iloyolastm.com/wp-content/uploads/2015/07/business-ass… · web viewfree transferability of...

Bus. Assoc. Outline Maynard Spring 05

I. IntroductionA. Overview- “Business” describes all types of profit-making activity.B. Principal Forms of Business Organization and Relevant Statutes

1. Basics of Agency Lawa. Sole Proprietorship- Business owned by a single individual. Personally liable on all business obligations b/c no legal separation btwn owner and business.b. Fundamental Agency Principles- §1.01 (Rst. of Agency) Agency is fiduciary relationship that arises when one person manifests assent to another person that the agent shall act on the principal’s behalf and subject to principal’s control, and the agent manifests assent or otherwise consent so to act.

- Consensual relationship, agent has to consent to act on principal’s behalf.- Agency law is largely common law- Being an owner is in complete odds with agency relationship

2. General Partnerships- Partnership is an association of 2 or more persons to carry on as co-owners a business for profit. (UPA §6)

- All of the partners have personal liability of the debts of the business- Partnership is a separate legal entity. Can be created inadvertently.- Concept of unlimited liability personal liability coupled with partner’s right to manage the business gives right to mutual agency relationship of partnership law.

3. Limited Partnership- LLP is a general partnership except that statute provides that partners have no personal liability for firm obligations that exceed assets of general partnership.

- Requires at least 1 general partner and 1 limited partner- General partner controls business decision, manages business but has unlimited liability.- Limited partner has limited liability, but still at risk for whatever he invested.

- If the limited partner takes part in control, then he runs the risk of losing his limited liability making him liable like his is a general partner. (UPA §7)

- Formalities need to be met to make a limited partner, need to fill out certificate with local authority so there are costs associated w/ limiting liability.

- Certification will identify limited partners- Can’t form limited partnership inadvertently

4. Limited Liability Company (LLC)- Provides limited liability for all participants, whether or not they are active in the management of the business and permits total flexibility in internal management.

- Benefits of incorporation without limitations and rules applied to corporations5. Corporations- Provides limited liability for all investors and participants. Separate entity from its shareholders. Corp. assets can be seized by corporate creditors and shares of stock can be seized by personal creditors.

- Need to file Articles w/ Sec. of State- Publicly held: Corp. has shares that are traded on public securities- Closely held: no shares traded on public securities- 3 tiers of every corporation Board of directors, shareholders, and officers

- Specialization of function

1


a. Board of Directors- Directs company- Have more information than shareholdersb. Shareholders- Owners, claim to residuals of corp., gets profit.- Elects the board.c. Officers- Do day-to-day stuff. True agents of corp.

6. Federal Securities Laws7. State Securities Law-Blue Sky Statutes- In order to issue shares, need to be authorized as a corporation. Administered by Dept. of Corp.

C. Overview of Basic Agency Principles1. Agency Relationship: Agent & Principals- Hierarchical: Principal has control over agent but agent doesn’t have control over principal- Consensual: Both principal and agent have to manifest asset to agency relationship2. Scope of Agent’s Authority: Actual Authority and Apparent Authority

a. Apparent Authority- §2.03 Power held by agent to affect a principal’s legal relationship w/ 3rd parties when a 3rd party reasonably believes the agent has authority to act on behalf of principal and that belief is traceable to principal’s manifestations.

- Based on reasonable belief of 3rd party. But 3rd party has to be reasonable.- Principal can put 3rd parties on notice, but will have transaction costs.

b. Actual Authority3. Doctrine of Respondent Superior- §2.04 An employer is liable for torts committed by employees while acting in the scope of employment.4. Risks and Control: Incentives and Monitoring- Amount of discretion being delegated is going to affect costs in getting information and monitoring

- Whenever you delegate any amount of discretion, have to monitor them. Costs of monitoring are part of creating the agency relationship. (Klein & Coffee)a. Incentives- Commissions- Share in profits but this makes them closer to an owner without actually making them an owner. If you make them an owner, dilutes owner’s interest.

5. Importance of Fiduciary Duty Law- Important constraint on conduct on participants in any business organization- Founded on duty of care and loyalty. Implicit element.

- Duty of care: Exercise good judgment- Duty of loyal: Agent will violate this duty if he puts his own interest in front of employer’s.

II. Choice of Business EntityA. General Partnership

1. Formation and Need to Written Agreement- Advantages of written agreement: avoid future disagreements; readily proved in court, while oral agreements involve factual controversy; focus on potential trouble spots; IRS benefits; could state what happens when one of the partners dies or retires.- In absence of written K, relationship will be governed by applicable state partnership statute, which might defeat expectations of partners.

2


- Where real estate is involved, should have written agreement to comply w/ statute of frauds.

2. Sharing of Profits and Losses- If there is no agreement, then profits are allocated equally. (UPA §18). Waivable.- Shares of losses are allocated according to profits.3. Inadvertent Partnerships- General partnerships can be formed inadvertently, no need to mention the word partnership, without ever having a writing.

- UPA becomes default rules- In order to change default rule, you need to have a contract, which involves transactions costs.

- Martin v. Peyton (1927): Martin is trying to reach investors of K&K as creditor of K&K, which is bankrupt. Operated as a partnership. P argues that Ds should be liable as general partners, b/c under default rule, would be liable for all debts of the partnership. Shared profits but had a min and a cap. Had veto power, had right to be informed. Had discretion to protect their investment. Court held that they weren’t general partners.

- 2 Pieces of general partnership: Carrying on business (manage) and co-owners4. Management of Partnership Business- Partner has right to carry on the business, unless partner has no actual authority and person with whom he is dealing knows that the partner has no authority.

- Reasonable for 3rd party to assume partner has authority. Need notice.5. Duties of Partners to Each Other- Partnership is a mutual general agency relationship. - Every partner is a fiduciary.- Meinhard v. Salmon (1928): Formed a partnership that was to last 20 yrs for a specific purpose. Salmon managed business. Salmon secreted made a lease for 80 yrs before lease ended without telling Salmon. Court held fiduciary duty requires disclosure b/c this opportunity belonged to partnership, not Salmon. Lease expansion was business opportunity.

- Obligation was to disclose, so they could negotiate, NOT to share.- Courts think that you can’t completely eliminate fiduciary duty, but there are 2 separate schools of though that say yes or no.- Business Opportunity: 2 Tests. Line of Business or Interest/Expectancy Test.

6. Dissolution of General Partnership- Defined as a change in legal relationship “caused by any partner ceasing to be associated in the carrying of the business.”

- Has nothing to do with disposition of assets or closing down or selling the business7. Law Firm Partnerships- Professions usually elect to be organized as LLPs.8. Limited Liability Partnerships (LLPs)- LLP election says that you are a general partnership, but LLP statute will insulate you from personal liability for your partner’s malpractice so long as you weren’t involved.

- Doesn’t protect you from liability of your own malpractice.- Doesn’t protect you against foreseeable liability. Ex. if truck driver hits someone.- Have to register your partnership by making a filing w/ sec. of state.

B. Fundamental Considerations in Choice of Entity Decision1. Limited Liability- Protects you from vicarious liability of your partner’s malpractice.2. Informality, Flexibility and Cost of Operation and Formation- Partnership: no rules about formalities- Corporations are governed by formalities

3


3. Continuity of Life- Corporations last forever.- Partnership – In the absence of agreement, partnership dissolves by operation of law at death of one of the partners, unless there is a survivorship clause.

- Partnership interest is property, his estate will keep his interest- Transferability of partnership: No person can become a member of a partnership without consent of all the partners. (§18g). But widow will be entitled to ½ of the value of the partnership. this is the default rule, unless you plan around it.- Partner can express will to get out, but might have to pay damages.a. Economic Continuity v. Legal Continuity- Death of a partner terminated and dissolves the partnership, unless agreement provides otherwise. Business might still continue as new partnership or sole proprietorship.- Death of a shareholder has no affect on corporation. No dissolution

4. Centralization of Management- Every partner is a fiduciary to other and all have equal rights.

- Could be subject to agreement (UPA §18). - Corporation is a hierarchy.5. Free Transferability of Interests- Transferability of partnership: No person can become a member of a partnership without consent of all of the parties. (§18g). Interests are not freely transferable.- For a shareholder to leave a corporation, he needs to find someone to buy his shares. This is usually not a problem for a publicly-held corporation, might be for a closely held one.

C. Corporation vs. Partnership: Reflecting on Certain Basic Federal Income Tax Considerations1. Income Tax v. Capital Gains Tax- Income is taxed at a higher rate than capital gains arising from the sale of capital assets.

- Capital assets are assets held for profit making or investment purposes.2. Entity Level Taxation v. Conduit or (Flow-Through) Taxation- All businesses calculate taxable income the same way by taking gross receipts, less business expenses. Tax treatment will depend on the form.

- Well established that corporations are separate entities, but not for partnerships.a. Entity Level Taxation- Corporations are subject to a problem known as “double taxation”

- Corporation will pay an entity level tax. (highest marginal tax rate is 34%)- After tax, Corp. will be left with net income which it could leave in company or distribute it out as dividends.

- If income is paid out as dividend, each individual shareholder will report that dividend as income and shareholder will be taxed at individual marginal rate.

- Dividends are considered ordinary income and not capital gains. Problem of double taxation.

b. Conduit or Flow-Through Taxation- Company is not taxed, but instead report to IRS its taxable income and how the company is going to divide that income btwn its partners. Partners then put amount on their individual tax returns and they are taxed at their own individual marginal rate.

- If the company doesn’t make any distributions, this might create a cash flow problem for partners.- Losses can be distributed to partners as well tax shelter.- Sole proprietorships also get flow-through system.- Subchapter S: Can make an election to get flow-through treatment if organized as a corporation and defined as a small business. (now 75 owners) Also, can’t have more than 1 class of stock.

4


3. Strategies to Minimize Incidence of “Double-Taxation” Burdena. Zeroing Out: Minimizing the amount of tax an entity will pay by distributing money as deductible expenses such as salary, rent and interest paid.b. Accumulation Bail Out: Accumulating earnings and then selling stock to buyer for amount that is accumulated in bank. Keep money that would have been taxed as dividends, which are ordinary income, now income will be computed as capital gains from sale of stock.

- Transmuting ordinary income into capital gains.- IRS now taxes excess amounts of accumulation.

c. 1986 Reforms: Highest individual marginal tax rate when down to 28%, while corporate rate stayed at 34%. Disincentive to disincorporate and become master-limited partnership. - In response, Gov’t said publicly traded limited partnership would be taxed as entity too.- Now corporate rate is still 34% but individual marginal rates have also increased.

D. Combination of Forms of Business Organization: Evolution of Modern Limited Partnership with Corporate General Partner- General partnership has unlimited liability for the debts of the limited partnership, but formed a corporation to be general partner. Hybrid.- Old ULPA §7: Limited partner loses protection of limited liability if they participate in control.- Revised UPLA §303(a): Still lose protection of limited liability if you participate in control of the business. But now liability only to persons that transact with limited partners with reasonable belief that the limited partner was a general partner.

- 2 Part Test: 1) 3rd party reliance AND 2) Exercise powers of general partner.- CA: Explicit that 3rd party has to have actual knowledge of actual control exercised by limited partner - Delaney v. Fidelity Lease Ltd. (1974): Fidelity was a limited partnership (at least 1 limited partner and 1 general partner) set up to buy fast-food franchise. 22 limited partners, 3 of whom are promoters, others are Drs. with the money. General partner was a corp. (Interlease) formed by promoters. Precursor to limited liability company. Interlease has unlimited liability for the general partnership, but owners of corp. have no liability. Landlord sued for breach of the lease, but limited partnership has no money. Everyone was on notice that general partner was corporation. Court dismissed case against 19 passive investors. 3 promoters exercised control but argued that they were just acting on behalf of the corporation. Court said this was legitimate. Fully disclose all material facts.- Mt. Vernon Sav. & Loan v. Partridge Assoc. (1987): Limited partnership owned and operated apts. MIW is a key investor. Borrowed money from Vernon who goes out of business and gov’t took over loan. Gov’t want to collect. American Housing is general partner but has now money. In order to hold MIW liable, they need to hold themselves out as acting as general partner to 3rd party. Court said no evidence of reliance on the part of Vernon that MIW was a general partner. Also no evidence that MIW exercised control so MIW is not liable. Important that MIW doesn’t mislead 3rd party.

1. Scope of Fiduciary Duty in Modern Limited Partnership2. IRS “Check the Box” Regulations- Basic principles:- Entity will be classified as a corporation for tax purposes if it is created under a statutes that “describes or refers to the entity as incorporated as a corporation, body corporate, or body politic” or as “a joint-stock company or joint stock association.” Such an entity must be taxed as a C corporation or and S corporation.- Entity not classified as a corporation and has at least 2 members can elect to be classified for tax purposes either as a corporation or as a partnership by making an election at the time it files its first tax return. If its entity does not formally elect to be taxed as a corporation it will be taxed as a partnership.- Entity that has only 1 member may elect to be taxed as a corporation or it will be taxed as “nothing” i.e. as though it has no separate existence from its owner.

5


- If entity elects to change its classification, it may not change its classification back within 5 years without permission of Commissioner

III. History of the Corporation: Development of Corporation Law in U.S. A. Race of the Lax: Competition for State Incorporation Business- Competition among states to attract business to incorporate.- Implications of separation of ownership from control

- Agency costs- Social costs, i.e. effect of local communities, environment, etc.

B. Pre-eminence and Influence of Delaware Law- Development of Delaware’s statute- Modern corporation code as enabling v. regulatory- Role of Delaware’s judiciary- Fiduciary duty law as constraint on managerial discretionC. Development of MBCA- Goals of MBCA

- Protect creditors, both voluntary and involuntary (tort liabilities)- Protect consumer, employees, environment and community

D. Internal Affairs Doctrine and California Corporations Code §2115- Internal affairs doctrine: Law of the state where you incorporate governs your internal affairs choice of law principle.- Cal. Code 2115: Quasi-foreign corporations are ones that are incorporated in other state, but has significant contacts with Cal. in terms of property, payroll and sales.

- If the average of property, payroll, and sales is more than 50% and more than ½ securities are held in Cal, then treated as a Cal. corp. Tries to override internal affairs doctrine.

- All publicly traded companies are exempt, affects small businesses.E. Theories of Corporateness- Separate Entity Theory: Corporations are separate entities.- Realist Theory: Entity is really the identity of its individual investors.- Contract Theory: Corporations Code is an “off the rack” set of rules.F. The Future- Intersection of state corporation law and federal securities law- Reforms of Sarbanes-Oxley Act of 2002

IV. Incorporation and its PitfallsA. Incorporation Procedures: Formation of a Corporation

1. Where to Incorporate- Local jurisdiction, plan to operate OR Delaware

- Disadvantage of incorporating in Delaware is that you can be sued there, expensive.- Small businesses generally incorporate locally.

- File articles with Sec. of State2. Filing- Cal. §169: “Filing” – Filed in the office.

- Cal. §110 – Sec. will file it if taken as a whole otherwise conforms to law.- Sec. has a lot of discretion big difference btwn Model Code & Ca.- Only a corp. once you receive your certificate.

- RMBCA §1.25: Duty of Sec. of Stated to determine it if is legit, i.e. that everything mandatory is included.

- §2.03(a): If it has all the requirements, Sec. of State will accept them for filing, effective date is when you dropped them off.- Corp. is in existence when the articles are filed if they are accepted.

6


3. Preparation of the Articles of Incorporationa. Name- Cal. §201(b): Can’t use a name which is likely to mislead the public or resembles so closely as tend to deceive.- MBCA § 4.01: Must have a corporate name distinguishable upon records of Sec. of State from corporate name of a corporation incorporated or authorized in that state.

- Easier standard. Limits discretion of Sec. of State.- Can reserve a name for up to 120 days under model act, check Cal. §201(c).- MBCA §4.03: Foreign companies have to register in order to protect their name from anyone else using it. Renew every year.b. Duration- Under Model Code and Cal., corporations automatically have perpetual duration unless you change it.c. Amendments- MBCA §10.03: In order to amend articles, need board and shareholder approval. Have to file amended articles with Sec. of State.d. General Purpose Clause- MBCA §3.01(a): Purpose is to engage in any lawful business unless a more limited purpose is set forth.- Cal. §202(b)(1)(i): Need to state specific statutory language. “The purpose of the corporation is to engage in lawful act or activity for which a corporation may be organized….”e. Powers- MBCA §2.02(c): Don’t need to set forth any powers.

- Most attorneys don’t want to because if you left something out, might be denied that power.

- Cal. §202: Articles shall not set forth powers except limitations- Corporations have the powers of a person.

- Might want to limit charitable powers if partners have different views.f. Initial Board Members- MCBA §2.02(b): Option to include names of initial board members. If they are named, they have to do certain things and if they are not named, then certain things have to happen. (a) lists requirements, (b) option.

- If not named, shareholders will have to get together and elect a board.e. Incorporators/Directors- MCBA §2.01: One or more persons may act as an incorporator.

- §1.40: Persons include foreign corporations.- Cal. §200(a): Foreign and domestic corporations can serve as incorporators.

g. Directors- MBCA §8.03: 1 or more individuals must be on board.

Individual means natural persons.- Cal. §212: Need at least 3 people to be on board.

- If you have 1 or 2 shareholders, then can have less can 3. h. Misc.- Cal. §202 (mandatory) v. §204 (optional)

- In Cal., need a registered agent and registered office.- Capitalization: Need to set max. of authorized shares, all of the shares will be of the same class unless you change it. No price requirement.

4. Post-Filing Procedures- Adopt by-laws which may contain any provision for managing business so long as the provision is not inconsistent with law or violated articles. (Cal. §207(b))

7


- By-laws are private documents. - If bylaw conflicted with articles, then articles would control.- If article conflicted with code, then code would control, unless code allows alteration.

- Initial board meetingsB. Corporation’s Purposes and Powers: The Decline of the Ultra Vires Doctrine- Company is either without the powers to do something or the power it wants to do is beyond the scope of its corporation.- MBCA §3.04 leaves open the possibility for ultra vires (1) action by shareholder against corporation to enjoin the act OR (2) proceeding by corporation directly, derivatively, or through legal representative against someone that is part of the company for violating articles or (3) attorney general. (Cal. §208 is similar)- 711 Kings Highway Corp. v. FIM’s Marine Repair Serv., Inc.: P leased D corp. premises that were to be used as a theater even though D was restricted to marine activities. L argues that it’s beyond narrow purpose clause, but court said that ultra vires didn’t apply so L loses.

- Investor should not rely on protection of a narrow purpose clause because would have to make a claim before 3rd party enters into K with corp., because 3rd party will make reliance arguments.

- Theodora Holding v. Henderson (1969): Ex-wife’s holding company sued corporation for making a lavish gift under ultra vires ($500,000). Court said that this gift was valid.

- Corporations have the power to make charitable organizations, but has to be reasonable.C. Premature Commencement of Business: Liability on Pre-Incorporation Agreements

1. Promoter’s Liability on Pre-Incorporation Contracts- Promoter is the person who takes the initiative in founding and organizing a business.- General rule: Promoter will have personal liability on these contracts unless there is an explicit statement about who will be liable.

- If the other party knows that the corporation is not formed yet, but nevertheless agrees to solely look to corporation and not to promoter for payment, promoter will NOT be personally liable.

- Burden of proof is on promoter.- These rules encourage promoters to disclose all material facts.

- Stanley How v. Boss: Boss signed a contract for architectural services on behalf of a corp. to be formed. Corp. was never formed. Court held Boss personally liable because promoter wasn’t clear that he would be liable.- Quaker Hill v. Parr: Nursery needed to sell some plants. Parr signs on behalf of company not yet formed, other party knows the company is not made yet. Parr said that nursery had assumed the risk since he let them know that they were looking to the unformed corp. for liability. Look at facts surrounding the way the order got signed.

2. Corporation’s Liability on Pre-Incorporation Contracts- A corp. is not automatically bound on pre-incorporation contracts. Requires adoption by board, which can be either express or implied. Promoter’s liability doesn’t end when there is only an adoption, promoter will be secondary obligor.

- Expressed adoption are usually in the board’s minutes are board resolution.- Promoter will not be liable only if there is a novation, which is an expressed statement usually made by the promoter with vendor when contract is made.

D. Defective Incorporation1. De Jure Corporations- By law, i.e. conforms w/ all mandatory requirements, requires that you have your certification

- Under Cal. §200(c) and §209, you are a de jure corporation when you file and you have your certification.

- Robertson v. Levy: Levy forms corp. to buy Robertson’s record business. Levy’s articles got bounced back but where later accepted. Levy allowed the transaction to close with a nonexistent company. He knew there was no corporation since his articles got bounced back. Trial court

8


decides that Levy is not liable because doesn’t want to give windfall to Robertson since Robertson was looking to corp. for payment. But appellate court reverses and hold Levy liable since he assumed to act as a corporation without authority to do so.

- Court decided this case under prior MBCA §139, “All persons who assume to act as a corporation without authority to do so shall be jointly and severally liable for all debts and liabilities incurred or arising as a result thereof.”

- Encouraged people to file articles and follow through.2. De Facto Corporations- Requires 1) valid statute under which to organize, 2) good faith effort to organize you business and 3) acting as a corporation, reflected in dealing.- Cantor v. Sunshine Greenery, Inc.: Signed lease as president of Sunshine Greenery. At that time, he thought that he had a corporation since had already filed his articles. Articles got sent to DMV and then got forwarded to Sec. of State. At the time he signed the lease, both D and landlord thought there was a corporation so D is not personally liable on the lease.

- §2.04 “All persons purporting to act, knowing there was no incorporation under this Act, are jointly and severally liable for all liabilities created while so acting.”

- Requires knowledge that there is no corporation so D also gets off.- States can go after a de facto corporation.

3. Corporations by Estoppel- Prevents 3rd party from denying corporate existence if the 3rd party looked to corporation for liable and acted as if there was a corporation. Also prevents corporation itself from denying corporate existence in order to avoid liability if acted as if there was a corporation.

- De facto makes a corporation good against the world, but estoppel only works against the person who acted as if or thought there was a corporation.

- Cranson v. IBM: Cranson bought typewriters from IBM. Both Cranson and IBM thought Cranson was a corporation. Cranson has signed the articles in May and his attorney told him they had been filed. In actuality, there was an oversight by the lawyer and articles were not filed until Nov. Court held that IBM was estopped from denying corporate existence since they look at corporation for liability and never to Cranson personally.

- Not de facto since Cranson didn’t do anything to comply, no good faith effort.- Frontier Refining Co. v. Kunkel’s Inc.: Kunkel is the promoter and Beach and Fairfield are passive investors. Kunkel was supposed to run business and open after he had incorporated. Kunkel fails to incorporate and ends up owning money to Frontier for gas because of a mistake Frontier’s driver makes. Court holds Beach and Fairfield are not personally liable since they were passive investors and never acted as if they were a corporation. Not de facto because they didn’t do anything. Could have been treated as an inadvertent partnership but would have given windfall to Frontier. Kunkel would have been personally liable as promoter, but he disappeared.

- A loan is usually accompanied by written contract and lenders gets interest only.- Sharing profits creates presumption for a partnership, but it can be rebutted.

F. Promoter’s Fiduciary Duties- Promoters must deal fairly with corp. Promoters can make a profit, but it cannot be a secret profit, i.e. disclosing all material facts to subsequent creditors.

- Under securities law, corporation needs to disclose dealings with promoters for 2 years or until note continues to be a material part of the capital structure.

- Frick v. Howard (1974): Promoter, Preston, is dealing with his own corp. Preston buys land from 3rd party for $240,000 and while in escrow, he forms his own corp. Sells land to his own corp. for $350,00 and company assumes mortgage and gives Preston a note for $110,000. Company cancels note and substitutes a $145,000 note. Promoter sells $145,000 note for $72,500 to Frick. Receiver represents creditors and Frick wants to foreclose on his security interest. Receiver objects to foreclosure by trying to show that there was something wrong in the note that causes the note to be invalid. Frick is not a bona fide creditor since he got the note at a deep discount.

9


V. “Piercing the Corporate Veil”: Risks of Corporateness Being Disregarded- Standard: Courts exercise their equitable power to look through the shield of limited liability by reasons of fraud, illegality, and fundamental fairness.

- Alter ego piercing: Corp. is formed but there is no respect for corporate formalities. Liability not because of the mere failure to respect formalities, but because of failure to follow corporate formalities that result in misleading of creditors.

- Mere failure to respect formalities is not enough, nor is the failure to put money in corp.- No court will pierce b/c owners/managers had subjective intent to protect themselves.

- Factors: 1) fraudulent misrepresentation by directors, 2) undercapitalization, 3) failure to observe corporate formalities, 4) payment by corp. of individual obligations, 5) use of corp. to promote fraud, injustice, or illegality. A. Common Law Doctrine

1. Contract Creditor Cases- Bartle v. Home Owners Assoc.: Cooperative owns land and Westerlea is its wholly owned subsidiary. Westerlea enters into contract with builders. Trade creditors sue parent b/c Westerlea has no assets. Piercing corporate veil of Westerlea to get to Coop, not to owners of Coop. Court wasn’t willing to pierce because there was no evidence of fundamental unfairness, misrepresentation or illegality. Maybe creditors were entitled to think that Westerlea would try and make a profit, but Westerlea disclosed everything so they were on notice.- Dewitt Trucking Brokers v. W. Ray Flemming Fruit Co.: Ray is 1 man corp. Plaintiff is trying to reach individual. His salary fluctuated in order to zero out assets of corp. Dewitt is getting screwed since Ray is siphoning off corp.’s assets. Ray had also personally promised that Dewitt would get paid. Alter ego piercing theory is at play here, but court pierces b/c Ray lied and defrauded Dewitt.2. Tort Creditor Cases- There can be a distinction btwn creditors who dealt with company on a voluntary basis and what they knew or didn’t know becomes very important in deciding.- Arrow Bar: Neuroths put 5K in cash and loan $145K that was personally guarantee to start a bar. Bartender serves alcohol to driver who hits plaintiff. Bartender and driver have no assets so plaintiff tries to pierce the corporate veil of the bar to reach Neuroths. Court didn’t see any reason to pierce the corporate veil. They were undercapitalized but didn’t affect P’s dealings.3. Parent-Subsidiary Cases- Radaszewski v. Telecom Corp.: P was seriously injured by truck driven by Contrux employee, Contrux is a wholly-owned subsidiary of Telecom. P is trying to pierce Contrux’s veil in order to reach Telecom. In deciding whether to pierce, court looks at whether the sole shareholder of Contrux put enough money into Contrux. Control is important since we are dealing with a parent-subsidiary relationship. Court looks at 1) complete control, 2) control must have been used by D to commit fraud or wrongdoing, and 3) Aforesaid control and breach of duty must proximately cause the injury to injustice complained of. Standard is still fraud, illegality and fundamental unfairness. Telecom was very aggressive in relying in debt but did buy insurance, just so happened that insurer went out of business. Court decides that Telecom is not liable to this creditor since the undercapitalization was not relevant to P’s claim.- Walkovzky v. Carlton: P was injured by taxi. Carlton owned 10 cabs as their own corps. They were an “enterprise entity”, P could go after the assets of the sibling corps. No real money. Fundamental unfairness would be that Carlton didn’t have enough insurance. Court said that the amt. needed was for the legislature to decide.- Fletcher v. Atex: Injuries occurred in NY, but Atex is a Delaware corp. Plaintiff had to show 1) that the parent and subsidiary operated as a single economic entity and 2) overall element of injustice or unfairness. P failed to show that Kodak and Atex operated as a single economic unit.

10


B. Cases that Masquerade as PCV cases- Stark v. Fleming (1960): Appellant placed her assets – a farm and a duplex house – in a corporation and drew $400 per month for salary. Corporation was set up to qualify appellant in a short time for social security. Court said that this was ok but need to determine reasonable salary. She was trying to build up her SS account. She probably started late. State was trying to disallow the SS benefits. - Roccograndi v. Unemployment Compensation Board (1962): Appellants are all members of a family who are involved in the wrecking business together. All 3 are officers. During periods of insufficient work, they would hold a meeting and determine who would be “laid off”. Bureau of employment denied claims b/c said that they were self-employed. Court affirmed because they had sufficient control to lay themselves off.

- These are not piercing cases since the courts were looking at statutes (entitled to SS if she works, unemployment is meant to relieve labor) and not with avoiding fraud, illegality and fundamental unfairness. Court looks at who is being protected by statute.

C. Equitable Subordination Doctrine- Eliminating the priority of a creditor’s claim over another creditor, doesn’t go to merits of claim.- Pepper v. Litton: Litton was owner/manager and sole shareholder of Dixie. He let his salaries accrue. Pepper is not getting paid his royalties. Pepper sues Dixie. Litton then sues Dixie for his back wages, which causes his company to confess judgment. Litton becomes judgment creditor and Dixie files for bankruptcy. Bankruptcy court decides to subordinate Litton’s claim, i.e. eliminates Litton’s priority over Pepper. Pepper can’t sue Litton for his personal assets.

VI. Financial Structure of the Closely Held Corporation- 2 Ways to get more capital: securities (debt & equity) or run a profit.

A. Types of Securities: Debt and Equity1. Debt- Associated with the idea of borrowing, must be repaid at some point and interest on the amount borrowed must be paid periodically. Repayment on principal and interest is not contingent on success of business.2. Equity- “Ownership”. Value of an owner’s equity in a piece of property equals the market value of the property minus the market value of debts that are liens against the property.

B. Different Types of Equity Securities- Rights, preferences and privileges of every class of stock have to be described in articles.- Liquidity: Refers to ability of shareholder to sell their stock.

-Stock is freely transferable unless there are restrictions imposed on the right to transferred.- Publicly traded shares are liquid, while shares in AB Furniture are not.

- “Authorized shares”: Maximum number corporation can sell.- Statement of authorized capital must be set forth in Articles.

- “Issued shares”: Number actually sold- Can’t issue more than authorized, but can issue less.

- “Outstanding shares”: Numbers sold and not reacquired.1. Attributes of Common Stock- Residual lawyer of ownership, right to receive dividends contingent upon profits.- Common stock usually has financial rights (dividends, distributions in liquidation and redemption) and voting rights.

- Financial rights allows investors to get a return- Voting rights allows investors to monitor their investment and gives right of control

2. Preferred Stock: Use of Multiple Classes of Stock- Class of shares with right that are preferential to those assigned to common shares, but limited in some way. Usually (not always) not voting.

- Preferred has rights that have to be honored before common. - Ex. Could have dividend rights, i.e. have to get paid dividends before common

11


- Creditors always have priority over stockholders both common and preferred.a. Changes in Rights and Privileges of a Class of Outstanding Preferred Stock- Need to amend Articles.- Terms of an outstanding class of preferred stock cannot be amended without first obtaining the preferred stockholders’ consent to such changes (usually by a majority vote of such class) – even if such shares are otherwise non-voting.

- Need approval of affected class – gives rights to class voting.3. Shareholder Distributions- Any payment to shareholder.

a. Dividends- Distribution to shareholders from current or retained earnings.

- Right to receive dividends is at the discretion of the board.b. Distributions in Liquidation- Payments in liquidation or dissolution out of capital.c. Distributions in Redemptions- Where company repurchases it shares.

4. Different Type of Preferences- Preferences are required in Articles.

a. Dividend Preferencesi. Cumulative- If a preferred dividend is not paid in any year, it accumulates and must be paid (along with the following years’ unpaid cumulative dividends) before any dividends may be paid to common stock.ii. Partially Cumulative- In any given year if a dividend isn’t paid, cumulative to the extent of earnings and profits, and noncumulative with respect to any excess dividend preferences.iii. Non-Cumulative- Not carried over from 1 year to the next, if not dividend is declared during that year, the preferred shareholder loses the right to receive the dividend for that year.

- This is the default rule.b. Preferences on Liquidation or Dissolution- When a corp. is dissolved and all creditors have been paid (secured and unsecured), then preferred shareholders have priority over common shares to extent of their preference in any further distribution of any remaining assets.

- Usually a fixed amount.- After payment of liquidation preferences, distribute any funds to common stock pro rata, since they are the residual owners.c. Voting Rights- Preferred stock is usually nonvoting, but could bargain for them at the time purchase. Would have to be in Articles, which represents shareholders’ contract w/ corp.- Often triggered by consecutive defaults on dividends rights of preferred stock.

- Voting rights get triggered in publicly-traded stock usually when 4 quarterly cycles pass in default.- Gives shareholders some right to monitor/control.

d. Participating vs. Non-participating- Participating preferred stock is a hybrid security, having some features of common stock like the right to participate in further dividend distributions made by the company, as well as having some preferences over common stock.

- has rights to participate in further distributions, but gets paid first- If not spelled out in Articles, then default is non-participating.

12


5. Classes and Series of Shares- Ex. Preferred stock is a class, but might have different series with different rights/privileges.6. Blank Check Preferred Stock- Allows Board flexibility to establish financial terms of a particular class (or series) of shares at time of issuance.- Authorizes Board to fix preferences at time of sale instead of having to amend Articles all the time. Need to file a certification of determination and then list rights and privileges.7. Redemption and Conversion of Rights of Preferred Stock

a. Redeemable Preferred Stocki. At Option of Corporation – Callable- Corporation has power to buy back shares at option of the Board usually callable at price fixed in Articles (redemption price) and subject to any other terms.

- Shareholder has no choice and if shareholder refuses, corp. deposits redemption price in bank account and refuses to recognize that the shares are outstanding or that shareholder has any rights.- If company repurchases shares, they are no longer outstanding and will be considered “treasury stock.”

- Generally, shares that are redeemed or repurchased can be reissued.

ii. At Option of Holder- Shares that are redeemable at option of stockholder are often considered a hybrid security b/c looks like a demand note.

- Allows investor to get money back.- Ok in Cal.

b. Convertible Preferred Stock - Convertibility can be given to both equity and debt holders.- Allows holder to convert their holdings into some other class of stock, usually.c. Forced Conversion of Board’s Call for Redemption- Board assumes that preferred stockholder will convert if trading price of common stock exceeds redemption price of preferred stock at time Board makes a call for redemption.

- Corp. can retain cash that would have been used to redeem stock.- Need to make sure there are enough authorized shares for the conversion.

8. Redeemable and Callable Common Stock- In most states, common stock cannot be made convertible or redeemable b/c supposed to be residual level of ownership.- Model Act (minority view) – Allows you to do anything you want with common stock.- Cal. §402(c): Prohibits use of redeemable common stock.9. Upstream Conversions- Right to convert common shares into preferred stock, or to convert either common or preferred into debt securities and interests.- Most state prohibit upstream conversion.- Model Act follows “freedom of contract” approach, which allows people to do anything.

C. Issuance of Shares1. Subscription Agreements- Historically, persons agreed to purchase a specified number of shares contingent upon a specified amount of capital being raised.

- Actual formation would occur only if a sufficient number of preincorporation subscriptions have been obtained.

2. Number of Authorized Shares: “Dilution”- Articles should authorize at least the number corp. wants to issue.- If you authorize more than you want to sell, can raise capital later without amending Articles.

13


a. Disparate Contributions of Founding Shareholders- When founding shareholders are not paying for the shares with the same consideration.

- Any number of shares can be issued at any price so long as combination totals aggregate consideration.- Raises problem of equity dilution on premature liquidation, since assets would be liquidated equally.

b. Valuation of Non-cash Consideration- Board of directors and shareholders will valuate consideration.c. Concept of “Earn-Outs”- Shareholder’s interest will not fully vest until they “earn” them by working. Length will be negotiated.e. Eligible v. Ineligible Forms of Consideration- Valid consideration is cash, property (tangible or intangible), services already rendered.

- Future services are not a valid form of consideration in CA and under old Model Act. There is only value to company to extent that the service has already been rendered.

- Protects creditors. - Cancellations of indebtedness is legal consideration both in Cal. and Model Act.- Under MBCA, promissory note is not adequate consideration.- In Ca, promissory note needs to be adequately secured to be valid consideration.- Revised Model Act has abolished distinctions.

3. Concept of “Par Value”- Arbitrary dollar value assigned to share of stock which, after being assigned, represents the minimum amount for which each shares may be sold.

- Gave shareholders assurance that every stock paid in at least the par value, needed this in the past b/c didn’t have a market. Protected investors against dilution.- Par value relates only to original issuances of shares and has no application to subsequent transaction in shares themselves, which may be bought or sold to any mutually acceptable price.- Cal. has eliminated par value. Just have consideration and earnings, no stated capital.- MBCA either has eliminated par value entirely or made optional concept of par value. a. Balance Sheet Accounts- Shareholder’s Equity = Assets – Liabilities- Balance Sheet

ASSETS LIABILITIES and CAPITAL ACCOUNTS

Cash _________________ Liabilities $ 0.00

Shareholder’s EQUITY:Capital Accounts: Stated Capital _______________ Capital Surplus ______________ Retained Earnings____________

i. Stated Capital- Rule: Always place par value in stated capital, any excess go into capital surplus.

- If there is no par value, board may decide to allocate a portion to capital surplus. Discretion belongs to board.

ii. Capital Surplus- Excess capital

14


iii. Retained Earnings b. Watered Stock Liability- Shares issued for property worth less than par value.- Watered stock liability protects creditors.

i. Common Law- Shareholder is liable to creditors to extent his stock has not been paid for.

- Shareholders’ initial capital investment is what protects their personal assets from further liability in corporate enterprise.

1) Trust fund theory – par value is held in trust for creditors.2) Applied contract theory – Statutory duty to pay for shares issued.3) Holding (fraud theory) – Lying on balance sheet- Hospes v. Northwestern Mfg. & Car. Co.: Court held that under some circumstances the recipients of watered shares should be required to pay in the par value even though they never agreed to do so.ii. Modern View- Shareholders have a statutory duty to pay for shares that were issued to them.- Hanewald v. Bryan’s Inc.: Stated par value was $1000 per stock. Issued 10 shares for $100K. Paid for stock with $10K and they took back a note on which corp. was liable. Court holds them personally liable for amount up to $100K.

4. Legal Restrictions on Dividends and Other Shareholder Distributionsa. MBCA- Under legal capital rules, can distribute everything but stated capital.

- Can’t render the company insolvent, can take all of retained earnings.- Can make distributions out of capital surplus as well, but need to disclose to shareholders, both the assets and liabilities.

Cal. and RMCBA have abandoned this approach.b. Cal. and RMBCA- Insolvency Test: Can’t make a distribution if it would render the company insolvent.

- Insolvent means that you can’t pay bills when they come due OR balances sheet test (liabilities exceed assets).

D. Use of Debt Financing- Debt is not set forth in Articles, just a power of a corp.- Amount of debt depends on lender.- Corporation’s power to take on debt can be limited in Articles, in which case there might be a ultra vires problem that arises if they over the power.

1. Different Types of Debt Securitiesa. Bond- Secured debt, usually by lien or mortgage on corporate property. Has collateral.b. Debenture- Unsecured corporate obligation.c. Revisiting the Concept of “Hybrid Securities”

2. Concept of Leverage- Using other people’s money to make money for yourself. Favorable to borrower when borrower is able to earn more on borrowed capital than cost of borrowing.

- Ex. Borrow money to buy property, if it appreciates in value then I can sell and pay off mortgage and all debt. If pay out all your debts, can keep all the proceeds.- Risk is that the price might not go up and you will be stuck with all this debt. Also, still need to pay carrying cost.a. Loans made by Third Parties (“outside” debt)- Debt owed to 3rd parties.

15


b. Loans made by Shareholders (“inside” debt)- Interest payments are deductible to corp., while distributions are paid out after taxes- Obre v. Alban Tractor: O capitalized a corporation with N partly by $ 35,548.10 unsecured promissory note. When the corp. went into insolvency, court held that the corp. was not undercapitalized b/c treated O’s preferred stock as an equity investment. Court held that this was a valid debt since there was no showing of undercapitalization, fraud, misrepresentation or estoppel. Also, the loan could have been easily discovered by creditors by looking at public state tax filing, requesting a financial statement or by obtaining a credit report. So court does not subordinate O’s loan to other creditors.

3. Tax Advantages of Debt- Interest payments are deductible to borrower whereas dividends payments on equity securities are not. Also, reduces double taxation problem.

a. Debt-Equity Ratio- Ratio btwn corp.’s liabilities and shareholder equity.

- IRS suggests that you keep a debt/equity ratio of 10/1.b. “Thin” Capitalization”- Corp. with high debt/equity ratio.

E. Use of Limited Liability Company (LLC as an Alternative to Incorporation)- Hybrid entity: Offers limited liability and flow-through taxation.- No shares.- Can do whatever you want with financial rights and management.

- Member-management: Default rules start to look like a partnership unless there are changes in the agreement.- Manager-managed: Similar to a corp.

- Transaction costs: Have to file articles of organization with Sec. of State, will get a certificate, have to set out rights and privileges of members in operating agreement.- Court will decide issues based on whether LLC look more like a corporation or partnership.F. Public OfferingsG. Doctrine of Preemptive Rights

1. Traditional Common Law Approach- Stockholder has an inherent right to a proportionate share of new stock in order to protect voting control. Preemptive rights was a property right incidental to share ownership.- Stokes v. Continental Trust Co.: Bank had 5,000 shares authorized and outstanding. Par value as $100. P owned 221 shares. Blair company wanted to buy $5,000 shares at $450. Have to amend articles. P wants to purchase a proportional share at par value of the new issuance in order to protect his proportionate voting control. Court said that he had this right.- Both MBCA and Cal. have an opt-in clause, i.e. no preemptive rights unless stated in Articles.2. Modern Doctrine of Quasi-Preemptive Rights- When issuing price is shown to be far below book value in a close corporation AND where remaining shareholders benefits, then there is a case for judicial intervention.

- Claim is based on fiduciary duty.- Katzowitz v. Sidler : P is a director and stockholder of a close corporation which he owns and runs with 2 other people, Sidler and Lasker. The 2 other directors wanted to disassociate themselves from P. Increased shares of common stock and gave P an chance to buy 25 shares substantially under value. P waived his right. When the corporation was dissolved, P received only $3,147.59 and the other shareholders received $18,885.52 b/c of the other shares they purchased. (Freeze-out). Court held that all the stockholders should be treated equitably since there was no business justification for the disparity in price.3. “Freeze-out” Transaction- Decreasing proportional ownership of shareholder.

16


VII. Management and Control of the Closely Held Corporation: The Respective Role of Shareholders, Directors and Officers

A. The Respective Role of Shareholders and Directors1. Shareholder Agreements and the Rule of McQuade- Shareholder agreements are void as against public policy because it violates corporate norm.

- Corporate norm: Board of directors manages business affairs and has to be able to act in the best interests of the corporation. (Model Act §801 & Ca.)

- McQuade v. Stoneham: Stoneham was the majority holder and made an contract with McQuade. There is a falling out and Stoneham “squeezes him out” and P sues for breach of contract. Court holds that the agreement was void b/c violated corporate norm2. Exceptions to the Rule in McQuade- If shareholders all agree and agreement only slightly impinges on board’s discretion with no damages to anyone, then court will still uphold agreement.

- Other shareholders depend on the Board’s discretion to act in company’s best interests.- Clark v. Dodge: Dodge is 75% owner and Clark is 25%. Dodge wants his secret formula and in exchange Dodge promises Clark that he can’t lose his job. Clark loses his job. Court holds that the agreement was valid since all the shareholders were a party to the agreement and doesn’t affect other shareholders.- Long Park v. Trenton-New Brunkswick Theaters Co.: All shareholder agree to give 1 shareholder “full authority and power to supervise and direct operation and management” of certain theaters. Court held that this contract was not valid since it deprived the Board of all power. Went too far.

3. Modern Judicial View of Shareholder Agreements in Closely Held Corp.- For contract to be valid, need unanimous agreement and provision has to be only a slight impingement.- Galler v. Galler: Drug company is owned 50/50 btwn 2 brothers. Estate is mostly made up of stock and wanted to make sure wife was ok after he died. After he dies, his brother doesn’t want enforce the agreement and argues that it violated public policy. Court held that agreement to amend bylaws was ok b/c shareholders have the right to amend bylaws. Also agreement to vote shares a certain way doesn’t violate public policy b/c doesn’t affect board’s discretion. They also agreed that a certain amt. of dividends would be paid as long as a certain amount of capital surplus was left. Violates McQuade b/c it is the Board’s job to declare dividends but court said that it was only a slight impingement since not overreaching. Also, agreed to put restrictions on transferability of stock. Doesn’t violate McQuade since shares are personal property and doesn’t involve Board. Court said that the provision that provided for continuation of salary was void b/c Board has decision to decide salary. Agreement was supposed to end at wife’s death since didn’t want to have a dead-hand problem.

- Dead hand provisions where you try and run company after death are usually void.4. Modern Legislative Approach and the Close Corp. Election- Under Cal. §300(b): No shareholders agreement in a closed corporation shall be invalid on the ground that it interferes with the discretion of the board.

- Cal. §158: Closed corporation is one that has a provision that says that shares will not be held by more than 35 persons and you need to make this election in your Articles by saying “this is a close corporation.” - Cal. §186: Shareholders agreement is an agreement among ALL shareholders.- Disadvantages as a C-Corp: Can’t have more than 1 class of stock, can’t have corp. as a shareholder, entity level tax, etc.

- Under Model Act §7.32, there is no limitation on # of shareholders, but can’t be publicly traded and still needs to be unanimous.- Zion v. Kurtz: Kurtz needed money and sold shares to Zion. Had an agreement that can’t make agreements unilaterally. Kurtz entered into 2 agreement without Zion’s consent and he

17


sues. Contract btwn corp. and 3rd party is not invalidated but Zion can get damages. Didn’t say it was a closed corp. in Articles, but court orders the Articles amended and Kurtz is estopped from denying it is a closed corp.

- Dissents follows statutory language so shouldn’t be enforced.- Delaware 13 years later follows dissent so limited by statute.

5. Shareholder Monitoring of Directors and Business Affairs of Corp.- Under CL, ability to remove directors is inherent power of shareholders but only for cause, i.e. serious misconduct, gross abuse of authority.- 2 Ways to remove directors. (Cal. §303 & §304)

1) Call a special meeting and vote them out.2) Can file a lawsuit with shareholders holding at least 10% to remove for cause if there is “fraudulent or dishonest conduct, or gross abuse of authority or discretion, with respect to corporation.”

- Have to vote in order to remove them without cause.- Special meeting can be called by board, any person authorized in company’s articles/bylaws or any shareholder/shareholders who own at least 10% of voting stock. (Cal. & Model Act)

- Can only call the meeting for a proper shareholder purpose and have to include in notice exactly what will be voted on.

- Ex. Can’t make a motion to remove Pres., since Board elects Board.- Cal. §305: Vacancies created by removal may be filled only by approval of shareholders unless Articles or bylaws state otherwise. Vacancies created by death or resignation can be filled by board OR shareholders.

B. Shareholder Voting and Shareholder Pooling1. Election Inspectors and Other Mechanics of Shareholder Election of Directors

a. Notice- Need to give notice for both a special and annual meeting.

- For annual meeting, need to state what will be talked about, but can talk about anything that is the proper subject for shareholders.- For special meeting, need to state things that will be voted on, and can’t talk about anything else.

- Notice can be waived either expressly or impliedly. (Cal. §601(e), MBCA §7.06)

- If you show up, then you have impliedly waived notice.b. Quorum- General rule is that a majority of shares entitled to vote have to present. (MBCA §7.26, Cal. §7.06)c. Proxy- Shareholder can direct proxy holder to vote shares a certain way or can also give proxy holder the discretion to decide.

- MBCA §7.22(a): Signing form (writing) or electronic transmission.- Legal relationship btwn proxy and shareholder – agency. Shareholder is the principal and proxy is the agent.- Cal. §705(a), proxy is good for 11 months b/c directors are elected annually.

- Proxies are revocable, can make it irrevocable but requires certain parameters.d. Registered Owner/Record Owner v. Beneficial Owner- Owner on record date has the right to vote, but beneficial owner is the person with their financial rights at stake.

- Beneficial owner might want to get a proxy so they can vote the shares.- Meeting date can’t be more than 60 days after record date.

18


e. Election Inspectors- Election tabulates vote and he has discretion on which votes to accept. Discretion is reviewable but only after inspector has certified his results.- Salgo v. Mathews: Electro Dynamics is having board election. Pioneer is a company who has stock in Electro. Shepard is the sole shareholder of Pioneer’s stock and he is in bankruptcy. Receiver has been installed at Pioneer to preserve its assets. This case is about trying to figure out who has the right to vote Pioneer’s shares. Mathews, insurgent shareholder, presents court order directing receiver to vote shares. Election inspector doesn’t accept it and Mathews challenges it before inspector certified results. Court wants to give election inspectors discretion to make preliminary review.

2. Shareholder Voting- 3 Formulations for shareholders to approve an action.

- RMBCA §7.25: Majority of shares actually voted.- Abstentions doesn’t affect outcome.

- Old MBCA: Majority of shares present.- Abstentions affect outcome.

- Cal. §602(a): 2 part test. Majority of shares present and voting AND majority of required quorum.

- Abstentions are treated like no votes.3. Cumulative Voting vs. Straight Voting- Directors are elected either through cumulative voting and straight voting.- Cumulative voting: Number of total votes that each shareholder may cast is first computed (# of shares x # of directors) and each shareholder is permitted to distribute these votes as he sees fit over 1 or more of the candidates.- Straight voting – Shareholders vote their total number of shares for each candidate

- Cumulative voting increases minority participation on board.- To figure out whether you have enough votes to get someone elected use formula (S/D+1) + 1

S = # of shares that will actually vote, not number outstanding.D = # of directors to be elected

- CA has cumulative voting as mandatory. Directors must stand for election very 1 year. However, §301.5 says a listed corporation may divide board into 2 or 3 classes to serve for 2 or 3 years, so can eliminate cumulative voting.

- Listed corporation: Stock is traded on NY stock exchange, American or NASDAQ.- To prevent majority shareholders from just voting minority stock holder out. Cal. §303(a) provides that NO director may be removed unless the entire board is being removed, when the votes cast against removal would be sufficient to elect the director if voted cumulatively at an election with the same total number of votes were cast.- Board can create committees to decrease the effectiveness of a certain board member. Committees can do a lot of things, but cannot authorize distribution, fill vacancies, nor amend the bylaws. (RMBCA §8.25(a), Cal. §311 is similar but a little broader).

- Humphreys v. Winous co. (1956): Cumulative voting statutes guarantees shareholders right to cumulative voting, but not necessarily to the effectiveness of that voting to elect minority representation.

4. Shareholder Pooling Agreements and the Use of Irrevocable Proxies- Shareholders can pool their votes together and agree on how to vote their shares. Such an agreement is valid and does not violate public policy. If a party goes against the agreement, remedy is to not count the votes of the shareholder that didn’t go along with agreement.

- MBCA §7.31: 2 or more shareholders may provide for the manner in which they will vote their shares by signing an agreement for that purpose. Enforceable.

19


- Ringling Bros v. Ringling (1947): 7 directors were elected through cumulative voting. North had 370, Edith had 315 and Aubrey had 315. Edith and Aubrey had entered into a pooling agreement. Their attorney would act as an arbitrator if they had disagreed on who to vote. Attorney told them to vote a certain way and Aubrey’s husband, who had brought a proxy giving him the power to vote any way he wanted, went against the agreement. So instead of getting 5 members of the board, they only got 4. Still a majority but Edith sues. Supreme Court held that Aubrey’s votes should not count at all. Control shifts from Edith and Audrey to North.

- In order to avoid this, shareholder of record should grant irrevocable proxy to arbitrator or each other. If shareholder of record shows up, then they can vote.

- Generally, proxies are revocable. In order to make it irrevocable, has to say it on its face and needs to be couple with an interest in the company, could be a pooling agreement. We want to make sure the proxy will vote in the best interest of the company.

5. Use of Voting Trusts- Shareholders transfer legal title to their shares to a voting trustee, but keeps financial rights. Trustee has exclusive voting power over transferred shares and will give voting trust certificates to beneficiaries. Can’t be for more than 10 yrs, which can be renewed. Requires written agreement. However, this gives a lot of power away to trustee.6. Action by Written Consent, i.e. Without a Meeting - Shareholder can take action by signing a paper consenting to action.

- Model Act requires everyone to agree.- Cal. requires absolute majority.

- Valid if there is consent in writing by holder of not less than minimum number of shares that it would be necessary to take that action at a meeting, where all the shareholders are present. (Ex. 1000 shares, need consent of 501 shares).

7. Use of Classified Stock to Elect Directors- Valid to divide directors on board and designate seats to be elected by a certain class.

- Lehrman v. Cohen (Del. 1966): Cohens have AC stock and Lehrmans have AL stock. AL shares elect 2 directors and AC shares elect 2 directors, identical financial interests. Everyone agrees later to create 5th director to avoid deadlock, so they create a 3rd stock and give it to D. D sits on the board and never has to do anything for 14 yrs. D then resigns and has right to nominate his successor. Then Lehrman’s sues to get D out by trying to show that AD stock is not valid. Court said AD stock was valid, not a de facto voting trust (10 yrs) since there was no separation of ownership and rights, only dilution. They had agreed to dilution. Also, didn’t matter that AD stock only had right to vote.

8. Use of Stock Transfer Restrictions- Restrictions have to be reasonable and need to be conspicuously noted on face of agreement.

- Ling Co. v. Trinity Sav. & Loan (1972): Ling & Co. is a broker deal and has a seat on NY stock exchange. Bowman uses his shares as collateral. Bank want to foreclose and Ling objects. Restrictions required approval from NY stock exchange and prevent sale without 1st offering it to corp. or other holders of the same stock (right of 1st refusal). Court said the restrictions were reasonable.

- If it wasn’t clear on note, but bank had actually notice, might still enforceable.9. Use of Buy-Sell Agreements- Buy-sells enable shareholders to require either the corp. or their fellow shareholders to buy out their equity interest in the corp. at some mutually agreed upon price, upon the occurrence of some mutually agreed upon triggering event. Binding obligation.- Right of 1st Refusal requires option to be given to buy shares at occurrence. Not binding.

- What events usually trigger a buy-sell agreement? Death, divorce, impulse, disability.

20


- Should consider buy-sell agreement at outset since this is when all parties have an equal interest in setting fairest terms possible.

C. Problems of Dissension and Deadlock1. Willful Inattendance- As a matter of public policy, director cannot willfully stay way from a meeting to prevent any action by board due to lack of quorum. Don’t want to paralyze board. Can’t complain later.

- Gearing v. Kelly (1962): Meachum (50% owner) willfully stayed away from board meeting to prevent quorum. 4 directors, 1 resigned so needed 3 for quorum. 2 directors that met voted in new director anyway. Court said that even though there was a failure under rules, Meachum breached her fiduciary duty b/c she caused a lack of quorum so she is estopped from challenging election of the new director.

- Directors cannot willfully abstain from their responsibilities.- In effect, transformed her 50% interest into a minority interest.- Note when there is a vacancy on board created by death or designation, either the shareholders or directors can fill it.

2. Dissolution- MBCA §14.30: Shareholder can file a petition for dissolution, but has to show grounds for dissolution. A court in its discretion may order involuntary dissolution if the shareholder shows board deadlock, shareholder deadlock, or misconduct. Misconduct includes oppression, illegality or fraudulent behavior by those in control.

- Need to have 2 consecutive years of deadlock.- Discretionary.- In Re Radom & Neirdoff, Inc. (NY, 1954): After death of respondent’s husband, she got his 50% interest in a successful lithographing business run with her brother. She and her brother can’t get along. He runs it and doesn’t really want her to work. She doesn’t sign his paychecks. He files for dissolution but court doesn’t grant it since the business is doing well and Radom won’t run it into the ground since not in his best interest. He originally offered to buy her out for 1 yrs income and she also offered to allow 3rd party to act as tie-breaker. She will probably sell if he offers her more.

D. Modern Remedies of Oppression, Dissension, and Deadlock1. Evolving Standard of “Oppression” and Emerging Remedy of Court Ordered Buyout- In lieu of dissolution, court can order a buy-out. Courts are split on whether they need a statute to authorize this or if they can act in equity.2. Use of Provisional Directors- Under Abreu, provisional directors don’t have to be impartial so long as they act in the best interests of the company.- In CA, provisional directors cannot have any family or economic relationship with shareholder.

E. Action by Directors and Authority Officers1. Meeting Requirement for Board Action- For board to take action, requires a meeting unless there is written consent. (RMBCA §8.20).- Meeting requires property notice unless it is a regular meeting stated in Articles.

- Model Act requires 2 days of notice for special meeting.- CA requires 4 days notice by mail for special meeting or 48 hrs personally, telephone or electronic transmission.- Can waive notice.

- Board member can participate through phone or video under Cal. §301(a)(6) as long as it is interactive.2. Board Action by Written Consent- RMBCA §8.21 requires unanimity.- Cal. §307(b) requires unanimity.

21


3. Mechanics of Board of Director Meetings- If a quorum is present, board can take action with majority vote of those present.4. Authority of Officers: Revisiting Agency Law Principles of Authority- Model Act doesn’t mandate any specific officers except Secretary, but CA mandates President (CEO), Sec. and Treasurer.

a. Scope of Officers’ Actual Authority- Duly adopted board resolution is source of authority.b. Scope of Officers’ Apparent Authority- If there is no actual authority, apparent authority might bind corporation.- Inquiry is whether it was reasonable for the 3rd party to think that it was within the agent’s authority to act.

Ex. Pres. has authority by virtue of being president to take actions in the ordinary course of business. Anything that is extraordinary would be unreasonable.

- In extraordinary situations, need actual authority.c. Importance of Certified Board Resolutions- If a document is appropriately executed and sealed by corporate sec., 3rd parties without specific knowledge about the actions taken may rely with confidence on the document.

VII. Corporate Governance in the Publicly Held CorporationA. Goals of a Publicly Held Company?

1. Traditional View: Primacy of Shareholder Interests- Maximize profits of shareholders.2. Scope of a Corporation’s Social Responsibility- Managers often take other constituencies into consideration

- Ex. Environmentally friendly, public relations with neighborhood.- Increase costs in the short-run, but in the long-run this still maximizes profits.- “Other constituency statutes” explicitly allow management to consider effects of actions on employees, consumers, communities and other interested parties. Just discretionary.

3. Law & Economics View- Separation of ownership and control creates agency costs. Managers should manage the business in order to maximize profits accd. to shareholder primacy model. If managers do that, then socially optimal results will occur.

- To extent that market forces fail, gov’t can intervene.B. Role of Shareholders

1. Publicly Held Companies and the Agency Costs of Separation of Ownership from Control: To Whom is Management Accountable?- Owners have no managerial control.

- Shareholders think of themselves are investors, not owners. Looking for dividend return on their capital.

- Need ways to get management to work for them.- Too expensive for minority shareholder to act.- Collection Action Problem: Shareholder might be able to change something for the better, but they took all the costs and everyone else benefits.- Passive Theory of Ownership – shareholder doesn’t really care or doesn’t take action.a. Reputation Market for Corporate Managers- Reputation market also acts as a disciplinary figure.b. Use of Incentive Stock Options to Align Managers’ and Shareholders’ Interests- Stock options make a manager an owner.

- Will want to exercise the option only if the price goes up.c. Exercise of the “Wall Street Vote”: Shareholder vs. Stakeholder- Wall Street Vote refers to right of shareholders to sell their stock.

22


- If co. is performing badly, then enough shareholders will sell their stock to drive its price down. This will cause the board to start paying attention.

d. Market- Unfettered market can act as a disciplinary figure over management. They will want to keep prices up to prevent a hostile takeover, i.e. tender offer.

2. “Street Name” Ownership: The Use of Nominees- Shareholder doesn’t actually own shares in their name b/c transaction costs are too big, but rather they have an account at a brokerage firm, who takes custody. Brokerage firm will be owner of record. All brokers belong to a depository institution that has custody.

- There are at least 2 layers btwn beneficial owners and corp.3. Concept of Control

a. Majority or Voting Control- When someone owns majority stock and thus, can act unilaterally.

Ex. Bill Gatesb. Minority or Working Control- Don’t need to own majority to exercise control.

- Ex. If 1 owner owns 30%, everyone else owns less than 2%. Quorum is 51%. The 1 owner with 30% can act unilaterally since he has enough votes for majority of quorum. He has effective working control.

c. Management Control- Management has a strategic advantage since they control proxy.

4. Publicly-Held Companies and Efficient Market Theory- Markets impound information fairly rapidly and adjust price to reflect public info available.- Historical prices don’t accurately reflect price

- Paradox: Market is efficient b/c people want info, even though history doesn’t predict price.

- Trading price only tells you a consensus price, not value.- Price is for a willing buyer/willing seller for 1 share.

5. Market for Corporate Controla. Proxy Contestsb. Negotiated Acquisitions (Board approval and shareholder approval)- Mergers require board and shareholder approval (2/3 vote).c. Tender Offers (Direct offer to shareholders)- When bidder bypasses board and offers a premium to shareholders of target so they can gain control by buying stock.

- Bidder will have to offer a certain premium over current share price so shareholders will unload.

6. Institutional Stock Ownershipa. Who are these “Institutional” Shareholders?- Pension funds, hedgefunds, mutual funds.

- Mutual funds allow small shareholders to have adequately diversified portfolio.- Institutions owns more than ½ of the stock on NY Stock Exchange.b. The Role of Institutional Shareholders: What are Their Options- Either exercise their Wall Street Vote OR at ballot box to get better managers in.c. Institutional Shareholders as (Investor Activists)- As institutional shareholders increase their stake, they have an incentive to spend the money to monitor their investment and get involved, so they don’t have to dump their stock and depress prices. As a result, more institutional shareholders are getting more involved with corporate governance.- They will hold onto their stock in companies they think are good.

23


C. Respective Roles of Officers and Directors In Public Companies1. Who Manages the Business Affairs of the Modern Publicly Held Corporation- MBCA §8.1: Board manages business affairs, either directly or under direction.2. What is the Function of the Modern Board of Directors?- Board doesn’t manage day-to-day business affairs. Board monitors CEO and determines whether senior executive officers are doing their job.

- Might get involved in big decision.3. Role of Outside Directors

a. Management v. Non-Management Directors aka Inside vs. Outside Directors- Outside directors are not employed by the company.- Inside directors are both an officer of the company and a director.b. Who Truly Qualifies as a Truly “Independent” Director?

D. Reforms Adopted as Part of Sarbanes-Oxley Act (SOX)1. Increasing Use of Board Committees Consistent of Independent Directors

a. Audit Committee- Maintains system of internal financial controls.

- Under SOX, audit committee has to have independent directors and outside auditor has to report directly to audit committee. No management.

b. Compensation Committee- Primary responsibility is setting compensation of CEO and other executive officers.c. Nominating Committee- Nominates people that will be up for board positions.

2. Gatekeeper Function: Role of Lawyers and Auditors of Public CompaniesE. Federal Proxy Rules- State law creates right to vote and vote by proxy. But SEC was concerned that state law wasn’t doing enough to regulate proxy rule so process is now regulated by Federal Securities law.- Goal of federal law is to promote corporate democracy by making it more transparent.

1. Scope of Federal Regulations of the Solicitation of Proxies: Definition of “Reporting Companies”- Rule 14a-9 regulates proxy voting in companies registered under §12, i.e reporting companies.- Reporting companies either publicly-traded, listed for trading on one of the exchanges OR can have stock traded over the counter, such as stock on NASDAQ OR meets 2 Prong Definition: Have assets of $10 million or more AND class of securities holders numbering 500 or more.2. Proxy Solicitation Materials: Proxy Forms, Proxy Statements and Annual Reports- Periodic disclosure requirements provides a regular stream of information to public.- Proxy statements has to be complete and accurate, provides full and adequate disclosure of all material facts.3. False and Misleading Proxy Solicitation Material: Rule 14a-9

a. Implied Civil Liability for Violations of Rule 14a-9- Plaintiff needs to show that company is a reporting company, soliciting votes and misrepresented material information.

- Solicitation is defined broadly. Starting to talk to people is enough. This makes it hard for shareholders to communicate with each other to exercise rights.- Studebaker: Studebaker was a reporting co. subject to all these rules. Gittlin is an insurgent shareholder who wants to nominate his own directors. Nominating committee will put up its own nominees. Gittlin has to campaign to get shareholders to vote for his directors. He is willing to take on costs of sending out proxy. Co. sues him before he event sends out proxy, just talking to people. Co. wants to stop him unless he meets proxy rules. Court said he was already soliciting by just talking to people.

24


b. Rule 14a-9 Liability for “Materially” Misleading Proxy Statements- Materiality: If there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote.

4. Rule 14a-8: Shareholder Proposal Rule- SEC will decide whether these have to be included in proxy statement or whether it can be excluded.- Allows shareholders to reach lots of people and talk about a lot of things.- SEC likes this b/c allows shareholders to communicate with each other, but management says this is just a tool to voice their own personal opinion.

IX. Management’s Fiduciary DutiesA. Duty of Care and the Business Judgment Rule- Board owes a fiduciary duty of care to the corporation.

- Suppose to decide what is in the company’s best interests.- Shareholder primacy model – shareholders invests to make money.

- Cause for the breach of fiduciary duty belongs to corporation.1. Traditional Statement of Business Judgment Rule- Board decisions are presumptively valid unless plaintiff can show fraud, illegality or conflict of interest/self-dealing.

- Board enjoys this presumption as long as they have acted in good faith and in the company’s best interests.

- A director who is present is presumed to have assented to action taken unless you object in a timely manner and you should also get your dissent in writing.- If you don’t like what the board is doing, then sell your shares, sue OR elect new directors.

- Shlensky v. Wrigley (1968): Plaintiff shareholders brings suit against corp. and board asserting that the board has neglected its fiduciary duty by failing to install night lights. Plaintiff though this was causing lost profits. This is a derivative suit since cause of action belongs to corp. Wrigley was the dominated shareholder and plaintiff tried to argue that Wrigley was just acting for his own personal interests and not for the company’s. If board was just going along with him, then they are guilty of mismanagement. But board gave reasons why they weren’t just following Wrigley, such as concern for the neighborhood. Court said that plaintiff failed to state a cause of action.

- Cal. §309(a): Directors shall perform duties in accordance with the following:Serve in a good faith manner that director believes is for the best interests of the company with the care an ordinarily prudent person in a like position would exercise under similar circumstances.

- Sounds like a negligence standard, but this there will be a causation prob.2. Modern Statement of Business Judgment Rule- To get benefit of business judgment rule, need a board operating in good faith, no fraud, illegality nor conflicts AND have to exercise informed decision-making (gross negligence).

- Smith v. Van Gorkum ( Transunion ): Plaintiff is a minority shareholder challenging board’s decision to approve a merger alleging that the board failed in its fiduciary duty b/c they didn’t do a property valuation. Direct action since shareholder were harmed individually since they sold-out for a cheap price. Supreme Court said that the board acted grossly negligent in failing to get the needed information to make a decision.

- Business judgment rule focuses on the process, not the decision itself.- We want businesses to take risks.- Court assumes that if you got through the process correctly a better decision will be made.

25


3. Statutory Limitations on Director and Officer Liability: A Backlash?- Delaware §102(b)(7): Opt-in raincoat provision. If you serve on a Delaware Bd., cannot be held personally liable for money damages for conduct that amounts to the breach of fiduciary duty of care. Provided that you don’t eliminate liability for the breach of the duty of loyalty, intentional misconduct, knowing violations of the law or actions taken not in good faith. Can’t eliminate any action from which the director personally benefited.

- Only thing protected is honest, good faith mistake of business judgment.- Equitable relief is still allowed, so can sue to enjoin the transaction.

- Cal. §204(a)(10): Similar provision. Optional. Has to be in Articles.- So will need approval of board and shareholders

4. Fiduciary Duty of Disclosure- In Re Caremark Intern Inc.: Derivative action where Board was sued for breaching fiduciary duty to corp. for failing to adequately monitor the business. Co. had been fined for making illegal kickbacks. Corp. benefited from kickbacks, but co. was harmed by huge fines. Directors aren’t held personally liable since they had opted-in. They didn’t do anything intentional and didn’t personally benefit. They didn’t personally approve the bribes. This is a failure to monitor case.

- Most important function of the board is to have adequate monitoring systems in place.- Ex. Enron failed in this regard.

B. Duty of Loyalty and Conflicts of Interests1. Self-Dealing Transactions

a. Common Law Rule of “Automatic Voidability”- Corp. can decide to set-aside a transaction tainted by self-dealing.

- Marciano v. Nakash: Guess jeans, stock is evenly divided 50-50. Company is in judicially-supervised dissolution proceeding by reason of deadlock on board. Have to pay off creditors 1st. Left over equity goes to shareholders. Only have common stock. Nakash submitted claim in dissolution proceeding. Had lent money to company $2.5 million of cash to the company. They took back a note. Company is obligated to pay if the note is valid and enforceable. If they can set aside the loan as void, then that leaves $2.5 million dollars in the business to get distributed 50/50. Marciano argues that the loan is not valid and not enforceable b/c they were an interested party, self-dealing transaction. Transaction btwn company and one of its directors. Self-dealing transactions are voidable, not per se void. Company is harmed by self-dealing to it can decide to set-aside the transaction.

b. Modern Approach: Fairness Standardi. Modern Statutes: Shifting Burden of Proof- Cal. §310: Requires full disclosure of all material facts, then board has to make a good faith approval by disinterested directors by a vote sufficient not counting vote of interested directors AND transaction has to be fair to the corp.

- Interested directors may be counted for quorum.- Plaintiff shareholder will have burden of showing that it is unfair if the requirements of the statute are met. If not, then the interested director will have the burden of showing that it is fair.

- Judge will decide fairness.- Interested shareholder should try and get shareholder approval, but need to meets rules for valid shareholder meeting.

- Judge won’t decide whether it is fair or not b/c will assume that shareholders acted in the company’s best interests.

- Weinberger: Self-dealing b/c parent is getting something at expense of minority shareholder of the subsidiary in merger. Plaintiff says that it

26


didn’t get adequate disclosure at shareholder vote, so even though shareholder approved it since the vote wasn’t valid, interested party, i.e. the parent will have the burden of showing that it is fair.

c. Subchapter F- Different public policy view, wants to validate interested party transaction. Removes possibility of judicial review.- Very few states have adopted this, Cal. and DE have not.

2. Executive Compensation – Judicial Standard- Not the court’s job to decide what just compensation is, but allows the stockholders to decide so long as they are not wasting, or misusing or abusing property.

- Heller v. Boylan (1941): Derivative lawsuit by 7 of 1000 minority shareholders of a tobacco corporation. By-law passed by stockholders gave 10% of the corp’s profits to executive officers. 2 ½% to Pres. and 1 ½% to each of the 5 Vice-Presidents in addition to their salary. By-law was passed legally. Not per se unreasonable, but ended up giving huge amount of money to each. Board sets compensation, they took it to shareholders to get protection of §310(a)(1).- Brehm v. Eisner: Old board decides to hire Ovitz and new board decides that his termination is no-fault, which allows him to leave with tons of money after 14th months. Original cause of action was waste, which was dismissed. Next complaint focus on the process under the breach of duty of care. Old board didn’t do a reasonable analysis and new board didn’t make a proper analysis if they could fire him for cause. Plaintiff will have to show that board didn’t go through process correctly.

3. Parent-Subsidiary Dealings- Parent is a controlling shareholder of subsidiary.

a. Definition of “Self-Dealing” in this Context- In the case of the relationship involving a controlling shareholder and the company the shareholders controls, self-dealing is whether parent is on both sides of the transaction AND parent is getting a benefit to exclusion of minority shareholders of the subsidiary.

- If there is self-dealing, then we use an intrinsic fairness test and parent has the burden of showing that the transaction is fair.- If there is NO self-dealing, then we apply the business judgment rule and minority shareholder will have the burden of proof.

- Sinclair Oil v. Levine (Del., 1971): Minority shareholders brought derivative action on behalf of Sinven (subsidiary) on 3 claims. 1st claim is that Board gave out too much in dividends. This is NOT self-dealing since minority shareholders got their proportionate share of the dividends, so apply business judgment rule. Also, claims that Sinclair breached is contract with Sinven and Sinven’s board didn’t do anything. Used intrinsic fairness since there was self-dealing since parent received benefit so parent has burden of proof to show that it is fair. 3rd claim was that Sinven wasn’t getting any oil exploration opportunities and board breach their duty by allocating opportunities to other subsidiaries. To be successful on this claim, plaintiff has to prove that those opportunities belonged to Sinven either through Line of Business Test OR Interest or Expectancy Test. Plaintiff couldn’t so this so lost on this claim. So apply business judgment rule.

b. Modern Standard of Judicial Review of Squeeze-Out/Freeze-Out- Parent owes minority shareholder a fiduciary duty, will have to show that the cash-out merger was fair, fair price and fair dealing. Parent should get approval of the disinterested shareholders. Assuming full and adequate disclosure, plaintiff cannot challenged fairness since stockholders approved it.

27


- Weinburger v. UOP, Inc. (Sup. Ct. of Delaware, 1983): Parent owed 50.5% of the outstanding shares. Proposed a cash-out merger of the other shareholders of UOP at $21, conditioned on a majority of the minority shareholders voted in favor of cash-out merger at the annual meeting. Merger was approved by 2/3 vote. But some minority shareholders challenged validity of price. Because the vote was not valid, i.e. didn’t have adequate disclosure, Court held that the merger was not fair. Parent has director on both sides of the transaction, he was conflicted since he was on both boards and didn’t disqualify himself.

4. Corporate Opportunity Cases- There is a breach of fiduciary duty if the opportunity belonged to the corporation and there was no adequate disclosure. Should get a written waiver to protect yourself.- In order to decide whether it is a corporate opportunity, use either the line of business test OR Interest or Expectancy Test:

- Line of business test: Whether opportunity is so closely associated with existing business activities that it would bring corporate officers purchasing it into competition with his company.- Interest or expectancy test: If company was contemplating going into that business.

- If the opportunity did belong to the company, then the co. really owns it and all of the financial benefit will go to the company even though legal title might be in the officer’s name.

C. Shareholder Derivative Litigation and the Business Judgment Rule1. Standard of Judicial Review of Recommendation by Board or Committee to Dismiss- Derivative suit is a mechanism through which a concerned shareholder can assert a right that belongs to the corporation, for harm suffered by the corporation. Shareholder brings the action presumptively b/c directors failed to bring the action on behalf of corp.

- In order to bring a derivative suit, need to be a shareholder at the time the harm occurred and through litigation and judgment.- Nature is 2-fold: Lawsuit against corp. to compel corp. to sue AND suit brought by company and asserted by shareholders.- 2 Types: Suit against 3rd party AND suit against company insider, such as manager, officers, directors for breach of fiduciary duty.

2. Traditional Business Judgment Rule Approach- If it is demand-required and demand was made and refused, court will apply business judgment rule to board’s decision to refuse to bring lawsuit on shareholder’s demand.

- If demand is required and refused, shareholder’s right to bring suit will terminate, but can attack decision to not to sue under business judgment rule.- So it will be presumed valid unless plaintiff can show that board’s refusal is tainted by self-dealing, fraud, illegality or gross negligence.

- If it is demand-excused, then business judgment rule will not apply and judge can look at merits of plaintiff’s claim.

- Gall v. Exxon Corp. (NY, 1976): Lawsuit against Exxon, shareholder was alleging that board allowed bribes to Italian officers. Not a self-dealing case since directors didn’t personally benefit. Raincoat provision was in place so plaintiff sues for equitable relief. Exxon created a special committee made up of directors on board at the time the board failed to detect these payments. Special committee tells management to make a motion to dismiss and NY court decides whether to grant motion. Chose to use business judgment instead of intrinsic fairness. Court remanded since there were directors on the committee that were not independent so plaintiff can do discovery to show whether committee was tainted.

- If plaintiff can show it was tainted, then motion will be denied.- If motion to dismiss is granted, lawsuit is gone (forever if with prejudice).

28


3. Broader Standard of Judicial Review- If demand is excused and litigation continues and committee want to terminate lawsuit, court will figure out when to dismiss suit under a 2 part test:

1) Inquire into independence and good faith of the committee and the basis for supporting the motion.

- Corp. has burden of showing that its committee process was in good faith and acted effectively.

2) Trial court should apply its own independent judgment to decide whether the motion should be granted. Court is balancing the competing interests of the shareholder and the corp.(Remember this test doesn’t apply where it is demand required and demand is refused.)

- Zapata Corp. v. Maldonado (Del. 1981): Shareholder brought derivative suit against directors alleging breaches of fiduciary duty for accelerating date to sell their stock option to avoid tax liability. Since they personally benefit by reducing their tax liability then this is a possible breach of the duty of loyalty. If a committee, composed of independent and disinterested directors, conducted a proper review of the matters before it, considered a variety of factors and reached, in good faith, a business judgment that the action was not in the best interest of the corporation, the action should be dismissed.

4. Demand Requirement and Test for Demand Futilitya. Delaware’s Approach – Demand Requirement Tied to Judicial Review- Demand is futile when plaintiff includes in complaint particularized facts, a reasonable doubt is created that (1) directors are disinterested and independent OR (2) challenged transaction was otherwise the product of a valid exercise of business judgment, i.e. fraud, self-dealing, illegality or gross negligence.

- If the board was independent and decision not to bring lawsuit is protected by business judgment rule, then plaintiff will lose.- Aronson v. Lewis (Del., 1984): Stock ownership alone is not enough proof of domination, has to show other relationships. Method of election is also not enough because doesn’t touch on independence. The fact that directors approved challenged transaction is not factually supported. Court concluded plaintiff failed to allege facts with particularity indicated that Meyers directors were tainted by interest, lacked independence, or took action contrary to Meyers’ best interest in order to create a reasonable doubt as to the applicability of the business judgment rule Only in presence of reasonable doubt may a demand be deemed futile.

b. ALI’s Approach – Universal Demand Requirement- Shareholder is required to make a demand upon board.

- The more significant the claims in the demand are, the more the judge will expect investigations to be thorough and take measures to prevent the same problem in the future.

X. Insider TradingA. Introduction: Transactions in the Company’s Shares by Directors and Officers.- Insider trading is a subset of a breach of fiduciary duty claim, can give rise to claim under state law and under 10b-5.B. Approach under State Law

1. Traditional Common Law Rule- Under common law, there was fraud liability for an affirmative statement of a material fact that someone justifiably relied on to their detriment. But, there was no affirmative duty to disclose in the absence of a relationship of trust and confidence.

- Insider owed no duty to shareholder.

29


- Doctrine of Half-Truths: For material omissions, where there was no relationship of trust and confidence in certain situations, the omissions were so egregious that it amounted to fraud.

- Goodwin v. Agassiz: Corporate officer bought shares from plaintiff in an anonymous transaction prior to release of good news of which defendant was not aware that raised the price of the stock. No liability on the part of the corporate officer because there was no affirmative misstatement by defendant.

2. Modern Approach and Scope of Insider’s Duty to Shareholders- Majority rule: A director or officer of a corporation has no duty, in purchasing shares of a stockholder, to disclose information that he has gained in his position which is unknown to the shareholder and which would increase the value of the shares to be purchased.- Minority rule: Director or officer has a duty to disclose all information which he may possess which may increase the value of the shares to be purchased.- Special fact or circumstances rule: Director or officer is required to disclose facts or circumstances of which he is aware that would increase value of shares he intends to purchase.

Line btwn special facts and strict accountability is blurred in practice.- Strong v. Repide: Majority shareholder knew company was entering into negotiation with Philippine gov’t to sell land. He bought shares but concealed his identity. If seller knew that he was buying shares, seller would ask questions and hold out for a higher price. She wants to sue the insider who bought them. Court says he is liable, not under fraud but under “special facts doctrine”. Can’t trade b/c he has “special facts.”- Hotchkiss v. Fischer: Plaintiff wanted to sell her stock if no dividend would be declared and went to talk to defendant, who was president of the company. He said that he couldn’t tell if there was going to be a dividend until the directors met. She sold her stock to D for $1.25. 3 days later, directors declared a dividend of $1. He owes a fiduciary duty to shareholder as a director. Scope of fiduciary duty is to be fair, which would have required him to tell everyone the information OR not buy any stock b/c the insider by virtue of his status has access to inside information. Can’t just tell her the info, Rule 10b-5 doesn’t like selective disclosure either.

C. Development of an Implied Remedy Under Rule 10b-5: Kardon and Its Progeny- Kardon: Slavin are the managers and enter into negotiations to sell. Slavin offers to buy the company. Company is selling assets, not the company. This is what Slavin tells Kardon. Slavin says that 10b-5 prohibits omissions of a material fact, even though shareholders don’t owe a duty to each other.10b-5 was as federal law. Problem: jurisdictional AND private right of action. Court implied a private cause of action.D. Scope of Rule 10b-5 Remedy: Elements of an Implied Cause of Action under Rule 10b-5

1. Jurisdiction- Requires use of interstate commerce AND has to involve sale of security, either debt instrument or stock.

- As long as the transaction at some point touches interstate commerce.2. Standing- Actual buyers OR actual seller OR SEC can bring suit.- Defendant can be anybody.

- Blue Chip Stamps v. Manor Drug Stores: Claim was by a person who was offered an opportunity to purchase securities but failed to do so because of materially misleading and overly pessimistic statements in the prospectus. No standing.

- Plaintiff could still sue under state law if there was an affirmative misstatement. Would need a duty to disclose, for state action for an omission.

3. Scienter Requirement- Negligence is not enough, mental state embracing intent to deceive, manipulate or defraud is required. Not clear whether gross negligence is enough.- No claims for aiding and abetting.

30


- Ernst & Ernst v. Hochfelder: Nay, the found of 1st Securities, took money from clients and kept money for himself. Ernst & Ernst did audit every year and failed to discover the fraud. Plaintiff tried to argue that they were an aider and abettor to Nay. Court said no.

4. Conduct that Violates Rule 10b-5a. Fraudb. Failure to Disclose a Material Fact- Requires duty to disclose.c. Insider Trading – Tippee Liability

5. Material Requirement- Materiality: Reasonable investor would consider the information important.

- Same test as proxy.6. Reliance Requirement

a. Actual Relianceb. Fraud on the Market Theory

7. Damages- Disgorgement: Return of profits

- Court will allow 3x penalty when they disgorge their profits in order to make the damages punitive.

E. Insider Trading as a Violation of Rule 10b-51. Nature of the Problem- Court want to level playing field. Insiders trading with information advantage is unfair. Other investor won’t be willing to invest.

- Unfair to existing shareholders, and also to investors who are thinking of buying.2. Genesis of Rule 10b-5 “Duty to Disclose or Abstain” From Trading- Parity of information theory for insider trading violations under Rule 10b-5.- Possession of material nonpublic information will create liability under 10b-5 if person traded on that information before it was made public.

- Rule: Disclose or abstain rule. Strict liability.- Have to wait for effective dissemination of information for market to react.

- SEC v. Texas Gulf Sulphur: Hugh ore discovery in Canada. Senior executives keep it to themselves and don’t even tell board. Do a land acquisition program, so they could really have disclosed. People with info bought stock and call options, which give you the right to buy shares at a fixed price. Material since people that never bought before where buying and they knew that this was big. Court said they should have abstain and disgorges their profits.

3. Modern View- Court rejects parity of information theory and establishes that insider trading violations re tied to insider’s breach of fiduciary duty. So need to find a fiduciary duty to have a breach.- There is a duty to disclose or abstain only where there is an independent source of a duty to disclose.

- Chiarella v. U.S.: Criminal prosecution. Bidder decided to prints its tender offer and printer’s employee figures out the company’s involved and buys stock in the target. Mere possession is material nonpublic information doesn’t create duty to abstain or disclose. Didn’t have fiduciary duty to target company since worked for bidder. Might have been liable for breach of fiduciary duty to employer but not decided in this case. This wasn’t presented to jury.

4. Misappropriation Theory- Breach of fiduciary duty to the source of information, even if the source is a complete stranger to the traded securities.

- Any fiduciary duty will give rise to liability and duty to disclose or abstain.

31


- U.S. v. O’Hagan (1997): O’Hagan is partner in law firm. Dorcey & Whitney is in position of printer. Grand Met is bidder who hires the law firm to help it plan for target (Pillsbury). O’Hagan is a litigation partner not working on matter completely. Gets info while chatting with corporate partner. He then takes the largest single individual call option in Pillsbury. No duty to company or shareholders. Hadn’t be hired by target so no fiduciary duty to the stock his bought. Could have been a temporary insider, had he been entrusted with confidential information. He did however owe a duty to his firm, which owed a duty to the bidder. This duty to his employer when he violates it allows court to find him liable under misappropriation.

5. Tipper-Tippee Liability- Requires the insider to breach their fiduciary duty AND tippee knew or should have known of the breach.

- Breach is decided on whether the tipper personally benefited from disclosing the information.- Not clear what tippee’s scienter requirements are. Seems like we have 2 scienter requirement for tipper-tippee liability.

- Dirks v. SEC: Seacrest was a company insider who got fed up with fraudulent practice who quit and tried to expose fraud. Tells Dirks who works for a brokerage firm who has financial analysts, and he is intrigued by what Seacrest is saying. He starts investigating. He has a few institutional clients and tells them to unload. Daisy chain of sub-tippees. Seacrest is insider who has info, then passes it to Dirks, Dirks then passes it the info to institutional investors. SEC is suing Dirks. He should have told everyone or not anyone at all. He only told a few people. This is a case about selective disclosure. No liability since tipper didn’t pass information for any personal benefit so no breach of fiduciary duty.

32

iloyolastm.com/wp-content/uploads/2015/07/business-ass… · web viewfree transferability of...

Documents