is another important addition to ’34 Act.

Companies that fall into public companies category can accompany 1934 disclosure when they file

their offering

o Merger situation -Basic v. Levinson

3rd circuit test – no disclosure necessary until there has been something like a document that expresses the

intent to merge. Negotiations before this are speculative and do not require disclosure.

2nd circuit test – Not necessarily the signing of a piece of paper – “Probability of magnitude test” = weight the

probably that the merger will occur against the magnitude of the event if the event does go through – with a

merger this is important

The determination of which test to use will depend on the public policy of full disclosure

*** Combining with TSC for new standard for materiality: Materiality is what a reasonable investor would

want to know. This depends on the facts of the situation the company is currently in. With respect to mergers,

the materiality of information depends on the likelihood that the merger will actually occur and the size of

the merger. – This is the Probability/Magnitude Test

ASK Kate about bright line test here and if these two circuit tests are specific to mergers….

INSIDER TRADING – still 10b5

o In General

Insider trading is when someone who works for the company uses the information for their own investing

purposes at a point in time when the investing public is not privy to such information.

Good News – If this type of news, the insider can profit by buying stock from shareholders before the

price rises – maybe purchase call options

Bad News – The inside can profit by selling to unknown investors before the price falls – possibly by

selling short or buying put options

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o Classical Theory

Insider, Temporary, Someone who is tipped

o Disclose or Abstain Rule – SEC v. Texas Gulf Sulfur

DUTY of PERSON WITH INFO: Anyone in possession of material inside information must either disclose

to the investing public or if unable to disclose it b/c of fiduciary duty owed to corporation, must not trade or

recommend the securities concerned while such inside information remains undisclosed. SEC v. Texas Gulf

Have to wait for a period of time that allows the information to disseminate into the public

Insiders: disclose to corporate shareholders????

Outsiders: disclosure made to information source????

This test is the “deceptive or manipulative” device which is prohibited in §10(b). Materiality – this duty arises where the information (i.e. information relating to an extraordinary situation of

the corporation) is reasonably certain to have substantial effect on the market price of the security if the information is disclosed. Texas Gulf Sulphur

Whether a reasonable man would attach importance in determining his choice of action in the transaction in question. o Those facts which affect the probable future of the company and the desire of investors to buy,

sell, or hold the company’s securities. o Probability/magnitude: materiality depends on balancing both the indicated probability that the

event will occur and the anticipated magnitude of the event in light of the totality of the corporation activity, (look to the conduct of the insiders). Texas Gulf Sulphur v. SEC

In this case, the company was not putting out full, fair adequate information in their press releases. The press

release fell under 10b-5 corporate misrepresentation. The individual defendants, the employees, were

prosecuted for insider trading. The employees had information that was material under the

probability/magnitude test.

Essence of 10b5: Anyone who, trading for his own account in the securities of a corporation, has access,

directly or indirectly, to information intended to be available only for a corporate purpose and not for the

personal benefit of anyone may not take advantage of such information knowing it is unavailable to those

with whom he is dealing, i.e., the investing public. SEC v. Texas Southern Gulf.

o 10b-5 & its Relation to Specific Types of Insiders

Strangers –

Stranger with no fiduciary relationship to the corporation or its shareholders, or to the course of the

confidential information has no 10b-5 duty to disclose just because he is in possession of material,

nonpublic information. Chiarella see below for facts in this case.

Fiduciaries/Temporary Insiders – Insiders and Agents

Abstain or disclose duty exists while in possession of material, nonpublic information obtained in

their fiduciary position and in which the corporation has a confidentiality interest. Duty Extends to

constructive insiders who have a direct or indirect relationship to the corporation.

Accountants, Lawyers, Consultants

Fiduciaries – Outsiders and agents of information source

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Outsiders with no relationship to the corporation in whose securities they trade also have an abstain-

or-disclose duty while in the possession of material, nonpublic information obtained in a fiduciary

relationship. O’Hagan – this was a misappropriation case

o Newspaper reporter from an editor for example

o Irrelevant that source of information has no interest in the traded securities

Tippers

Insiders and others who knowingly pass on improper tips are liable as participants in illegal insider

trading. Insider is liable for tipping material, nonpublic information if she anticipates some direct or

indirect personal benefit from the disclosure. Dirks

o The tip is improper if the insider anticipates reciprocal benefits

o The tippee derivatively assumes the insider’s fiduciary duty to the shareholders not to trade on

material nonpublic information only when the insider has breached his fiduciary duty to the

shareholders by disclosing the information to the tippee and the tippee knows or should have

known that the insider has breached his duty. Dirks v. SEC

This leaves open the possibility that the tippee may not be liable where he does not know

that the insider is breaching his fiduciary duty.

The tippee must either publicly disclose that information or refrain from trading.

The tippee assumes the duty b/c the information has been made available to him

improperly. Tipper can be held liable even though he does not trade, so long as a tippee or

sub-tippee down the line eventually does.

An insider may disclose information to an outsider by not breaching his fiduciary duty, (e.g. an analyst) o Market analysts, while outsiders who knowingly receive material nonpublic information from

insiders, are not under a duty to disclose or abstain. Dirks Noninsider tippees & sub-tippees

Those without a fiduciary relationship to the corporation inherit the insider’s 10b-5 abstain-or-

disclose duty if they knowingly trade on improper tips. Dirks.

The duty only passes if the insider’s original tip was a breach of fiduciary duty.

Overhearing a conversation between insiders in a crowded restaurant would not create tippee liability

because the insiders did not anticipate any personal gain from their indiscretion.

o Fiduciary Duty of Confidentiality - Cases

*** In General, a person in the possession of material, nonpublic information has a duty to disclose the

information, or abstain from trading, if the person obtains the information in a relation of trust and

confidence – a fiduciary relation.

Chiarella:

Employee of printing company figures out identity of merger target company, buys stock in the target

and sold for profit after announcement.

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Court: 10b-5 does not require a parity of information. Merely trading on the basis of nonpublic

material information does not trigger duty to disclose or maintain.

o No duty was owed to shareholders with whom he traded because he had no fiduciary relationship

to the targets or their shareholders.

o Absent fiduciary duty no duty to disclose or abstain

Dirks v. SEC:

Analyst learns of fraud in a company from a former employee of company, analyst investigates and

passes on information to his clients who sold their shares before the news became public.

Court: Court finds analyst did not violate 10b-5 because tipper’s, former employee, reasons of

tipping were not to obtain advantage for himself.

o TEST: For there to have been improper tipping, there must be fiduciary breach on the part of

the tipper for a personal benefit and did the tippee know (or should have known) of the

breach?

There would have to have been an attempt of personal gain – maybe cash money under the

table, or personal benefit of those involved in the tip

The test can filter down to the subtippee?

Temporary Insiders: FN 14: pg. 495

Outsiders who are employed for some particular project may become bound by the classic theory and

are bound

Generally someone who is retained by the company – like an outside lawyer

o Misappropriation Theory

Under this theory, the person commits fraud in connection with securities transactions and violates 10b-5

when he misappropriates confidential information for trading purpose in breach of duty owed to the source of

that information.

it is not the same as the disclose or abstain rule. One particular difference between what an outsider

is subject to in terms of not trading on material nonpublic information and the classic theory. Under

the misappropriation theory, the idea is that he stole the information and used it for his own personal

benefit in violation of his fiduciary duty.

Policy This protects the integrity of markets from outsiders who have access to information.

This type of 10b-5 liability arises when a fiduciary breaches a duty to the information’s owner.

O’Hagan:

O’Hagan does not fit the classical theory. Partner in law firm retained by bidder planning tender offer,

partner purchases common stock and options on the target’s stock before bid announced, after

announcement – sells for profit.

Court: Unauthorized use of confidential information is

o (1) use of deceptive advice under § 10(b), and

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o (2) In connection with securities trading

Violation occurs when the information is used to purchase or sell securities.

O’Hagan couldn’t be held liable for insider trading because he owed no duty to bidder-company and

he wasn’t a temporary insider, but he did owe a fiduciary to his law firm.

See problems on 510

o Tender Offers & Insider Trading: Rule 14e-3 O’Hagan

Fraudulent, deceptive, or manipulative acts or practices, in connection with any tender offer

Refers only to tender offer transactions -

Rule 14e-3 prohibits someone who receives material non-public information about a tender offer, who knows that the information is non-public, and who gets the information from the offering person, the target company, or any person acting in behalf of the target company from buying or selling stock in the target company.

This rule does not require that anyone breach a fiduciary duty. The court finds that the SEC had discretion to come up with an alternative route to liability so long as the regulation is not arbitrary, capricious, or manifestly contrary to the statute.

There is a requirement that states that when there is a person who has information about a tender offer and

knows that it isn’t public and he gets the information from the target or the purchaser, it is illegal for that

person to purchase or sell the securities subject to that transaction.

There is not requirement that anyone breached a fiduciary duty—one who hears that there will be a tender

offer and trades on that knowledge can violate 14e-3.

o New SEC rule 10b5-2

Provides a non-exclusive list of three situations in which a person has a duty of trust or confidence for

purposes of the misappropriation theory

(1) whenever someone agrees to maintain information in confidence

(2) Duty exists between two people who have a pattern or practice of sharing confidences such that

the recipient of the information knows or reasonable should know that the speaker expects the

recipient to maintain the information’s confidentiality

(3) Such a duty exists when someone receives or obtains material nonpublic information from a

spouse, parent, child, or sibling

SHORT-SWING PROFITS

o § 16 Intro

STATUTE: §16(b) of the 1934 Act provides that: officer, directors, and 10% shareholders of a corporation must pay to the corporation any profits made w/in a 6 month period, from buying and selling the corporations stock

This is strict liability for all profits made w/in the 6 months for those covered This is a prohibition/control on insider trading. Policy To deter price manipulation by insiders in public

corporations and encourage insiders to acquire long-term interests in their corporations

§16b presumes that any officer, director or holder of 10% or more of an SEC reporting company who

purchases and sells or sells purchases within a 6 month period is presumed to have traded on inside

information.

Strict Liability you cannot come in and say that you didn’t have insider information

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Requires specified insiders to report their trading in their company’s securities and

AUTOMATICALLY REQUIRED TO RETURN THE PROFITS TO THE CORPORATION, even if

there is no insider knowledge Authorizes the corporation to recover from these insiders any profits made on

stock transactions in a narrow six-month period – “short-swing” profits

§ 16 applies to trading in any equity securities of registered companies, whether or not the particular

securities are subject to § 12 registration.

Also a requirement to report how much stock is owned be certain individuals. 16a

o Elements of § 16(b) violation

Realization of profit

By a director, or 10% shareholders (aka beneficial owner)

From matching purchases or sales during any six-month period

Of equity securities of a public company

o Requirements In General

Covered Transaction

Liability is based on the matching of any purchase with any sale, regardless of order, during a six-

month period in which the sales price is higher then the purchase price. – Is sales price is lower that

purchase price, it doesn’t matter.

Covered Person

Directors and officers : the functional equivalent for purposes of insider access.

Functional Officer : Any employee who has a position that gives him access to confidential inside

information that is not freely circulated.

10 % Beneficial Ownership a person is a beneficial owner is she receives the pecuniary benefits of

ownership. 16a owner of more than 10% of the stock of the company – sometimes people hold

stock but the benefits go to someone else – the person who gets the benefits is also a beneficial holder

Officer or director status must exist at either sale or purchase

*** Must be a 10% SH at the “front of the swing” : 10% Shareholder status must exist immediately

before both transactions

o In Foremost-McKesson, Inc. v. Provident Securities Co.(DiD NOT COVER IN CLASS), the

U.S. Supreme Court held that a 10% or more holder was not liable unless he qualified as such

before he made the purchase in question. Thus, the purchase that first lifts a beneficial owner

above 10% cannot be matched with a subsequent sale for § 16(b) liability purposes.

***For 10% shareholders, it is necessary that the person have held more than 10% immediately

before both the purchase and the sale that are to be matched.

o In Reliance Electric Co. v. Emerson Electric Co., the U.S. Supreme Court approved of a “two

step” transaction. The case involved a defeated takeover player who held 13.2% of the target.

The player first sold 3.6% reducing its holding to 9.6%. Subsequently, it sold the 9.6%, all within

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six months. The Court held that while § 16(b) applied to the first transaction, and profit from it

would have been disgorged, § 16(b) did not apply to the second transaction.

o At all times during the transaction – needs to be a 10% shareholder

Remedy

Profits go back to company

INDEMNIFICATION

In General

o To encourage qualified individuals to accept corporate positions and to take good-faith risks for the corporation,

corporate statutes permit the corporation to indemnify directors and officers against liability arising from their

corporate position.

o In general, indemnification applies when the director is or was (or was threatened) a defendant in any civil, criminal,

administrative, or investigative proceeding. The rights can continue after leaving the corporation.

Delaware General Corporation - § 145

o §145(a) sets out the general rule that a corporation shall have the power to indemnify :

An officer, director, employee or agent of the corporation

Who by way of their position is a party to any pending or completed action (civil, criminal, administrative, or

investigative, unless you are being sued by the corporation)

Such person may be reimbursed for any expenses, including attorney’s fees judgments, fines, and

amounts paid in settlement if:

o The individual acted in good faith, and

o In a manner he reasonably believed to be in or not opposed to the best interests of the

corporation,

o And in a criminal case if he had no reason to believe his conduct was unlawful.

o §145(b) provides that if you are a defendant in a derivative suit, the corporation has the power to reimburse the

director, officer, etc. for expenses incurred in defending such suit, if he acted in good faith and in manner he

reasonably believed to be in the best interests of the corporation.

The corporation shall not indemnify for judgments, fines, and amounts paid in settlement. o 145(c) This section says that if a former director has been successful on the merits in the defense of a claim, that the

party should be entitled to reimbursement for the fees incurred in defending such claims. This section is mandatory.

On the Merits: Successful on the merits has been equated to vindication. Courts will not look into the

reasons for which there was a settlement. Waltuch

Thus, success can also be successful on procedural grounds – for example, if the plaintiff lacks

standing, or the statute of limitations has run.

To the extent successful: This will compel the corporation to reimburse the director’s litigation expenses

related to those claims or charges which she defends successfully.

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Waltuch v. ContiCommodity Services, Inc. Delaware: The court held that he was entitled to

indemnification as a matter of right for the litigation expenses related to the charges that were

dropped. The director was charged with conspiring to corner the silver market.

o “Success” in terms of §145(c) is vindication in terms of escaping any liability and in a criminal action this means any result other than conviction. Waltuch If the director has to pay any money or incurs any liability, he has NOT been vindicated.

Waltuch o 145(d)

o 145(e) This is a right to advance for litigation if the party agrees to return advance if he is found liable. The money is

advanced pending the adjudication on the merits. It is a permissive provision.

This is different from an indemnity pursuant to one of the other 145 sections.

A C may (permissive) advance reasonable costs of defending a suit to a director even when the suit is brought by the C (derivative suits). Citadel Holding (agreement in this case made said the C ‘shall’ advance such expenses)

In Citadel such advances were mandatory b/c that was the language of the agreement, and in absence of an agreement the corporation has the option to advance such expenses.

“Reasonable expenses” are those related to the C’s business. Citadelo 145(f) Corporation can give greater protection. Permits to make mandatory to what is merely permissive in section

(a). It does not however, allow addition power to escape what is in (a). There may be greater rights in contract than

what 145(a) provides. There is non-exclusivity language

Parties cannot contract away the good faith requirement Waltuch

provides that the rights set forth in §145 “shall not be deemed exclusive of any other rights to which those seeking indemnification or advancement of expenses may be entitled under any private agreement b/t such officer/director and the corporation.

Under §145(f), a corporation may provide indemnification rights that provide additional rights than those provided by the substantive provisions of §145, but the private agreement may not be inconsistent with the substantive provisions of §145. Waltucho As such, any private agreement which purports to limit the “good faith requirement of §145(a)-

(b) is inconsistent with the statutory provisions and t/f such a good faith limitation is ineffective. Waltuch This good faith requirement is explicit in §145 and cannot be contracted around

o 145(g) Express Power to buy insurance - A corporation may purchase insurance on behalf of any officer/director for expenses suffered by the officer/director in the defense of any action brought against him in his corporate capacity.

The corporation will have the power to purchase insurance for liability, whether or not the corporation would have the power to indemnify such person against liability under §145.

If §145 gave unlimited powers to C’s to indemnify directors and officers, than the final clause of §145(g) would be unnecessary. Waltuch

§145(g) was necessary b/c under §145 the C is powerless in some situation to indemnify its officers and directors directly. Waltuch

o Cases

o Waltuch

Indemnification to the extent successful:

o Citadel Holding Corporation v. Roven

A corporation may advance reasonable costs in defending a suit to a director even when the suit is brought by

the corporation.

Reasonable expenses are expenses related to the corporation’s business

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In this case, the intent of the indemnification agreement was to provide R with more protection than

before

Under the DGCL, a corporation may advance such costs to a director—the indemnification agreement

made this advancement mandatory.

Since these proceedings are related to proceedings that deal with C’s business, they are reasonable.

PROBLEMS OF CONTROL

PROXY FIGHTS

Intro

o In publicly traded corporations, voting often occurs prior to the shareholder meeting because shareholders generally

do not wish to incur the cost of attending the meetings. To facilitate voting in this situation, the statutes permit the

use of proxies.

o Managers send out proxies to the shareholders requesting their votes. If there exists a group which opposes

management, that group may send out its own proxy material – this is a proxy fight.

Type and Uses of Proxies

o Uncontested

There are annual meetings of shareholders for various important matters, the most important being the

election of directors

For an uncontested context, it is accepted law that a company can reimburse itself for proxy costs because it

is a mandatory part of carrying out the operation of a business

o Contested

Someone is trying to take control of the board of directors alternative to tender offer

o DGCL § 216 : In a shareholder meeting, a quorum is needed to be present in person or by proxy. The amount is

typically a majority.

o It is expressly permitted by Delaware law for shareholders to vote via proxy

o There is both state and federal regulation with proxies

Two techniques for corporate control

o Proxy Contests & Solicitations

Someone might get a notice of plans from current management and disagree, so that shareholder will set up a

rival proxy group.

Reimbursement - Using Corporate Funds to Pay For Proxy Solicitation – State Level

Management has an advantage in proxy solicitation because corporate funds pay the expenses of the

proxy solicitation.

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It is permitted for corporate management to pay for their own expenses when it is clearly related to

the policy differences. With respect to the amount spent, it cannot be excessive. This rule extends to

incumbent management also, even if the amount is more than normally spent.

Incumbent Reimbursement Factors to be met in order for this to happen Levin v. MGM

o (1) Genuine Policy Conflict

Should not be a personal vendetta – must be characterized as a corporate policy difference

o (2)Amounts cannot be excessive

o (3) Shareholder must be fully informed

o HOLDING from Levin: Incumbent directors may use corporate funds and resources in a proxy

solicitation contest if the sums are not excessive and the shareholders are fully informed.

The proxy statement fully disclosed that MGM would bear the costs incurred in the

solicitation of the proxies, and the firms that were retained and the amounts paid to them.

The proxy statement fully disclosed the situation to stockholders and the sums were not

found excessive under the circumstances.

o *** It is permitted for corporate management to pay for their own expenses when it is clearly

related to the policy differences. With respect to the amount spent, it cannot be excessive.

Possibly also, methods not illegal or unfair

Insurgent Reimbursement

o Successful insurgents may be reimbursed for such expenses by an affirmative vote of the shareholders. Rosenfeld v. Fairchild However, where it is established that such moneys have been spent for personal power,

individual gain or private advantage, and not in the belief that such expenditures are in the best interests of the stockholders and the corporation, or where the fairness and reasonableness of the amounts allegedly expended are duly and successfully challenged, the courts will not hesitate to disallow them. Rosenfeld v. Fairchild

o Factors to be met in order for this to happen Rosenfeld v. Fairchild Engine & Airplane Corp. The

court in this case allowed reimbursement for the defeated incumbent managers and the successful

insurgents.

o (1) Has to be a policy issue, not personal

make sure the fight is not a “power play”

o (2) Good Faith

o (3) Reasonable Expenses

The court placed the burden of proof on the shareholders to show that the expenses were

unreasonable

o (4) Shareholders have to approve reimbursement – Insurgents can only be reimbursed if they

win, but incumbents always can be reimbursed –

Proxy Solicitation on the Federal Level

SEC Rule 14a-8 – Authority § 14 of 1934 Act

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o Dictates that management is required to give full disclosure surrounding the

information the proxy statement relates to – also an anti-fraud provision in this section

o The anti fraud provision relates to securities registered under § 12 of the Exchange

Act. Thus, the prohibition applies to publicly traded corporations.

o The rule states in pertinent part:

“If any security holder of an issuer notifies the issuer of his intention to present a proposal

of action at a forthcoming meeting of the issuer’s security holders, the issuer shall set forth

the proposal in its proxy statement and identify it in its form of proxy and provide means

by which security holders [presenting a proposal may present in the proxy statement a

statement of not more than [500] words in support of the proposal].”

Exception – Rule 14a-8(i)(5)

o An issuer of securities “may omit a proposal and any statement in support thereof” from its proxy

statement and form of proxy”

“if the proposal relates to operations which account for less than 5 percent of the issuer’s

total assets at the end of its most recent fiscal year, and for less than 5 percent of its net

earnings and gross sales for its most recent fiscal year, and is not otherwise significantly

related to the issuer’s business”

Shareholder proposal – in accord with 14a-8

Company is required to include a shareholder proposal when

o Proposal is recommendation/requirement that co/board of directors take action, intended to be

presented at meeting of company’s shareholders.

o Company must be publicly traded?

o Must be a shareholder.

o Have to have at least 1% of company’s securities and entitled to vote at meetings; OR value of

shares worth at least $2k – Substantial Value

o Each shareholder may submit a single proposal, limited to 500 words

o Submitted to company within 120 calendar days before the date the proxy materials are going to

be sent out

o If there is failure to observe one of these, company may exclude proposal, but only after

notifying proposing shareholder within 14 days, who failed to correct within 14 days

o Proposing shareholder must attend the meeting to present.

Exceptions for the corporation’s exclusion of proposal – Lawful exclusion 14a-8([i])(5). Lovenheim

Improper under state law

Violation of law

Management can exclude proposals that would require the company to violate any law,

including the SEC’s proxy rules and in particular Rule 14a-9’s proxy fraud prohibition.

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This allows management to exclude proposals it considers to be materially false or

misleading.

Violation of proxy rules

Personal grievance / special interest

Management can exclude proposals that relate to any personal grievance. This

category covers the frequent phenomenon of proposals by disgruntled employees who

seek to have the body of shareholders recognize their talent and tribulations

Relevance / Insignificant part of Issuer’s business

Absence of power/authority

Management can exclude proposals that deal with matters beyond the corporation’s

power to effectuate

Moot. Management can exclude proposals that are moot, because the company is already

doing what the shareholder proposes.

Mgmt functions

Related to election to office.

Management can exclude proposals that relate to the election of directors or officers.

This prevents from “clogging” the company’s proxy statement with their own

candidates or views on management nominees.

Conflicts with management proposal.

Management can exclude proposals that “directly conflict” with management

proposals. Otherwise, the rule would create an open forum in which every shareholder

could offer a proposal to undermine any management initiative subject to shareholder

vote

Substantially implemented

“Recidivist.” Management can exclude “recidivist” proposals that had failed in the

past. This exclusion covers any proposal dealing “with substantially the same subject

matter” as a proposal submitted in the last five years that failed to get 3% on its first

try, or 6% on its second try, or 10% after three tries.

Duplicative.

Management can exclude proposals that duplicate another shareholder proposal to be

included in the management’s proxy materials.Resubmissions

Specific amt of dividends

Only need one of the exceptions

If a shareholder proposal makes it through all of these procedural requirements and substantive

exclusions, management must include it in the company’s proxy statement and permit shareholders to

vote in the proxy card though management has a chance to object to the proposal and give its reasons

for objection.

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SEC may send no action letter indemnifying company who doesn’t send out proposal

***Courts might allow proposal even though it is not economically related – it may be significantly

related like in the Lovenheim case.

o In Lovenheim v. Iroquois Brands, Inc., Iroquois imported pate from France. Shareholder

Lovenheim requested the directors to form a committee to study the methods of production to

determine if the involved animals were caused undue pain or suffering. Iroquois used 141-8(c)(5)

– claiming that the pate sales were less than 5% of net earning and gross sales and not

significantly related to the business. Finding the proposal to have a “significant relationship to

the issuer’s business,” and also to have “ethical and social significance,” the court granted

prelim. inj. ordering the inclusion of the proposal in the proxy statement.

o RULE: A shareholder proposal can be significantly related to the business of a securities issuer

for noneconomic reasons, including social and ethical issues, and therefore may not be omitted

from the issuers proxy statement even if it relates to operations which account for less than 5% of

the issuer’s total assets.

The court in this case discussed the requirements for an injunction.

1) First, the proponent must demonstrate a likelihood that he will prevail on the merits.

2) Then a determination must be made as to

o whether plaintiff will suffer irreparable injury without such relief,

o whether issuance of the requested relief will substantially harm other parties, and

the public interest

o Shareholder Inspection Rights –state law

In General

Under state law, shareholders may be able to inspect the books and records or the list of shareholders,

so long as there is a proper purpose.

If the corporation is not publicly traded, these rights are very important because there isn’t mandatory

disclosure.

The shareholder list is very important if a group of shareholders would like to communicate with

other shareholders or challenge management in a proxy contest.

Proper purpose and the burden of proof issues are intended to deal with the tension between the

shareholders’ legitimate right to be informed and right to communicate with other shareholders and

the possible harassment of managers and abuse of the information.

Del. § 220 : Any stockholder shall have the right upon written demand to inspect for any proper purpose to be

able to inspect the books and records and shareholder list.

Proper Purpose

In seeking the Shareholder List, the burden of proof is on the defendant corporation to prove improper

purpose. 220

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For a request to inspect books and records, the plaintiff shareholder has the burden of proof on proper

purposes. 220

Delaware: State ex. Rel. Pillsbury v. Honeywell, Inc.. In this case, shareholder bought 100 shares in

order to challenge the mfg of munitions for the Vietnam war; he sought SH list to communicate

political views. He was denied access – the court found the request to be an improper purpose,. The

sole purpose was political rather than economic. There should be some relation to the business

operations,

o RULE: In order for a stockholder to inspect shareholder lists and corporate records, the

stockholder must demonstrate a proper purpose relating to an economic interest

A proper purpose constitutes those relating to a shareholder’s economic interest in the

corporation

New York: Crane v. Anaconda: There was an attempt to get SH list in an unfriendly takeover. The

corporation must show improper purpose to deny.

o The court held that disclosure is a value that was respected by courts in the context of the federal

statute. Here, the state statute uses the same policy – shareholders have the right to receive

information with respect to certain transactions in a company. This particular transaction had the

potential to effect the whole company – the vitality and the business direction.

o RULE: A shareholder wishing to inform others regarding a pending ender offer should be

permitted access to the company’s shareholder list unless it is sought for an objective adverse to

the company or its stockholders.

REQ of STATUTE: The NY state statute permits access to qualified shareholders on

written demand accompanied by affidavit stating the inspection is not unrelated to the

business of the company and that the shareholder has not sold stock lists within the

previous 5 years.

The pendency of a tender offer necessarily relates to the business of the corporation and to

the safeguarding of the shareholder’s investment.

A’s shareholders should be afforded the opportunity to make an informed judgment

regarding the sale.

o BURDEN SHIFTS: Once the shareholder has established that they fall under the statute, the

burden is on the refusing corporation to establish that is it not for a proper purpose

o Tender Offers

A bidder decides that they want to get control and does so by buying up shares of a corporation – possibly via

the open market – normally, a tender offeror goes to the corporation and offers to buy shares directly

The tender offer tends to give more to the shareholders in economic

DGCL 220

o Also know NYC Bus. Corp. law 1515

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PROBLEMS IN CLOSELY HELD CORPORATIONS

Vote pooling and voting trusts

o In General

Often in a close corporation, no one shareholder will have voting control. Shareholders will agree formally or

informally to vote as a voting block.

o Straight Voting v. Cumulative Voting

Straight Voting: Under this voting method, candidates who receive the most votes for the open directorships

are elected. Pooling is a method for voters to group their votes to elect their preferred candidates.

Cumulative Voting: Under cumulative voting, the votes necessary to elect one or more voters is fixed by a

formula.

DGCL § 214

o Vote Pooling Agreements

In general, shareholder vote-pooling agreements are valid if they relate to a matter on which shareholders

may vote.

If the agreement relates to matters beyond shareholder power – such as the board’s management discretion –

the agreement may be invalid.

McQuade v. Stoneham

Three shareholders of the corporation that owned the New York Giants agreed as shareholders to

elect themselves as directors and to appoint themselves as officers at specified salaries. The NY AC

had no problem with the shareholder vote pooling, but it held the restrictions on directorial discretion

were invalid as a matter of public policy and invalidated the entire agreement, including the

nonseverable vote-pooling provisions.

Because of the large amount of shares they held, they were always going to win, so they were always

going to elect certain officers. This would be okay, but when they put on the hat of director, they had

a dual duty of managing in the best interest of the minority shareholders as well as their own – this is

a fiduciary issue.

RULE: a shareholder agreement prohibiting the board of directors from changing officers, salaries, or

policies, or retaining individuals un officer, is illegal and void absent express contractual consent.

Clark v. Dodge

Shareholders were to appoint each other as managers and directors. The difference from McQuade is

that Clark & Dodge are the sole shareholders.

The Court held that the contract could be upheld because no one would be harmed but themselves;

there were no minority shareholders to be harmed.

RULE: where the directors are also the sole stockholders of a corporation, a K between them to vote

for specified persons to serve as directors is legal, and not in contravention of public policy

o Voting Trusts

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Under a voting trust agreement, shareholders transfer legal title to their share to a voting trustee. The trustee

will then vote according to specified instructions.

Unlike a vote-pooling agreement, which in many jurisdictions can be of indefinite duration and may be kept

secret, a voting trust must be on file in the corporation’s main office and must be for a limited term, subject

to periodic extension.

§ 218 DGCL Section for voting trusts and other voting agreements

Freeze Outs – Abuse of Control

o Freezeouts isolate minority shareholders from corporate participation, forcing the minority to sell to (or buy from)

the majority on unfavorable terms. The majority can accomplish this by removing minority participants from office,

denying them compensation, imposing a no-dividend policy, and exclude them from stock issues or stock

redemptions.

o Minority shareholders often count on the close corporation for their livelihood – and typically have nobody to sell

their shares.

o Wilkes v. Springside Nursing Home, Inc. – Mass.

In this case Wilkes was supposed to be a director in the closely held corporation, but the other 75%

shareholders tried to force him out, basically denying him his salary.

RULE: In a closely held corporation, the majority stockholders have a duty to deal with the minority in

accordance with a good faith standard.

Determination of whether there was a breach of this duty is decided on a case-by-case basis

The court found that this closely held corporation was more like a partnership. In a partnership the parties

owe each other fiduciary duties. The test used by the court in this case is narrower than a normal duty of

good faith case:

1) Ask whether the controlling group can demonstrate a legitimate business purpose for its action

2) The minority group can then show that there was an alternative course of action less harmful to the

minority’s interest - the court will then weigh the legitimate business purpose, if any, against the

practicability of a less harmful alternative

BURDEN: The burden of proof is on the majority to show a legitimate purpose for its decision related to the

operation of the business. Then the minority may answer that the same objective could be reached through

less harmful means.

*** There was no legitimate business purpose found in this case

o In this case, there was no legitimate purpose proffered for W’s termination, nor was there any

evidence in the record legitimizing the majority’s action.

o Ingle v. Glamore Motor Sales – New York

Ingle trying to sue using a fiduciary duty claim. Ingle was an employee who became a shareholder. There

was an agreement that if he ceased to be employed, the corporation could repurchase the stock. Ingle was

voted out and he claimed he was owed a fiduciary duty. He was not protected because there was no fiduciary

duty owed.

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RULE: A minority shareholder in a closely held corporation, who is also employed by the corporation, is not

afforded a fid duty on the part of the majority against the termination of his employment.

a minority shareholder does not derive from that status protection against his termination in the

absence of contractual provision. A ct must distinguish between the fid duties owed by the corp to a

minority shareholder as a shareholder, in contrast to the duties owed to him as an employee.

Here I served as an employee at will, there being no evidence of the existence of an emp K.

The CL does not recognize an implied duty of good faith and fair dealing in such employment

situations.

Court relies heavily on the stock repurchase agreement

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