business associations section 2b: firms – internal relationships prof. amitai aviram...

Business associationsSection 2b:

Firms – internal relationshipsProf. Amitai [email protected]

University of Illinois College of LawCopyright © Amitai Aviram. All Rights Reserved

F14D

Firms: internal relationshipsModels of firm governance

Direct control• Management by consensus

(collective decision-making)• Works well when SHs have:

– Low cost to act collectively– Equal access to info/expertise– Similar business interests

• Good governance when it works well, but when it doesn’t it -– May be impossible (deadlock) or very

inefficient (meeting of 1M SHs)– Creates a majoritarian agency

problem (C vs. MSHs)

Delegated control• Management by authority

(central decision-making body)• Needed if SHs have:

– High cost to act collectively– Unequal access to info/expertise– Differing business interests

• Managerial agency problem (BoD & officers vs. SHs)– If firm has a controlling SH,

managerial agency problem is mitigated, but a majoritarian agency problem is created

© Amitai Aviram. All rights reserved.2

Firms: internal relationshipsOverview of Section 2b

1. Direct control– Rights of a beneficiary under direct control– Dysfunctions of direct control

2. Delegated control3. Intervention solutions4. Voice solutions5. Exit solutions


Direct controlEconomic rights of a partner in a GP

• Economic rights– Right to a share of firm’s profits, if they’re distributed: “Each partner is entitled

to an equal share of the partnership profits… [and losses]” [RUPA §401(b)]– Right to a share of firm’s assets upon dissolution: “Each partner is entitled to a

settlement of all partnership accounts upon winding up the partnership business.” [RUPA §807(b)]

– Right to alienate economic rights: “The only transferable interest of a partner in the partnership is the partner’s share of the profits and losses of the partnership and the partner’s right to receive distributions.” [RUPA §502]


Direct controlControl rights of a partner in a GP

• Control rights– Right to participate in collective management: “Each partner has equal rights in

the management and conduct of the partnership business.” [RUPA §401(f)]• “A partner is not entitled to renumeration for services performed for the

partnership [except in winding up the partnership].” [RUPA §401(h)] So why bother managing the partnership?

– Right & power to act (unilaterally) on firm’s behalf: Each partner is an agent of the partnership [RUPA §301(1)]. Actual authority determined by RUPA §401(j).

• RUPA §401(j)– Ordinary course of business → majority– Outside the ordinary course of business → unanimous– Amendment to the partnership agreement → unanimous

• Example: Ralph, Sarah & Tom are partners in a law firm– Partnership agreement silent about dividing profits between them– They vote 2-1 to add a section to the agreement that divides profits: 40% R,

40% S, 20% T. Is the new section valid?– They also vote 2-1 not to accept any employment law cases. Is this valid?



• RUPA 401(j) addresses the relationship between the partners (actual authority). What about third parties?– RUPA §301(1): “…An act of a partner… for apparently carrying on in the

ordinary course the partnership business… binds the partnership, unless the partner had no authority to act for the partnership in the particular matter and the person with whom he was dealing knew or had received a notification that the partner lacked authority.”

– RUPA §301(2): “An act of a partner which is not apparently for carrying on in the ordinary course the partnership business… binds the partnership only if the act was authorized by the other partners.”

• In other words:– Ordinary course of business → Partnership liable if either there’s actual

authority or T doesn’t know/have notice that A lacked authority– Outside the ordinary course of business → Actual authority required

• This is the same rule as in agency: partnership liable if partner acted with either actual or apparent authority– Actual authority: RUPA § 401(j)– Apparent authority: RUPA assumes a reasonable T would believe that a partner has

authority to act in the ordinary course of partnership business, and doesn’t have authority to act outside the ordinary course of business



• Limiting partners’ apparent authority– Hypo: Abe lacks common sense. His partners Becky & Charlie are concerned

that he will bind the partnership to third parties in half-baked transactions.– What can they do? [Note RUPA §303]

• Power regarding transfer of real property• All other powers


Direct controlDysfunctions of direct control

a) Inefficiency: – Direct control is efficient when SHs have:

• Low cost to act collectively• Equal access to info/expertise• Similar business interests

– The more SHs a firm has, the greater the cost of acting collectively – Large & changing SH group increases likelihood SHs will have different interests– SHs with small stakes in the firm likely to be rationally apathetic, lacking

incentive to know firm’s business & participate in the firm’s management (each SH has little power to change things & little to gain from changing things)

• Inefficiency is addressed by governing through delegated control



b) Deadlock: SHs veto each other– E.g., 50/50 split with neither side having a majority), causing the firm to be

unable to act• Deadlock is addressed via:

– [Most frequent solution] Shift towards delegated control via SH agreements & voting trusts (which require parties to vote in a particular way or based on a predetermined process)

– Suit for breach of fiduciary duty» Discussed in Section 2b3 (intervention solutions)

– Dissolution (liquidating the firm) or dissociation (buying out one group of SHs)» Discussed in Section 2b4 (exit solutions)



c) Oppression: Controller exploits minority SHs– By managing firm in a way that shifts value to controller at minority’s expense,

or that pressures minority to sell their shares to controller at a low price– Example: Bob owns 60% of Acme Corp, while Jack owns the remaining 40%.

Bob is Acme’s general manager. Jack doesn’t work at Acme. Acme’s BoD consists of Bob, Bob’s wife & Jack. How can Bob oppress Jack?

• Oppression is addressed via:– Suit for breach of fiduciary duty

» Discussed in Section 2b3 (intervention solutions)– Dissolution or dissociation

» Discussed in Section 2b4 (exit solutions)



1. Direct control2. Delegated control

– Rights of a beneficiary under delegated control– Actors for the corporation– Authority

3. Intervention solutions4. Voice solutions5. Exit solutions


Delegated controlEconomic rights of SHs in a corporation

• Economic rights– Right to a share of firm’s profits, if they’re distributed (i.e., if dividends are

declared by BoD)– Right to a share of firm’s residual assets upon dissolution (i.e., if both BoD &

SHs approve dissolution, or if court orders dissolution)– Right to alienate economic rights (and also control rights)

• Almost identical to economic rights under direct control (except that corporate law allows selling control rights together with economic rights, whereas partnership law does not allow unilaterally selling control rights)


Delegated controlControl rights of SHs in a corporation

• Control rights– Right to participate in collective management (as a SH meeting), but only for

the following acts:• Electing & removing directors [DGCL 211(b), 141(k); MBCA 8.03(c), 8.08]• Amending charter & bylaws [DGCL 242, 109(a); MBCA 10.03, 10.20]• Approving mergers & major asset sales [DGCL 251,271; MBCA 11.04,12.02]• Approving dissolution of the corporation• Approving corp’s independent auditor• Adopting precatory (nonbinding) resolutions

– No right or power to act unilaterally on firm’s behalf• Why are SH control rights so limited?

– When direct control is inefficient, firms use delegated control (delegate control to body that can efficiently exercise direct control: low cost to act collectively, equal access to info/expertise, similar business interests)

• Can this body be an agent of the SHs? (A acts on behalf of B & subject to B’s control)• Corporate organs act on behalf of B but not subject to B’s control

– Need other mechanisms besides B’s control to mitigate agency problem© Amitai Aviram. All rights reserved.13

Actors for the corporationTypes of actors

• Agents (act on behalf of firm & subject to its control)– Including officers, who do the day-to-day management

• Organs (act on behalf of firm, but not subject to its control)– BoD: has one/more of following functions

• Advisory: Directors add value through their advice, prestige & contacts• Executive: Directors add value through managing the company• Supervisory: Directors add value through their supervision of the officers• Representative: Directors monitor company on behalf of stakeholders that they

represent (e.g., particular SH, labor union, government), adding value by creating trust between corporation & stakeholder; representative function can be combined with other functions (often supervisory)

– BoD committee: part of the board; acts on behalf of the entire board– SH meeting: considered an organ in some jurisdictions, but has very limited

role in US law• Controlling SHs (no right to act on behalf of firm, but control firm’s organs)

– Will be addressed in the BA2 course (Section 3a2)© Amitai Aviram. All rights reserved.14

• Officers are a sub-class of a firm’s agents– I.e., all officers are corp’s agents, but not all corp’s agents are officers– Agency law governs all agents’ relations with corp & 3rd parties

• What distinguishes officers from other agents is:– (Actual) authority of the ‘office’ is determined by law, bylaws or BoD

• The ‘office’ is also a circumstance affecting their apparent authority• Officer may hold multiple offices

– Unclear whether officers benefit (like directors) from the Business Judgment Rule (“BJR”), an SoR that replaces the agency SoR

• For this course, use agency SoR for officers– Some laws impose duties/liabilities specifically on officers

• E.g., securities laws, environmental laws, service of process


Actors for the corporationAgents: Officers vs. other agents

Actors for the corporationAgents: Common officers

• Chief executive officer (CEO)– #1 officer in the hierarchy

• Chairperson of the BoD– Administers BoD’s activities– If Chairperson is affiliated with management, firm sometimes also has ‘lead director’

• Chief operating officer (COO)– Responsible for firm’s day-to-day business operations

• Chief financial officer (CFO)– Responsible for accounting & financial operations

• Treasurer– Same as CFO, or subordinate responsible for managing firm’s cashflow

• Secretary– Keeps minutes of BoD/SH meetings & authenticates corporate records

• President– Head of a business unit (or entire firm, overlapping COO or CEO)


Actors for the corporationOrgans: The Board of Directors

• Size [DGCL §141(b) / MBCA §8.03]– BoD consists of 1 or more natural persons– BoD size specified in / fixed in accordance with charter or bylaws

• Term in office– By default, directors are elected in each annual meeting (i.e., they serve a term

of 1 year, renewable) [MBCA §8.03(c)]– Exception: charter may create a staggered board, dividing directors into 2 or 3

groups; one group elected each year [DGCL §141(d); MBCA §8.06]• Removal [DGCL §141(k) / MBCA §8.08]

– Directors may be removed by SHs for cause– Directors may be removed by SHs without cause, if charter does not say

otherwise (MBCA) or if firm does not have staggered board (DGCL)– BoD may not remove a director

• Filling vacancies [DGCL §223 / MBCA §8.10]– SHs or BoD may fill vacancies in the BoD

• Meetings– Board of a typical public company meets 8 times a year; compensation & audit

committees typically meet another 6-9 times a year© Amitai Aviram. All rights reserved.17

Actors for the corporationOrgans: Status of individual directors

• BoD is a corporate organ, individual directors are not– Individual directors have no authority to act for the corporation, unless

they are granted authority by the board to act as a BoD committee (which may consist of a single director)

– Likewise, the SH meeting is an organ, individual SHs are not• Directors (and the board) are not the firm’s agents as such

– We discussed this in sub-section 1a2; same goes for SHs & the SH meeting• Directors individually owe FD to the firm

– This is derived from their status as directors, not as agents– So, when we (figuratively) say “X sued the board”, we really mean that X

sued each of the directors on the board– Why can’t X (literally) sue the board?


Actors for the corporationOrgans: BoD committees

• Appointing committee members [Steigerwald (IL 1956)]– Committee must consist only of directors

• Otherwise, BoD majority can delegate authority to someone unelected by SHs– Members must be selected by the board (directors can’t delegate nomination

to someone else, such as the CEO)• Common BoD committees

– Executive committee: Manages day-to-day operations/decisions– Nominating committee: Picks the directors that BoD recommends to SHs– Compensation committee: Negotiates/approves officer/director compensation– Audit committee: Oversight of financial reporting & disclosure (sometimes also

oversees regulatory compliance & risk management)– Risk committee: Oversees institution’s risk management practices– Ad hoc committees

• Above committees are typical standing (permanent) committees; BoD may also create ad hoc (temporary, single-issue) committees

• When create an ad hoc committee rather than using a standing committee?© Amitai Aviram. All rights reserved.19

Actors for the corporationOrgans: How corporate organs act

• Corporate organs act by approving resolutions, in one of two ways:– Written consent

• BoD or BoD committee may act by written consent if consent is unanimous [DGCL §141(f)]

• SHs may act by written consent if consent is signed by “holders of outstanding stock having not less than the minimum number of votes that would be necessary to authorize or take such action at a meeting at which all shares entitled to vote thereon were present and voted” [DGCL §228]

– Many corporations have a provision in their charter that eliminates SHs’ ability to act by written consent

– MBCA default requires unanimity [MBCA §7.04]– Meeting: three elements to a valid meeting

a) Call (authority to call meeting + notice requirement)b) Quorumc) Vote



a) Call– Authority to call a meeting

• BoD/committee: Charter, bylaws or BoD resolution may schedule regular (e.g., monthly, annually) meetings and may create a procedure for calling special meetings (e.g., chair may call special meeting); BoD resolution may call a special meeting (e.g., at end of previous BoD meeting, or by written consent)

• SH meeting: Annual SH meeting – as stated in bylaws [DGCL §211(b)], and court may order a meeting, if none was called for 13 months [§211(c)]; special SH meeting: BoD resolution + as stated in bylaws/AoI [§211(d)]

– Did the call provide sufficient information & advance notice?• BoD/committee: No notice requirement, but abuse may breach FD

– In contrast, MBCA §8.22(b) creates a default 2-day notice of date, time & place of meeting, but not of meeting’s purpose

• SH meeting: notice must be given no less than 10 days or more than 60 days before the meeting; notice must be in writing and specify place, date & time of meeting, means of remote communications [DGCL §222]



b) Quorum– BoD/committee: by default, majority of total # of directors; may be modified by

charter/bylaws upwards or downwards, but no less than ⅓ [DGCL §141(b)]• Presence via teleconference [DGCL §141(i)]: BoD meetings & BoD committee

meetings may be held via conference telephone or “other communications equipment by means of which all persons participating in the meeting can hear each other”

• Presence via proxy is not allowed– SH meeting: by default, majority of shares entitled to vote; charter/bylaws can

opt out of default, but never less than ⅓ [DGCL §216(1)]• Presence via proxy is allowed



c) Vote– BoD/committee: Vote of majority of directors present at a meeting constitutes

the act of the BoD (unless charter/bylaws require supermajority) [DGCL §141(b)]– SH meeting: varies depending on the type of vote

• Default standard: majority of shares present [DGCL 216(2)]– Bylaw amendments– Precatory SH resolutions

• Majority of disinterested shares present– Ratifying breach of FD [DGCL 144(a)(2)]

• Majority of shares entitled to vote– Mergers [DGCL 251(c)]– Sale of all or substantially all of C’s assets [DGCL 271]– Charter amendments [DGCL 242(b)]

• Plurality of shares present– Electing directors [DGCL 216(3)]


AuthorityCorporation’s authority (ultra vires)

• Ultra vires (Latin for “beyond its powers”) is a (mostly obsolete) doctrine regarding the corporation’s powers– History & erosion of ultra vires doctrine

• Doctrine of ultra vires originally stated that an act of the corporation that was not specifically authorized in the charter was void, meaning that it did not bind the corporation or third parties and could not be ratified by SHs

• Doctrine steadily eroded through creation of exceptions, liberal interpretation of “implied powers” & expansion of statutorily specified powers (e.g., DGCL §122)

• Eventually, statutes allowed corporations to state that they had the power to “conduct or promote any lawful business or purposes” (DGCL §101(b) & 102(a)(3); “engaging in any lawful business”: MBCA §3.01(a))

– Ultra vires occurs when firm acts in violation of its charter• E.g., in SEPTA v. Volgenau [Del. Ch. 2012], firm merged & gave different consideration to

some SHs, when charter stated that all SHs will receive equal consideration in a merger• DGCL 124/MBCA 3.04 allows raising ultra vires claims only in:

– Suits by state Attorney General to dissolve corp or enjoin ultra vires act– Suits by SHs to enjoin the ultra vires act– Suits by corporation (itself or derivatively by SHs) against the actor for damages

from ultra vires act• DGCL §124 limits ultra vires challenges to authority, but the same

action may also breach FD, and §124 doesn’t limit such suits [Volgenau]© Amitai Aviram. All rights reserved.24

AuthorityOrgan’s authority

• A firm’s actor can have authority in three ways– Grant of authority by law– Grant of authority by agreement (in charter/bylaws/valid SH agreement)– Grant of authority by approval (unilateral behavior of/attributed to B, either

before A’s act (prior consent) or after (ratification))


AuthorityAuthority of the BoD

• BoD’s authority granted by law– DGCL §141(a): “The business and affairs of [a corporation] shall be managed by

or under the direction of a board of directors…”• BoD’s authority granted by agreement & approval

– Usually irrelevant because under DGCL §141(a) BoD already has authority to take any act the firm can take

• BoD’s power to grant other actors authority by approval– BoD may delegate management authority and tasks to officers or other agents

of the corporation, but may not delegate authority that law, charter or bylaws specifically assign to the BoD [DGCL §141(a) / MBCA §8.01(b)]

• For this reason, directors cannot vote by proxy in a BoD meeting– BoD may delegate to a BoD committee authority that was specifically assigned

to BoD, with exceptions (see next slide) [DGCL §141(c) / MBCA §8.25(e)]– If authority is delegated BoD maintains oversight responsibility, but BoD can

rely in good faith on agent’s/committee’s/expert’s reports [DGCL §141(e) / MBCA §8.30(f)]


AuthorityAuthority of a BoD committee

• BoD committee authority granted by law: not relevant in this course• BoD committee authority granted by agreement: check charter/bylaws• BoD committee authority granted by approval [DGCL §141(c)]

– BoD may designate committees, each consisting of 1 or more directors– Committee may receive, in BoD resolution or bylaws, any powers or authority

of the BoD except:• Approving, adopting or recommending to SHs any matter that is subject to SH

approval (other than election/removal of directors)• Adopting, amending or repealing a bylaw

– Different exceptions in MBCA §8.25: approving distributions; filling board vacancies


AuthorityAuthority of the SH meeting

• SH meeting’s authority usually limited to the following:– Exclusive to SHs

• Electing directors• Ratifying selection of corporation’s independent auditor• Precatory (non-binding) SH resolutions

– Jointly with BoD• Charter amendments• Mergers / sale of all or substantially all of the firm’s assets• Dissolution of the firm• Ratification of certain unauthorized corporate actions (DGCL §204)

– Either SHs or BoD• Bylaw amendments• Ratifying breach of fiduciary duty


AuthorityAuthority of officers & other agents

• All agents (including officers) have actual authority as determined by agency law

– A reasonably believes that s/he is authorized; and– This reasonable belief is traceable to manifestations by P (i.e., an authorized

corporate actor)• Officers & actual authority

– Relevant manifestations by P include a grant of authority by law or by agreement (in the charter or bylaws)

– Like any other agent, officers may also have actual authority derived from other manifestations of the corporation (e.g., delegation of authority from the board)


AuthorityAuthority: Assumptions for exam

• On the exam, you may assume that the corporations discussed in the fact pattern have the following terms in their constitutional documents, unless fact pattern states otherwise

• Charter– Corp. is a stock corporation, has limited liability & perpetual existence– Corp. may conduct any lawful act or activity– Director FD is limited to the maximum degree allowed under §102(b)(7)– BoD may amend bylaws

• Bylaws– Chairperson of BoD is authorized to call a BoD meeting– BoD is authorized to call both annual & special SH meetings


AuthoritySection 2b mini-case (authority)

• Acme’s 5 directors are alumni of the Univ. of Chicago– They decide to have the corporation donate $5M to the U of C– Alice, a SH of Acme & a Yale alum, demands that half the donation go to Yale– Bob, another SH, wants to enjoin the donation & make Acme distribute the

money as dividends– Acme’s directors point to:

• DGCL §122(9) (or MBCA §3.02(13))• DGCL §141(a) (or MBCA §8.01(b))

• Does the board have authority for the decision to donate?• Is this enough for summary judgment in favor of the BoD?


AuthoritySection 2b mini-case (authority)

• Pressed for time, Carla –– Sends an e-mail to all other directors, explaining the deal in great detail &

attaching the proposed agreement• E-mail requests prompt reply as to director’s vote on the deal

– Calls Alan and asks him to come over to her office the following day at 5pm to discuss the deal

• The following day, Alan comes to Carla’s office– Carla shows Alan an e-mail she received from Barb, who says that she is in

favor of the deal & explains her reasons– Alan is in favor as well; explains his reasons. Carla agrees.– Carla & Alan sign a document stating their approval, to which Carla attaches

Barb’s e-mail• Is the approval valid?• If the approval was procedurally valid, is that the end of the inquiry?


Delegated controlGovernance solutions


BondingAlign A’s payoffs with B’s payoffs Performance-based compensation

Joint ownership

InterventionHave someone determine if A’s behavior was appropriate

RegulationContracts

Fiduciary dutySH litigation procedure

VoiceIntervention by B: Allow B unilaterally to act on behalf of

the firm or to force A to behave in a certain wayApproval

SH voting procedure

ExitAllow B unilaterally to end her relationship & receive her

share of the value produced by the relationship

TerminationDissociationAlienation


1. Direct control2. Delegated control3. Intervention solutions

– Duty– SoR– Application – BJR– Application – Entire fairness– FD in private firms

4. Voice solutions5. Exit solutions


Intervention solutionsInternal analysis frameworks

• Authority– Authority granted by law, agreement or approval

• For agents: is A an agent (Rest. 1.01) & does A have actual authority (Rest. 2.01)?• For organs: is A an organ & does a law, agreement or approval grant A authority?

– If authority is granted by approval, use the approval framework• For agents, Rest. 2.01 test is used for the “unambiguous” element of the approval framework

– Authority may have a procedural aspect (require particular process for A to act)– Authority is irrelevant when an inaction is challenged

• Fiduciary duty– Duty (does A owe B a fiduciary duty?)– Identify potential legal flaws in A’s behavior & determine SoR for each flaw

• For agents: always agency SoR• For organs in BA1: BJR or entire fairness• For organs in BA2: BJR, entire fairness or enhanced scrutiny

– Application of SoR to each potential flaw– Approval (if behavior of/attributable to B waives FD breach)


Intervention solutionsHow organ & agent analyses differ

• An organ is less able than an agent to rely on B for cover– Approval is more limited (approval by SHs is more limited than approval by P)– Why do we limit organs’ ability to rely on voice solutions (SH approval)?

• B faces more burdens to challenge an organ’s act than an agent’s act– Higher standards for proving negligence & self-dealing

• Negligence: gross negligence, not ordinary negligence• Self-dealing: fairness, not automatic breach

– Default SoR for organs (BJR) defers to A’s discretion more than agency SoR• But other SoRs – enhanced scrutiny & entire fairness – sometimes apply

– Why do we increase obstacles to B’s challenges?• Organs’ behavior may violate DoL even without proof of self-dealing

– Organ FD analysis has a bad faith category (in addition to negligence & self-dealing)– Why create an additional category (bad faith) for organs?


• Illegality– Actor intentionally violates the law (including fraud)

• Corporate waste– Act is so one-sided (against the firm) that no business person of ordinary,

sound judgment could conclude that the firm has received adequate consideration

– Corporate waste is occasionally referred to as:• “Irrational” acts• Act motivated by an improper purpose (a purpose other than B’s welfare or

A’s self-interest)• Conscious disregard of duty

– A intentionally fails to respond to a known duty or exhibits a conscious disregard of a known duty (i.e., knowingly refuses to do her job)

• Failure to disclose– Under some circumstances A has a duty to disclose information to other actors

Intervention solutionsBad faith (actions/inactions)


DutyExistence of a fiduciary duty

• Directors– Each director owes a FD to the firm (and to its SHs)– Exculpation: Under DGCL §102(b)(7), a firm can have a clause in its charter that

eliminates or limits directors’ personal liability for monetary damages for breach of FD, except:

• Self-dealing & bad faith (acts/omissions not in good faith, involving intentional misconduct or knowing violation of the law, and acts/omissions where director derived improper personal benefit)

• Unlawful dividend payment/stock repurchase– So, if a firm has this clause, a challenge based on unintentional negligence that

requests a remedy of damages (as opposed to an injunction) will fail• Officers

– The law is not clear as to whether officers are agents or organs– For this course, treat officers as agents

• Agents– Agents owe a FD to the principal (we already discussed that in sub-section 1a3)

• SHs– SHs do not owe a FD to the firm or to other SHs– Exception: SH may owe FD in exercising control of the corporation

• This exception is discussed in BA2; for BA1, treat SHs as never owing a FD© Amitai Aviram. All rights reserved.39

SoRWho decides whether A’s act was in B’s interest?

• Judicial discretion [entire fairness SoR]– Breach if court thinks action was unfair to B– Drawback of relying on judicial discretion?– Entire fairness SoR applies when an organ is self-dealing (also applies when

controller is self-dealing, but this isn’t part of BA1 material)• Actor’s discretion [BJR SoR]

– No FD breach unless A fails to use discretion (no decision/arbitrary decision) or acts in bad faith (i.e., knows she’s acting unfairly to B)

– Drawback of relying on A’s discretion?– BJR is the default SoR for organ behavior (acts/inactions)

• Beneficiary’s discretion [agency SoR]– FD breach unless B approves A’s act– Agency SoR limits both judicial discretion & deference to A – court must find a

FD breach if A is negligent or self-deals (unless B approves)– Drawback of relying on B’s discretion?– Agency SoR applies to all agent behavior (acts/inactions)


• Delegated control requires giving A broad authority to act (impractical to rely on B’s approval), so courts avoid second-guessing A (i.e., defer to A’s judgment)

• Example: To hire T to work for B, A offers her twice the normal salary. Can T rely on A’s offer, or does he need to talk to B?– In agency (e.g., A is an officer): possibly no apparent authority (cf. Lind)– So, T may need to get approval for the offer from B (the corporation)– But who speaks for the corporation? If the board is subject to same rules as an

agent, then an offer from the board may lack authority as well– So, T needs to get approval for the offer from someone else (SHs?)– But we use delegated control precisely because SH approval is likely to be

inefficient, expensive & uninformed• Conclusion: when direct control is an impractical governance system

(as is typically in firms using delegated control), we need SoRs that de-emphasize B’s discretion: BJR or entire fairness

SoRWhy not use agency SoR for organs?


SoREntire fairness

• Entire fairness SoR applies if A has CoI with respect to the challenged behavior, or received an unauthorized benefit from the fiduciary position

• Collective actors (e.g., BoD, BoD committee)– A collective actor has CoI if 50% or more of its members have CoI– Example: BoD, composed of 5 directors, votes 5-0 to hire Ann

• If 2 directors have CoI & 3 don’t, decision benefits from BJR• If 3 directors have CoI & 2 don’t, BJR is rebutted

– Trick example: Acme has 100 SHs, each owning one share• In SH meeting, they vote to approve a merger with Ajax• 52 SHs have CoI. Is the act tainted with CoI?

• Constructive CoI (based on Cinerama v. Technicolor [Del. 1995])– An actor or member of an actor who does not directly have CoI regarding an

act, may nonetheless be considered as having CoI if:• Someone with a CoI controls or dominates A

– Test for control/domination in Beam v. Stewart• Someone with a CoI failed to disclose their interest to A, and a reasonable A

would regard the undisclosed interest as significant to evaluating the act© Amitai Aviram. All rights reserved.43

SoRConflict of interest: Beam v. Stewart [Del. 2004]

• Beam, a SH of Martha Stewart Living Omnimedia (“MSO”) sues Martha Stewart, alleging Stewart breached FD by committing insider trading & mishandling subsequent media attention

• Standing issue: Stewart owes FD to MSO, not to Beam directly– Delaware law requires that Beam ask MSO’s BoD to sue Beam (“make a

demand on the board”), unless Beam can show reasonable doubt that a majority of MSO’s BoD is independent (show “demand futility”)

• Beam did not make a demand, so her suit must be dismissed unless her allegations show demand futility

• Even though this case doesn’t look at a BoD decision, it “simulates” whether it would have deferred to a BoD decision not to sue Stewart– If court wouldn’t have deferred, then it’s OK for beam not to have asked BoD to

sue


SoRConflict of interest: Beam

• MSO has six directors: Stewart, Patrick, Martinez, Moore, Seligman, Ubben

• Chancery Court finds Stewart & Patrick not independent• Beam abandons claim that Ubben lacks independence

– Stewart, Patrick, Martinez, Moore, Seligman, Ubben– How many additional directors does Beam need to prove lack

independence?



Test for control/domination• Court: “To create a reasonable doubt as to an outside

director’s independence, a plaintiff must plead facts that would support the inference that… the non-interested director would be more willing to risk his or her reputation than risk the relationship with the interested director.”



Martinez– Chairman of the Federal Reserve Bank of Chicago– Director in four prominent companies– Executive & director of major corporations since 1990 (14yrs)– Why do these factors affect independence?

• Evidence of lack of independence?– Recruited to MSO BoD by Beers, a close friend of Stewart– Worked for Sears, which bought many MSO products– Patrick said Martinez “is an old friend to both me & [Stewart]”– Do these facts create a reasonable doubt re independence?



Moore– Fewer positions of fiduciary responsibility than Martinez

• Evidence of lack of independence?– Moore & Stewart were invited to a reception for the wedding of

the daughter of Stewart’s lawyer– Fortune magazine published an article that focused on the close

friendship among Moore, Stewart and Beers– When Beers resigned as MSO director, Moore replaced her

• Court: Close call, but not enough for reasonable doubt– “…[F]riendship must be accompanied by substantially more…”– Rejects the “structural bias” argument



Seligman• Evidence of lack of independence?

– Seligman, while a director for JWS (a publisher), contacted JWS’s CEO about an unflattering biography of Stewart, that was slated for publication

• Beam claims that this shows Seligman preferred protecting Stewart over FD to MSO & JWS

– Court finds that this does not create reasonable doubt about independence. Why?

• Outcome in Beam v. Stewart– Stewart, Patrick, Martinez, Moore, Seligman, Ubben– 4 of 6 directors were independent


Application - BJROverview of the BJR SoR

• When BJR is the applicable SoR, application of the SoR takes 2 steps:– Does court defer to A’s discretion?

• When BJR does not apply (because of one of these exceptions or because entire fairness SoR applies), it is said that “BJR was rebutted” (BJR is seen as a presumption of A’s integrity)

– Applying judicial discretion, did A’s behavior breach FD?

• Step 1 (BJR rebutted?): court defers to A (no FD breach), unless –– A didn’t make a business judgment (inaction or negligent act)– A didn’t act in good faith pursuit of a legitimate corporate interest

• Step 2 (FD breached?): Once BJR is rebutted, FD is breached –– If legal flaw was negligence, FD is breached if act was grossly negligent– If legal flaw was a bad faith action, FD is automatically breached– If legal flaw was a bad faith inaction, certain tests for whether FD was breached


Application - BJRNegligence: BJR rebutted?

• If challenge is to an allegedly negligent inaction, BJR is automatically rebutted (no business judgment to defer to) – FD breached if inaction was grossly negligent (see later slide)

• Negligent act – is BJR rebutted?– Identify necessary expertise & information, taking into account the

importance of the challenged act to corporation/SHs– Did actor acquire necessary expertise & information?

• Reliance on actor’s own knowledge/expertise• Reliance on advisors (DGCL §141(e))

– Expertise– Independence– No abdication of decision


• SH sues BoD for approving the sale of the corporation for $55/share• Duty: yes, defendants owe FD as directors• SoR: VG may have CoI, but other directors don’t, so no self-dealing (BJR applies)• Application (possible flaws: negligence)

– Bad faith: No illegality or corporate waste– Lack of business judgment?

• Necessary expertise & information (this is a very important decision)– Legal analysis of merger agreement; valuation of the company; knowledge on how to

best auction the company• Did actor acquire necessary expertise & information?

– Reliance on actor’s own knowledge/expertise– Reliance on advisors (Romans/VG)

» Expertise? (Romans did not do a valuation; but VG has law degree)» Independence? (VG was nearing retirement)» No abdication of decision? (Hardly any deliberation; BoD not proactive)

– Conclusion: BJR rebutted due to lack of business judgment (BoD lacked the required info & expertise given the importance of the decision); once BJR is rebutted, court applies its own judgment to the challenged act (see next slide)

Application - BJRNegligence (Example: Van Gorkom)


Application - BJRNegligence: FD breached?

• If BJR rebutted, DoC is breached if actor was grossly negligent– McPadden v. Sidhu (Del.Ch. 2008):“gross negligence is conduct that constitutes

reckless indifference or actions that are without the bounds of reason”– MBCA does not use the term “gross negligence” and its language suggests an

(ordinary) negligence standard (MBCA §8.31(a)(2)(ii)(B) & (iv)), but MBCA commentary considers director’s subjective state (similar to gross negligence)

• When an action (but not an inaction) is allegedly grossly negligent, if BJR is rebutted then the action was grossly negligent (DoC breached)– When an inaction is allegedly negligent, BJR automatically rebutted, so you

now need to analyze whether inaction was grossly negligent (otherwise the inaction doesn’t breach DoC)


Application - BJRBad faith actions

• BJR rebutted & actor breached FD if:– Illegality: actor knowingly violates the law (including fraud)– Corporate waste: transaction is so one-sided that no business

person of ordinary, sound judgment could conclude that the corporation has received adequate consideration

• Alternative test: A knowingly pursues a purpose other than SH welfare or A’s self-interest


Application - BJRDodge v. Ford Motor Co. [Mich. 1919]

The superficial story• FMC cuts dividends to:

– Afford to reduce car prices– Double employee salaries– Build the River Rouge plant

• Dodge brothers, who own 10% of FMC, sue to enjoin construction of plant & require FMC to issue special dividends– No self-dealing is alleged

• Superficially, this seems like a dispute between FMC’s BoD (Ford) & some of FMC’s SHs (Dodge brothers) about what FMC should do with its profits– Court: FMC must issue special dividends; can continue with construction plans– Did the court get the law wrong? Even if court agrees with Dodge, doesn’t BJR

require it to defer to BoD?


Application - BJRDodge: Ford’s cross-examination

Henry FordJohn F. Dodge & Horace E. Dodge



• Counsel for Dodge: Do you still think that those profits were awful profits?

• Ford: Well, I guess I do, yes.• D: And for that reason you were not satisfied to

continue to make such awful profits?• F: We don’t seem to be able to keep the profits

down.[One more slide…]



• D: … Are you trying to keep them down? What is the Ford Motor Company organized for except profits, will you tell me, Mr. Ford?

• F: Organized to do as much good as we can, everywhere, for everybody concerned… And incidentally to make money.

• D: Incidentally make money?• F: Yes, sir.[End]


Application - BJRDodge: What is really going on?

• Interpretation of holding: The purpose of the corporation is to maximize SH wealth; BoD has discretion over the means to achieve this purpose, but cannot change the purpose

• Modified story– SHs (Dodge) argue that SHs are best served by reducing expenses & distributing

FMC’s profits as dividends– BoD (Ford) cares about the welfare of employees & customers (wages/prices)

at the expense of SHs (dividends)– BJR rebutted due to bad faith (corporate waste); court need not defer to BoD

• But the court still seems to be getting the law wrong…– Corporate waste test: “transaction is so one-sided that no business person of

ordinary, sound judgment could conclude that the corporation has received adequate consideration”

– Can Ford argue for any benefit (to FMC & ultimately to SHs) from reducing the price of cars? Doubling employee salaries? Building the River Rouge plant?


Application - BJRDodge: What is really going on?

• Now Ford’s position looks odd– Why doesn’t Ford tell the court these justifications?

• And now the Dodge brothers’ position looks odd. If Ford’s plans create value for SHs, why do the Dodge brothers object?

• Modified, modified story– Courts apply the corporate waste test very narrowly in determining if a BoD has

an improper purpose; almost any argument for a SH benefit from A’s challenged behavior suffices to establish a proper purpose

– But the Dodge brothers allege that Ford had an improper purpose, and Ford agrees, so the court is forced to accept that position and find corporate waste that rebuts the BJR and breaches FD – therefore dividends are enjoined

– But the court understands the real situation: Ford is acting in the interest of FMC SHs, while the Dodge brothers are not. So the court does not enjoin construction of the plant – FMC can easily finance this (and Ford’s other plans) by borrowing money


Application - BJRBad faith inactions

• BJR always rebutted (inaction); FD is breached when:– Failure to disclose

• Actor must disclose to other actors (e.g., BoD, BoD committee, SHs) all material info reasonably required for them to act on behalf of corp

• E.g.: since SHs elect the directors, BoD would act in bad faith if it failed to provide SHs all material info is has relevant to deciding whether to elect the proposed candidates

• MBCA duty of disclosure (MBCA 8.30(c); use this for Delaware law as well): duty to disclose info that is material to the discharge of another actor’s decision-making or oversight functions, unless disclosure violates a superior duty (imposed by law, confidentiality agreement, ethics rule, etc.)

• When info isn’t related to facilitating another actors’ acts, failure to disclose may still breach FD if it qualifies as a bad faith disregard of duty

– Conscious disregard of duty: Stone v. Ritter test


Application - BJRBad faith: disregard of duty

• Stone v. Ritter [Del. 2006]: AmSouth employees violated federal Bank Secrecy Act & anti-money-laundering regulations– Failed to notify gov’t when they suspected a transaction involved funds

derived from an illegal Ponzy scheme– Bank pays $50M to gov’t to settle charges

• No evidence that BoD had notice of employees’ illegal acts– If BoD knew employees were violating the law, what’s the analysis?

• Plaintiffs allege that BoD failed to implement appropriate compliance system, and failed to use existing system to monitor and ensure compliance– Thus, BoD allegedly showed conscious disregard for duties (in Delaware,

this is known as violating Caremark duties)– Why not frame this as a negligence allegation?


Application - BJRBad faith: disregard of duty

• Court: two alternative prongs for liability– Directors utterly failed to implement any reporting or information

system or controls– Having implemented such a system or controls, consciously failed

to monitor or oversee its operations, thus disabling themselves from being informed of risks or problems requiring their attention

• AmSouth BoD had implemented several compliance mechanisms, and used them to monitor compliance– Evidence of non-compliance doesn’t prove lack of a system or

insufficient monitoring


Application - Entire fairnessThe fairness test

• Hypo based on Bayer v. Beran [NY 1944]– Celanese Corp. of America (CCA) makes clothes made of Celanese, which is a

synthetic fiber that CCA brands as a sophisticated choice– Celanese Corp. has 4 directors on BoD: Anna (the CEO), Barry, Chuck & Dave

• Barry is CCA’s Chief Financial Officer• Chuck is the General Counsel of a large industrial company (unaffiliated with CCA)• Dave is the Chief Marketing Officer of a luxury handbag company (unaffiliated with CCA) & a

childhood friend of Anna– Anna negotiates a contract to hire Edgar (her husband), a famous opera singer,

to sing in CCA radio commercials• She is advised by Frank, a media consultant who is often hired to advise CCA’s management• Following Frank’s advice, Edgar is paid same as CCA paid the previous person who starred in

their radio ads (a famous public intellectual)– BoD approves the contract

• Anna didn’t tell the other directors that Edgar is her husband, but Barry & Dave know that he is (Chuck does not)

• SH sues BoD, claiming that the decision to hire Tennyson breached directors’ FD• What SoR applies to this challenge?

– Could CCA hire Edgar without exposing the decision to the entire fairness test?– Note: Oracle [Del.Ch. 2003] suggests that when a decision is delegated to an

ad-hoc (specially-created) BoD committee, the standard for independence is higher than in Beam (so, e.g., social connections could suffice to create a CoI)


Application - Entire fairnessThe fairness test

• Application of the entire fairness SoR: was the challenged behavior in B’s interest (i.e., wealth-maximizing for the SHs)?

• Detailed fairness test for acts– Was undertaking the act (e.g. hiring CEO’s spouse) in the firm’s interest?– Were the terms of act (e.g., employment contract) similar to what firm would

have received in an arm’s length transaction?• Fair process (for determining price/other terms) – indirect assessment• Fair price (valuation/comparison) – direct assessment of the terms

– Conduct the fairness test for the hypo in the previous slide• Detailed test for usurping a business opportunity (Guth v. Loft test: no

single factor is dispositive; court balances all factors)– Was the firm financially able to take the opportunity?– Was the opportunity is in the firm’s line of business?– Did the firm have an interest or expectancy in the opportunity?– By embracing the opportunity, would the actor create a conflict between his/her

self-interest and that of the firm?


Intervention solutionsSummary of FD analysis

FD analysis: SoR & Application stagesNeg. act Neg. inaction Bad faith act Bad faith inaction Self-dealing

SoR BJR BJR BJR BJR Test for self-dealing (apply entire fairness)

App.(BJR

rebutted?)

Van Gorkom test Automatic(for inaction)

Tests for illegality& corp. waste

Automatic(for inaction)

Fairness test

App.(FD

breached?)

Gross negligence (almost automatic)

Gross negligence

Automatic breach if BJR rebutted

Tests for disregard of duty (Stone) &failure to disclose


FD analysis: types of legal flaws

Negligence Self-dealing Bad faith

Negligent actNeg. inaction

CoIUnauthorized benefit from fid. position

IllegalityCorporate wasteDisregard of dutyFailure to disclose

Fiduciary dutySection 2b mini-case (FD)

• Challenged decision: Acme donates $5M to the University of Chicago• Authority: analyzed earlier• Fiduciary Duty

– Duty: The 5 defendants are directors & therefore owe FD to Acme• Legal flaws: (1) lack of business judgment; (2) corporate waste; (3) CoI• If suit is for damages & Acme has a DGCL 102(b)(7) exculpatory clause, no need

to further analyze the lack of business judgment flaw– SoR

• Lack of business judgment & corporate waste – BJR• CoI: Beam test to see if 50% of BoD is conflicted; if so, this flaw is analyzed

under entire fairness SoR; otherwise, no FD breach by this flaw– Application

• BJR– Lack of business judgment: Van Gorkom test to see if BJR rebutted

» If so, breach if decision was grossly negligent– Bad faith (corporate waste test) – if BJR rebutted, automatic FD breach

• Entire fairness– Was donating to a university in firm’s interest? (Likely yes & ALI principles allow

donations of reasonable amounts anyway)– Was process that led to choosing Chicago & determining terms of donation fair &

were the terms themselves similar to those in arm’s length donations?– Approval: If SH purported to waive FD breach, check if it was a valid approval


FD in private firmsBroader FD in private firms

• Wilkes v. Springside Nursing Home [Mass. 1976]: Wilkes, Riche, Quinn & Connor own Springside Nursing Home– When SNH accumulates cash, they distribute equal weekly ‘stipends’

• Wilkes isolated– Ill-will develops between Wilkes & Quinn; Riche & Connor support Quinn– In the next BoD meeting the stipends were replaced with salaries, and Wilkes

was fired (so he didn’t receive a salary)• Wilkes sues, alleging RQC breached FD as SHs

– Is this oppression? (Are RQC diverting the firm’s value to them at Wilkes’ expense?)

• Court quotes Donahue v. Rodd Electrotype, in which the court analogized FD in close corporations to partnerships– In a partnership, by default all partners share control & can’t be fired– No such protection to SHs in a corporation


FD in private firmsBroader FD in private firms

• The Wilkes court creates a new rule – SHs in a close corporation owe each other a duty of strict good faith:– If controller’s act is challenged by a MSH, controller must show a legitimate

business objective for its action– If such business objective has been demonstrated, MSH must show that

controller could have accomplished the business objective in a manner that was less harmful to MSHs’ interests

• Wilkes placed initial burden of proof regarding biz justification on the defendant; some jurisdictions place BoP on plaintiff:– Nelson v. Martin [Tenn. 1997] – Court places BoP on plaintiff to show lack of

business justification– Also, Nelson court states that if defendants were protecting the interests of the

company, the presence of spite or ill will would not render them or the corporation liable


FD in private firmsFD & SH agreements

• Courts are less likely to view as a breach of FD actions that are in accordance with an employment/SH agreement to which plaintiff is a party

• Blank v. Chelmsford OB/GYN, P.C. [Mass. 1995]: Doctor’s employment terminated in accordance with employment agreement. Shares in the corporation were redeemed in accordance with stock repurchase agreement.– Court: Donahue does not apply when all SHs in advance enter into agreements

regarding employment & share repurchase


FD in private firmsDelaware law

• Under Delaware law, controllers owe MSHs a FD when exercising control (in any corporation, not just close corporations)– This will be discussed in Section 3a2 (controllers)

• Nixon v. Blackwell (Del. 1993): FD in close corporations same as in any Delaware corporation– Court refuses to create a different FD standard for private firms– Justification: if direct control & restricted alienation increase risk of oppression,

a person entering a minority position in a private firm has several options to protect herself by provisions in the charter, bylaws or SH agreement (e.g., buyout provisions, voting trusts)

• Members of Delaware LLCs may waive FD entirely, though by default (if nothing is said about FD in the LLC constitutional documents) the law assumes that the parties owe FD


Intervention solutionsPractice questions: Take 1

• Alex and his wife Betty compose the BoD of a bank– Fraud by their son Charles (an employee of the bank) causes the bank to lose

$1B– Alex & Betty knew Charles always tried to get away with bad behavior, but

didn’t suspect he was committing fraud– BoD had no procedures to monitor employee fraud

• SHs sue BoD for failing to prevent the loss– Authority– FD

• Duty• SoR• Application• Approval: not suggested by the facts here



• Add active decision– Alex & Betty know Charles is committing fraud– In the next BoD meeting they consider whether to fire him and decide not to,

because they believe Charles’ skill in attracting clients offsets the expected harm to the bank from his fraud

• Charles’ fraud causes the bank a $1B loss; SHs sue BoD for the decision to keep Charles– Authority– FD




• Remove illegality & CoI– No fraud; Charles is simply absent-minded & maintains sloppy records– Failing to maintain good records in itself is not illegal– Charles is not related to Alex & Betty– Alex & Betty know that Charles maintains sloppy records, but decide to keep

him because they believe his skill in attracting clients offsets the cost of his sloppiness

• Sloppy records cause company to lose a $1B lawsuit; SHs sue BoD for the decision to keep Charles– Authority– FD




1. Direct control2. Delegated control3. Intervention solutions4. Voice solutions5. Exit solutions


• Types of approval– Prior consent: B grants A authority or waives FD breach before A acts– Ratification: B grants A authority or waives FD breach after A acts

• Approval gives emphasis to the beneficiary’s discretion– Approval is more restricted for organ acts than for agent acts. Why?

• Elements (same as agency, except as explained in following slides)1. Appropriate approver2. A’s behavior can be approved

– Attributed to beneficiary– Appropriate scope

3. Appropriate approval– Unambiguous– Informed– Timely (relevant only for ratification, not for prior consent)

ApprovalElements


• In the context of firms, appropriate approvers are:– The beneficiary

• Firm is beneficiary, but can’t approve (someone has to approve on its behalf)– A person who has authority to approve on behalf of the beneficiary

• BoD– BoD can approve behavior of corporate actors (based on its plenary

authority under DGCL §141(a) & on DGCL §144, 204)– As with agency law, BoD can’t approve its own acts & can’t approve acts

regarding to which BoD has CoI (e.g., no approval of controlling SH’s behavior)• SH meeting

– SH meeting can approve transactions suffering from self-dealing (DGCL §144)» Not clear if SH meeting can approve other behavior of corporate actors; even

if it lacks authority to approve, approval may be construed as waiving a SH’s right to sue for the legal flaw that was purportedly approved

– When approving, vote must be specifically designated as a ratification, and SH meeting can only approve acts that don’t require a SH vote to become legally effective [Gantler v. Stephens (Del. 2009)]

ApprovalAppropriate approver


ApprovalAct can be approved

• Same as agency, except for public policy reasons preventing B from approving (part of “attributed to beneficiary” element):– Void acts (can’t be ratified)

• Lack of corporation authority (ultra vires)– But unanimous SH ratification insulates BoD from future SH challenge

• Bad faith actions (illegal acts & corporate waste)• Probably also conscious disregard of duty

– Voidable acts (can be ratified): lack of actor authority, negligence, self-dealing & failure to disclose


• Same as agency, except for some details regarding ambiguity– Implied approval is interpreted from the approver’s behavior, rather

than expressly framed as an approval (same as agency)• E.g.: ratification implied by unambiguous acquiescence• Implied approval by BoD is possible if it is unambiguous, but implied

approval by SHs is probably impossible (inherently ambiguous)– Express approval is framed as an approval

• To be unambiguous, express approval must comply with formal procedures for call, quorum & vote

• There are specific statutory rules for the process of approval of a transaction flawed by self-dealing or lack of authority (see next slide)

ApprovalAppropriate approval


ApprovalAppropriate approval

• Approval procedure– Lack of authority: DGCL §204 (approval by BoD & in some situations also by the

SH meeting) (effective April 1, 2014)– Transactions in which a director/officer has CoI: DGCL §144(a), either:

• Approval by a majority of disinterested directors (even if disinterested directors do not compose a quorum)

• Approval “in good faith by vote of the shareholders” (in Fliegler the court said this requires a vote of the majority of disinterested SH)

– Any other act: no statutory authorization for approval, but approval is possible under BoD’s plenary powers (DGCL §144(a))

• Follows the normal process for BoD acts (written consent or call/quorum/vote)• Hypo

– Hypo: Acme’s board consists of A, B, C, D & E. They vote to ratify a contract between Acme & A’s wife (B, C & D do not have CoI). Only A, B and C show up for the vote. Do they have a quorum? [Note DGCL §141(b), §144 (b)]

– A, B & C all vote in favor of the contract. Was it approved? [Note §141(b), §144(a)(1)]




– Alienability– Dissociation– Termination (dissolution)


Exit solutionsTypes of exit solutions

• Exit solutions allow B unilaterally to leave the firm & receive her share of the firm’s value

– Alienability: allow B unilaterally (without requiring consent of firm/other Bs) to sell interest in the firm to third parties

• Allows for the firm’s longevity & maintains firm’s goodwill, but no guarantee business ownership remains in acceptable hands

– Dissociation: allow B to unilaterally sell interest in the firm back to the firm/other Bs (at the interest’s fair price)• Allows for the firm’s longevity, maintains firm’s goodwill & keeps business

ownership in acceptable hands, but requires that: (1) parties agree on the fair price; (2) firm/remaining Bs are able to pay; (3) firm is viable to the remaining Bs without the dissociating B

– Termination (dissolution): allow a SH to unilaterally cause the firm to terminate, liquidate its assets & divide the proceeds

• but allows restrictions on alienability, but sacrifices firm’s longevity & may lose firm’s goodwill (value of the “live” business - value of the “dead” business)

• Public firms favor alienability over dissolution/dissociation• Private firms favor dissolution/dissociation over alienability

– Why? (Compare to marriage)© Amitai Aviram. All rights reserved.85

AlienabilityRules on alienability in corporate law

• Transferable shares– By default, SH can sell shares without restriction– Restrictions on alienating SH rights separately from shares (e.g., selling right to

vote without selling shares)• Perpetual existence

– By default, a corporation exists indefinitely• Restrictive dissolution

– Individual SH has no right/power to dissolve– Dissolution if majority of both BoD & SHs vote in favor, or (in rare cases) by

judicial or administrative order• Capital lock-in (SH can’t withdraw equity capital, giving corporation financial

stability, but at expense of lost accountability)• When corp issues new shares, SH pays corp (say, $10) for shares• When SH wants to cash out, she can’t force corp to buy back her shares;

instead, SH can sell shares to T (corp keeps the $10)– Exception 1: if shares were specifically made redeemable– Exception 2: corp may choose to repurchase the shares


AlienabilityRules on alienability in partnership law

• April, a partner in a three-partner law firm, wants to cash out• Can she (unilaterally) sell a 1/3 share of the partnership assets (e.g.,

1/3 of the furniture) to Brian?– RUPA §501

• Can she (unilaterally) sell her control rights in the partnership to Brian? Her economic rights?– RUPA §401(i), 502, 503(a)(3)




– Alienability– Dissociation

• Dissociation• Buyout agreements• Relationship between dissociation & buyout agreements

– Termination (dissolution)


DissociationDissociation in corporations & partnerships

• Dissociation allows B to unilaterally sell interest in the firm back to the firm/other Bs (at the interest’s fair price)

• By default, corporations have “capital lock-in” (no dissociation)– But a corporation can issue shares that are redeemable at the SH’s option– Also, SHs can create a buyout agreement in which they agree on situations in

which one party may force other parties to buy her shares• In RUPA partnerships, each partner has a power to dissociate (this is

mandatory, not just default rule)– RUPA §602(a): “A partner has the power to dissociate at any time, rightfully or

wrongfully, by express will…”– Departing partner generally remains liable on pre-dissociation partnership

obligations unless released by creditors [RUPA §703]– If the partnership agreement prohibits or limits dissociation (e.g., requires

partner to remain a partner for X years, or give X days advance notice), a dissociation contrary to the agreement is called “wrongful dissociation” – it creates a dissociation, but former partner is liable for breach of contract


DissociationImplied terms may limit dissociation

• Ann & Becky are partners in building & operating a cafeteria• Ann supervises construction & operates the cafeteria (“service

partner”); Becky puts up the money– Partnership agreement states Becky is to be repaid $30K in 1st year of operation

& $60K/yr. thereafter, until her investment is fully repaid• Original estimate of building costs: $300K

– When building costs reach $600K, Becky refuses to put up more money; sues for dissociation

• Can Becky dissociate?– Can Ann make an argument that Becky wrongfully dissociated?


DissociationStatutory dissociation under RUPA

• By act of a dissociating partner [RUPA §601(1)]– By right: if the partnership is at will– Wrongful dissociation [RUPA §602(b)]

• By terms of partnership agreement [RUPA §601(2)-(3)]• By unanimous vote of all other partners [RUPA §601(4)]

– Limited to specified circumstances• By court order [RUPA §601(5)]• By operation of law [RUPA §601(6)-(10)]

– E.g., due to death, bankruptcy, unlawfulness


Buyout agreementsSome key considerations

1. Who buys the equity interest?– Third parties

• No buyout agreement; just avoid share transfer restrictions• Limited value if market is very thin (few buyers/sellers)• Undesirable business partners• Difficult when firm must have share transfer restrictions (e.g., Del. statutory

close corp.)– Remaining SHs

• Raises problems with liquidity of SHs• Can be used opportunistically to extract benefits

– Or else SH will cash out, forcing the other SHs into insolvency– The firm

• Raises problems with firm’s liquidity (can be used opportunistically)– Life insurance

• One of the most commonly implemented exit arrangements in close corporations is triggered upon a SH’s death. Why?

• Life insurance both helps with financing the buyout, and avoids arguments over valuation (since it’s clear the deceased SH’s estate would sell the shares, it would push for high valuation)


Buyout agreementsSome key considerations

2. Triggering event: what has to happen to allow a SH (or the firm) to force a buy-out?

– Check relevant statutes for mandatory/default right to dissociate, and make sure to cover all situations that allow dissolution/dissociation under the applicable statute

3. Price for which equity interest is bought-out– Parties may determine value periodically by agreement

• Parties often neglect to do so• As interests diverge, parties may disagree

– Parties may hire an appraiser• May be difficult to agree ex-post on the identity of appraiser• Appraiser may over time develop a closer connection to one party


Buyout agreementsSome key considerations (price)

• Parties may set a formula– Often a multiplier of annual cash flow or earnings– Example

• Acme is a close corporation that owns a shopping mall; annual profit: $500K• A similarly-situated company is publicly held, with 2M shares outstanding,

trading at $5 a share (market cap: $10M) & an annual profit of $1M (so price/earnings ratio: 10)

– If Acme has the same P/E ratio, it should be worth $5M ($500K x 10)– Acme’s buyout agreement can either specify the multiplier, or require checking

the multiplier at time of buy-out• Parties may use book value

– Book value is the price of the assets when purchased, reduced over the years for wear & tear (depreciation)

– Depreciation may not reflect real value (e.g., antique that appreciated in value; car that lost much value in 1st year)


Buyout agreementsSome key considerations (price)

• Strategic process– E.g., “You cut, I choose”: One party names a price, the other decides whether it

will buy from the other, or sell to the other, at that price– Works well if both parties have sufficient cash & info– Example: Banks A & B jointly own Acme, a home financing joint venture

• Bank A (much larger than Bank B) owns 75% of the shares; Bank B owns 25%– As a result of antitrust enforcement, banks required to break up the joint

venture; charter had a buyout clause that implements “you cut, I choose”• Bank A decides on a price per share (any price it wants)• Bank B then chooses whether to sell its interest to Bank A at that price, or buy Bank A’s

shares at that price– Assume that both banks have no financial constraints

• Would Bank A decide on price that’s higher or lower than Acme’s perceived value?– Now assume Bank A expects Bank B to have liquidity problems

• Bank B has less money & has to pay for 3 times the # of shares• Does A expect that B will buy or sell?• Would A decide on price that’s higher or lower than the perceived value of Acme?


Relationship between dissociation & buyoutHaley v. Talcott [Del. 2004]

Matt Haley

Greg Talcott

Matt & GregReal Estate, LLC

Redfin Seafood Grill

Owns 100%Employment Agreement

50% 50%

Bank

PersonalGuarantee

PersonalGuarantee

Loan/Mortgage


Relationship between dissociation & buyoutHaley v. Talcott

• Talcott owns Delaware Seafood (aka Redfin Seafood Grill), a restaurant operated by Haley

• Haley’s employment contract gives him a “bonus” of 50% of the restaurant’s profits, after the loan from Talcott was repaid– Why pay Talcott’s loan first?

• Is this a partnership?– What do the parties do to avoid framing this as a partnership?

• How is Haley vulnerable to misappropriation?– Firing Haley

• What does Haley do to protect himself?– Siphoning the profits out of the company

• How can Talcott siphon money out of the Redfin Grill?• What does Haley do to protect himself?



• Haley exercises the option; owns 50% of Matt & Greg Real Estate, LLC– LLC purchases the property, financing it through a mortgage from County Bank

• Both Haley & Talcott sign personal guarantees for the mortgage– Redfin Grill leases the property from the LLC for $6,000/month – enough to pay

the mortgage but probably below market rent• Relationship deteriorates

– Haley expects to receive equity interest in the Redfin Grill– Talcott refuses, and eventually sends Haley a letter purporting to accept Haley’s

resignation & forbidding Haley from entering the premises of the Redfin Grill– What right does Talcott have if Haley resigns?



• LLC Agreement has an exit mechanism– If a member elects to “quit” the LLC, the other member may elect to purchase

the departing member’s interest for fair market value.– If other member does not elect to purchase, LLC is dissolved

• Why does Haley want to dissolve rather than exercise the contractual exit mechanism?– How does Haley respond to Talcott’s letter?

• What’s Delaware law’s general attitude regarding judicial dissolution when a contractual exit mechanism exists?– How does it rule in this case?




– Alienability– Dissociation– Termination (dissolution)

• Forced dissolution• Statutory dissolution• Process of dissolution


DissolutionTypes of dissolution

• Voluntary dissolution: firm acts to dissolve itself– Corporation: BoD & SH vote (DGCL §275; MBCA §14.02)– Partnership: by unanimous vote of partners

• Forced dissolution: dissolution by unilateral action of any SH– Corporation: individual SH has no right/power to dissolve– Partnership: yes, by default (RUPA); yes, mandatory (UPA)

• Statutory dissolution: court/gov’t forces firm to dissolve– Administrative (DGCL §284; MBCA §14.20)– Judicial: Individual SH/partner can petition court to dissolve in some cases

(MBCA §14.30; RUPA 801(5),(6))


DissolutionDelaware corporations

• Voluntary: BoD vote + SH vote + Filing [DGCL §275]• Forced: no unilateral right for SH to dissolve• Statutory

– Administrative: Delaware AG may sue to revoke a corporate charter “for abuse, misuse or nonuse of its corporate powers, privileges or franchises” [DGCL §284]

– Judicial: No right of dissolution for “oppression” • Nixon v. Blackwell (Del. 1993): Court-imposed buy-outs are inappropriate

because contractual protection is available to MSHs• What’s the disadvantage of this approach?

– I.e., if parties can contract for dissolution, why should a court dissolve the corporation in situations not covered by an agreement?


Forced dissolutionThe tradeoff

• Forced dissolution can be made easier or harder

Liberal– Forced dissolution allowed (mandatory in UPA partnerships; default in RUPA partnerships)

– Judicial dissolution if MSHs’ interests are frustrated (Stuparich)

– Judicial dissolution if MSHs are oppressed (MBCA §14.30(2)(ii))

– Judicial dissolution only due to fraud/abuse (DGCL §284)

– Only voluntary dissolution allowed (majority vote)Restrictive

• Liberal dissolution sacrifices longevity and gives MSHs some leverage• On the other hand, it prevents/mitigates oppression


Forced dissolutionUPA

• Three triggers for dissolution:– By act of one or more partners [UPA §31(1)-(2)]; e.g.:

• At the termination of the partnership’s term or particular undertaking, or, if it has none, at the will of any partner

• Wrongful dissolution: In contravention of the agreement between the partners, by the express will of any partner at any time

– By operation of law [UPA §31(3)-(5)]• Due to death or bankruptcy of a partner, or due to bankruptcy or

unlawfulness of the partnership– By court order [UPA §31(6); §32]


Forced dissolutionContinuing operations (UPA)

• Archie, Beatrice & Chris are partners– Partnership agreement states that partnership will last for 10

years & that no partner may dissolve it before that time• Nonetheless, after only two years Archie announces that

he is dissolving the partnership– Can he do this?

• Beatrice & Chris now cease to be partners of each other, even though they desire to remain partners

– Can they do anything to continue the partnership?• Note UPA § 38(2)(b)


Forced dissolutionRUPA

• By voluntary dissociation of a partner, if the partnership is a partnership at will [§801(1)]

• By dissociation of a partner through operation of law, if within 90 days at least half of the remaining partners want to dissolve the partnership [§801(2)(i)]

• By the unanimous vote of all the partners [§801(2)(ii)]• By the terms of the partnership agreement [§801(2)(iii)-(3)]• By operation of law due to unlawfulness, but there are 90 days to

cure the illegality [§801(4)]• By court order [§801(5)-(6)]

– Partner’s suit: Economic purpose frustrated; not reasonably practicable to carry on the partnership business

– Transferee’s suit: if equitable and possible under the terms of the partnership agreement


Forced dissolutionRUPA vs. UPA

• Hypo: Anita is a partner in a law firm– Partnership agreement silent regarding partnership’s duration & right to

dissociate or dissolve– Anita informs the other partners she is dissociating from the law firm

• What happens to the partnership?– Note RUPA §601(1), 801(1)

• Can the partnership agreement opt out of this outcome?– Note RUPA §103(b)(6)-(8)

• Conclusion: Is a partner’s ability to dissolve different in RUPA than UPA?


Statutory dissolutionMBCA

• MBCA §14.30(2) – Dissolution may be ordered when:– Corporation is deadlocked

• BoD is deadlocked;• SH are unable to break deadlock; and• Irreparable injury or paralysis of the corporation will result from the

deadlock.– Shareholders are deadlocked

• SH are evenly divided• SH fail to elect successor directors in (at least) two consecutive annual

meetings– BoD or controller acts illegally, oppressively or fraudulently– Corporate assets are being misapplied or wasted


• North Carolina allows dissolution when it is “reasonably necessary for the protection of the rights and interests of the complaining [SH]”

• Meiselman: To dissolve a close corporation, sufficient to show that MSHs’ reasonable expectations are frustrated– MSH doesn’t need to demonstrate oppressive/fraudulent conduct by controller

• To be ‘reasonable’, expectations must -– be reasonable under the circumstances– be/reasonably should be known to controller– be central to MSH’s decision to join the venture

• Meiselman: In a close corporation it is a reasonable expectation to participate in the management of the business or be employed by it– But this is limited to expectations embodied in understandings, express or

implied, among the participants


Statutory dissolutionMeiselman v. Meiselman [NC 1983]

Statutory dissolutionStuparich [Cal. App. 2000]

• Siblings Malcolm Jr., Candi & Ann owned equal amounts of HFM’s non-voting shares, but Malcolm owned majority of the voting shares– HFM had a profitable mobile home park & an unprofitable furniture business– Malcolm, his wife & son worked in HFM (no claim of excessive salaries); Candi

& Ann didn’t– Candi & Ann wanted to separate the two parts of the business; Malcolm didn’t

• After their mother’s shares are distributed, C&A expect to gain control of the corporation, and call for a SH meeting to vote– They discover that their father (Malcolm Sr.) “clandestinely” sold his shares to

Malcolm Jr. for a low price (Malcolm Jr. now has 51.56% of voting shares)– C&A ask Malcolm to buy them out; Malcolm refuses

• At a family event at the home of the Malcolm Sr., Malcolm & Candi had an altercation that resulted in physical injuries to Candi– Fight may have been over the sisters’ unsuccessful attempt to impose an

involuntary conservatorship on their father© Amitai Aviram. All rights reserved.110

Statutory dissolutionStuparich v. Harbor Furniture Mfg.

• The sisters sue for dissolution– CA statute states that in close corporations (<35 SH) dissolution may be granted

if it is “reasonably necessary for the protection of the rights or interests of the complaining [SH]” (similar to NC statute in Meiselman)

• What are the sisters’ frustrated expectations?– Working for the company

• Under Meiselman, is fact that sisters didn’t work at HFM grounds for dissolution?– Disagreement about HFM’s strategy

• What principle can Jr. cite to justify his decision not to sell the furniture business?• Would the sisters’ argument be stronger if they wanted to keep the furniture

business & Malcolm Jr. wanted to sell it?– Expectation to control the company

• Does court recognize a reasonable expectation of the sisters to control the firm?– Acrimony & violence between SHs

• Does court allow dissolution of the corporation due to the violent incident between Malcolm Jr. & Cindi?


Process of dissolutionHypo

• Archie, Beatrice and Chris are partners in a grocery store– On January 1, they vote unanimously to dissolve the partnership– On January 2, Archie sells bread that is in the grocery store to customers

& Beatrice orders more bread from a bakery• Chris claims that these transactions do not bind the

partnership, because it has dissolved and so it no longer exists as a legal entity

• Is he right?– Note RUPA § 802(a), 804

• What effect does dissolution have? Why?


Process of dissolutionTerminology

• Winding-up– Liquidating the partnership’s assets/business– Settling the partnership’s debts/obligations– Dividing between the partners the remaining assets/money

• Termination: The partnership ceases to exist

• Dissolution: The process that begins with winding-up & ends in the termination of the partnership


Process of dissolutionDivision of profits & losses

• RUPA provides default rules on division of profits/loss• Division of profits

– Default rule: Profits divided equally between partners [RUPA §401(b)]– What if one partner contributed 90% of capital? Equal distribution– What if one partner contributed 90% of work? Equal distribution

• Division of losses– Default rule: Losses divided the same way as profits. [RUPA §401(b)]

• Partnership agreement can change this default– E.g., there need not be symmetry between division of profits and losses


Process of dissolutionCapital account

• Capital account: A running balance reflecting each partner’s ownership equity (see RUPA §401(a))

• Begins with the initial contribution– Not limited to money (also labor, assets & anything else partners agree on)

• Share of the profits is added• Share of losses & “draws” (distributions) is subtracted• Example

– April contributed $5,000 to ABC law firm in return for a 1/3 interest in the partnership

– Firm ended 1st year with a $3,000 loss (so April’s share of the loss was $1,000)– In 2nd year firm made a $9,000 profit (April’s share of that was $3,000)– At end of 2nd year, the partners made a draw of $4,500 (April received $1,500)– April’s capital account at end of 2nd year is: 5,000 - 1,000 + 3,000 – 1,500 = $5,500


Process of dissolutionDissolution as an incentive

• Most firms are worth more “alive” (as an operating business) than “dead” (assets sold separately)– For that reason, even in dissolution the business is often sold in one piece– Even if sold in one piece, some of firm’s value will be lost because -

• Dissolution forces to sell now, which weakens the seller’s bargaining position• Outsiders aren’t sure if firm has “skeletons in its closet”, so they discount the

price to account for risk of negative surprises– What is the likely outcome if a court orders dissolution due to frustrated

expectations/oppression?

• Judicial dissolution serves as an alternative to buy-out agreements, but also as an incentive to form buyout agreements– Analogy: parent threatens to take away a toy if siblings can’t agree how to

share it


business associations section 2b: firms – internal relationships prof. amitai aviram...

Documents

partnership rupa

direct control control

direct control rights

partnership profits

gp control rights

direct control economic

firms business

partnership accounts