CORPORATIONS
I. ORGANIZATION OF CORPORATIONS
A. Formation Requirements (People, Paper, Act) 1. People: Incorporators (Must have one or more.) a. What does an incorporator do? (1) They sign and file the articles (that’s it) (2) Can BAR/BRI, Inc. serve as an incorporator for Curl Up and Dye Beauty Supply Corp.? Can Michael Jackson? (a) Yes, it can be a person or entity 2. Paper: Articles of Incorporation. a. Purposes. (1) (1) The articles are a contract between corporation and shareholders. (2) (2) *And also a contract between corporation and state. (a) More important purpose b. Information in articles. (1) Names and addresses. (a) Corporate name. (i) Can I form a corporation with the name Bubba=s Bountiful Biscuits? No. It must include one of these magic words (or an abbreviation thereof): Corporation Company Incorporated Limited (ii) Name and address of each incorporator. In some states, also name the initial directors and their addresses. (In other states, don't name initial directors in articles; incorporators elect them later). (iii) Name of registered agent and address of registered office (registered agent is the corporation=s official legal representative, e.g., can receive service of process). (2) Statement of duration (a) Often required only if less than perpetual existence (3) Statement of purpose (usually required). (a) General statement of purpose. (i) Can the articles of Bubba's Bountiful Biscuits, Inc. indicate that the corporation's purpose is to engage in all lawful activity, after first obtaining necessary state agency approval? Yes. This is typically the way it is done because it is easy (b) *Specific statement of purpose and ultra vires rules. (more likely what the Bar will test on) (i) What if the articles of Bubba's Bountiful Biscuits, Inc. indicate that the corporation's purpose is to sell Southern-style sausage biscuits and the corporation later sells T-shirts as well as the biscuits? Selling T-shirts is an ultra vires act (beyond the scope of the articles). At common law, the contract could be voided as beyond the corporation’s capacity. How do we handle ultra vires today? [**3 important rules] Ultra vires contracts are valid (they are enforceable) Shareholders can seek an injunction The responsible Os and Ds and Es are liable to the corporation for ultra vires losses (4) Capital structure (stock).
(a) Definitions of background terms (to impress friends at parties) (i) Authorized stock maximum number of shares the corporation can sell. (ii) Issued stock number of shares the corporation actually sells. (iii) Outstanding stock shares that have been issued and not reacquired by the corporation. (b) Articles must include: (i) Authorized stock (ii) number of shares per class (iii) information on par value, (iv) voting rights and (v) preferences of each class. 3. Act. a. File articles with Secretary of State and pay required fee. b. Acceptance by Secretary of State is conclusive proof of valid formation. (In some states, Secretary=s issuance of certificate of incorporation is conclusive proof of valid formation.) (1) At that point, we have a De Jure Corporation c. Then, the board of directors holds an organizational meeting, where selects officers and adopts any bylaws and conducts other appropriate business. B. Legal Significance of Formation of Corporation [*Important points] 1. Internal affairs of doctrine = (e.g., roles and duties of directors, officers, and shareholders) a. Internal affairs of corporations are governed by the law of the state of incorporation. 2. A corporation is a separate legal person. a. It can sue and be sued, it can hold property, it can be a partner in a partnership, it can make charitable contributions, it must pay income taxes as an entity, etc. 3. *Generally, officers and directors are not personally liable for what the entity does. a. The principle of limited liability Shareholders generally are liable only for the price of their stock. (1) Generally, shareholders (owners) are not personally liable for debts of corporation. 4. So, generally, who is liable for what the corporation does? a. The Corporation b. So if the shareholders and directors fail to form a de jure corporation, they are nervous that they will be personally liable. In that case, think about: C. De Facto Corporation Doctrine: Corporation by Estoppel 1. Overview a. These are doctrines by which a business failing to achieve de jure corporate status nonetheless is treated as a corporation (1) Done so shareholders will not be personally liable for business debts. b. Generally, any person asserting either must be unaware of failure to form de jure corporation. 2. De Facto Corporation: a. Must show all three: (1) There is a relevant incorporation statute; (2) The parties made a good faith, colorable attempt to comply with it; and (3) Some exercise of corporate privileges. b. *If applicable, treated as corporation for all purposes except in an action by the state for exceeding its powers (called an action "quo warranto"). 3. Corporation by estoppel a. Defined: One dealing with a business as a corporation, treating it as a corporation may be estopped from denying the business’s corporate status. b. *May be invoked against those who dealt directly with the business as a corporation. c. May also be used to prevent company from avoiding an obligation by asserting its own lack of valid formation. d. *Usually available in contract, not tort, cases.
(1) It is narrower 4. *These two doctrines are abolished in many states! a. Should still discuss them on the Bar, but then explain that they are abolished D. Bylaws [not that important for Bar] 1. In most states, adoption of bylaws is not a condition precedent to formation of a corporation. a. But virtually every corporation has them They are for internal governance…lay out responsibilities, set regular meeting times and places, prescribe methods of giving notice. 2. Who adopts the initial bylaws? a. The Board 3. Who can repeal or amend the bylaws of a corporation? a. The shareholders b. In some states, the Board also can 4. *If bylaws conflict with the articles, the articles control. a. Why: Bylaws are an internal document, not filed with a state agency. (1) Unlike the Articles, which were filed by the state E. Pre-Incorporation Contracts [**Important] 1. A promoter is a person acting on behalf of a corporation not yet formed. a. For example, a promoter might enter a contract on behalf of a corporation-not-yet-formed. 2. Liability on pre-incorporation contracts. a. Liability of the corporation. (1) *Rule: A corporation is not liable on pre-incorporation contracts until it adopts the contract. (a) On January 10, P, acting as a promoter for a corporation not yet formed, leases a building from Don Zimmer and signs the lease Oscar de la Rental Cars, Inc. On February 20, Oscar de la Rental Cars, Inc. is formed. (i) Is the corporation liable on the contract? Yes, if it adopted the contract. How can that happen? Two ways Express - board of directors takes action adopting the contract. Implied – When the corporation accepts a benefit of the contract b. Liability of the promoter on pre-incorporation contracts. (1) *Rule: Generally, unless the contract clearly provides otherwise (never has this on the Bar), the promoter remains liable on pre-incorporation contracts until there has been a novation; (a) Novation – an agreement of the promoter, the corporation, and the other contracting party that the corporation will replace the promoter under the contract. (2) Assume here the contract says nothing about promoter liability… (a) Will P be liable on the lease if Oscar de la Rental Cars, Inc. is never formed? (i) Yes (b) Will P be liable on the lease if Oscar de la Rental Cars, Inc. is formed and adopts the lease? (i) Yes – There is no novation, so promoter is still liable. (c) Remember: Adoption makes the corporation liable too, but does not relieve P. So on this fact pattern, both the corporation and P are liable. F. Secret Profit Rule 1. Overview a. This is where the promoter deals with the corporation itself (1) Rarely tested in CA. 2. Rule: Promoter cannot make a secret profit on her dealings with the corporation. a. Two fact patterns of when there may have been a profit made (1) Sale to corporation of property she acquired before becoming promoter (a) Formula = price paid by corporation – fair market value (FMV) (b) On January 10, P begins working as a promoter. On April 4, P sells corporation Green Acres for $40,000. P had bought Green Acres in 1931 for $1.98. (i) Any profit? Maybe not! Apply the test price paid by corporation ($40,000) minus FMV.
If FMV is $40,000 (or more), there is no profit on this fact pattern. What the promoter paid is irrelevant (2) Sale to corporation of property she acquired after becoming promoter (a) Formula = price paid by corporation – price paid by promoter (i) Here we do care what she paid for it because she was a promoter when she got it. (b) On January 10, P begins working as a promoter. On February 20, P buys property for $18,000. On March 3, P sells that property to corporation for $25,000. (i) Any profit? Yes. $7,000 profit (ii) So we know she made $7,000. Is P liable to corporation? Only if the profit was secret! If the corporation knows about the profit, there is no liability. Only depends on whether it was kept secret or not. G. Foreign Corporations 1. Rule: Foreign corporations transacting business in this state must qualify. a. Foreign corporation = one incorporated outside this state. (1) Can just be anywhere outside of this state b. Transacting business = the regular course of intrastate (not interstate) business activity. (1) Not occasional or sporadic activity. c. Qualify by getting a certificate of authority from Secretary of State. (1) Apply by giving information from articles and a certificate of good standing from home state. (2) Must pay fees to state. (3) Generally, must appoint registered agent here too. 2. Consequences of foreign corporation transacting business without qualifying: a. Civil fine and b. Corporation cannot sue in state (but it can be sued). c. There are no other consequences for the foreign corporation. *The foreign corporation can sue once it qualifies and pays fees and fines.
II. ISSUANCE OF STOCK
A. What is Issuance 1. Defined: Issuance of stock occurs when a corporation sells or trades its own stock. It is a way to raise capital for the corporation. a. Examples: (1) Mayberry Realty Corp. sells 10,000 shares of Mayberry stock. (a) That is an issuance, because the corporation is selling its own stock. (2) Barney Fife sells 3,000 shares of Mayberry stock. Issuance? (a) No. It is only an issuance if the corporation is selling it’s own stock (i) All the rules below apply only in situations in which the corp. is selling its own stock B. Subscriptions 1. Defined: written offers to buy stock from corporation 2. *Revocation of pre-incorporation subscriptions. a. Example: On January 10, S signs a subscription, offering to buy 100 shares of C Corp., a corporation not yet formed. A week later, S changes his mind. Can S revoke? (1) No. (2) Rule: A pre-incorporation subscription is irrevocable for six months unless it provides otherwise or all subscribers agree. b. Post-incorporation subscriptions revocable until acceptance (1) The corporation and the subscriber become obligated under a subscription agreement when the board accepts the offer. (a) At that point, the subscriber is obligated to buy the stock and the corporation is obligated to sell to her. (2) The corporation's call for payment for stock must be uniform within each class or series of stock. (A "series" is just a subclass of stock.)
(a) Must apply to all in a class or series C. Consideration 1. What must the corporation receive when it issues stock? 2. Form of Consideration: split of authority on this. Be ready with two approaches. a. Traditional rule regarding permitted forms of consideration: (1) Can pay for an issuance with (these are good in all states today): (a) (1) money (cash or check), (b) (2) tangible or intangible property, OR (c) (3) services already performed for the corporation. b. The split (know both): (1) Traditional rule regarding prohibited forms of consideration (results in unpaid stock all treated as water): (a) Cannot “pay” with these (i) Future services and (ii) Promissory notes *Though some states allow promissory notes if they are fully secured. (2) Modern trend: (a) Increasing number of states allow payment with any tangible or intangible property or benefit to the corporation. (i) This definition would include promissory notes and future services to the corporation. 3. Amount of Consideration. a. Par = minimum issuance price. (1) C Corp. is selling 10,000 shares of $3 par stock. (a) It must receive at least $30,000 (b) Can it receive more than $30,000? Yes. (i) Par just means the minimum b. No par = No minimum issuance price. (1) Board of directors sets a price. c. *Treasury stock (aka reacquired stock) = This is stock that was previously issued and has been reacquired by the corporation. The corporation can then resell it. (1) C Corp is selling $3 par treasury stock. Is there a minimum it must receive? (a) No. You always treat treasury stock as no par d. *The board of directors is responsible for putting a value on the consideration received for an issuance. (1) Is the board's determination conclusive? Yes, if it is made in good faith (a) Note: In some states, it's conclusive if the board acted without fraud. 4. *Consequences of issuing par stock for less than par value; i.e., watered stock. [Typical Bar issue] a. Example: C Corp. issues 10,000 shares of $3 par to X for $22,000. The corporation (or its creditors if it is insolvent) wants to recover the $8,000 of water. (Some states do not allow the corporation to sue, but many do.) Who would be liable? (1) Directors? Yes, if they knowingly authorized the issuance (which is usually the case) (2) X? Yes (there is no excuse. You are charged with notice of the par value) (3) Classic Bar Hypo: What if X transfers the stock to A? A is not liable if she acts in good faith (did not know about the water). (a) But A's status (good faith or not) has no effect on the liability of X or the directors. D. Preemptive Rights [*Rarely tested] 1. Defined: The right of an existing shareholder to maintain her percentage of ownership by buying stock whenever there is a new issuance of stock for money (cash or equivalent). a. Some states do not include sale of treasury stock as Anew issuance. b. Some states do not include originally authorized but previously un-issued shares. c. Example: S owns 1,000 shares of C Corp. There are 5,000 shares outstanding (so she owns 20%) C Corp. is planning to issue an additional 3,000 shares. (1) If S has preemptive rights, then S has the right to buy 600 shares (she can buy 20% of the new issuance)
(2) What if the bar exam question does not indicate whether the articles of C Corp. provide for preemptive rights? (a) Split of authority. (i) Traditionally, preemptive rights exist unless the articles provide otherwise. (ii) Modern trend says preemptive rights do not exist unless the articles provide for them (this trend may be the majority today) (3) The articles of C Corp. provide for preemptive rights. C Corp. is issuing stock to G to acquire Green Acres from G? (a) No preemptive rights. (i) Why Because this is not a new issuance for money. (ii) The only time preemptive rights works is in issuance for money
III. DIRECTORS AND OFFICERS (*Major part of the Bar)
A. Statutory Requirements: Director 1. Number a. One or more adult natural persons. 2. Election. a. Shareholders elect directors (at the annual meeting). (1) Can elect the entire board or can stagger the board by halves or thirds ("staggered terms"). (a) For example, if there are 9 directors, could stagger by thirds, with 3 elected each year and serving 3-year terms. (2) A "classified board" is different (this is rarely tested) (a) There, directors are grouped into different classes and each class is elected by a designate class of shares. b. *Shareholders can remove directors before their terms expire. (1) Generally, majority of shares entitled to vote must vote for removal. (a) On what basis? Can remove with or without cause. Done by majority of the shares entitled to vote. (2) In some states, a court may remove a director for fraud or gross abuse of authority or discretion. (a) Most likely in a close corporation c. *Who selects the person who fills a vacancy on the Board? Generally, the board or shareholders (1) But if the shareholders created the vacancy by removing a director, the shareholders generally must select the replacement (rarely tested on bar) (2) Also if director was elected by a class of shares, that class should select the successor. 3. *Board action.[very important] a. There are two ways the board can take a valid act: (1) (1) unanimous written consent to act without a meeting, OR (2) (2) a meeting (can be held anywhere) that satisfies quorum and voting requirements. (a) A conference call qualifies as a meeting, just so all directors can hear each other simultaneously. (3) If neither (1) nor (2) is met, the act is void unless later ratified by a valid corporate act. 4. Notice a. Notice requirements for directors= meeting generally can be set in bylaws. b. Usually required for special meetings, but failure to give can be waived in writing or by attending without objection. c. *Are proxies or voting agreements OK for director voting? (1) No. They are void…they are against public policy. Cannot be done for director voting (different than for shareholders, where this is allowed) 5. Quorum for meetings a. Must have a majority of all directors to do business (unless a different percentage is required in bylaws). If a quorum is present at a meeting, however, passing a resolution (which is how the Board takes an act) requires only a majority vote of those present. (1) So, if there are 9 directors, at least 5 directors must attend the meeting to constitute a quorum.
(2) If 5 directors attend, at least 3 must vote for a resolution for it to pass. (3) *Rule: Quorum can be lost if directors leave the meeting. (a) Quorum of the board can be lost (broken) if people leave. Once a quorum is no longer present, Board cannot take an act at that meeting. b. If there is no quorum, any action taken is void unless ratified by a valid act. B. Role of Directors 1. Generally, the board of directors manages the business of corporation. a. e.g., it sets policy, supervises officers, declares distributions, recommends fundamental corporate changes to shareholders. 2. *The Board can delegate substantial management functions to a committee a. But a committee cannot: (1) Amend bylaws, (2) Declare dividends or (3) Recommend a fundamental corporate change to shareholders. b. How big is a committee of the board? (1) Just 1 or more directors C. **Duty of Care 1. The Burden on Plaintiff in these Cases! 2. Duty of care standard (write both sentences in your answer!) a. A director owes the corporation a duty of care. She must act in good faith; and b. She must do what a prudent person would do with regard to her own business. (1) Remember, directors are fiduciaries! 3. Nonfeasance (the director does nothing). a. Example: Justin Timberlake, a director of C Corp., fails to attend any of the board of directors’ meetings or to keep abreast of the company business. (1) Will he be held liable for breach of the duty of care? (a) State the duty of care standard. (i) A prudent person would attend some meetings. Justin failed to do anything a prudent person would have done, so he breached the duty of care. BUT HE IS LIABLE ONLY IF: his breach caused a loss to the corporation Not enough for the plaintiff to show that he breached the duty just by not acting like a prudent person; must also show that the corporation lost money or was hurt. This is tough to show, but it is required. 4. *Misfeasance (the board does something that hurts the corporation). a. Example: The directors of Hedonists’ Hot Tubs, Inc., vote to start a new line of hot tubs with builtin wine coolers and video cameras. The idea is a disaster and the corporation loses money. (1) Are the directors liable for breach of the duty of care? (a) State the duty of care standard. Here, the directors' action caused a loss to the corporation. (i) BUT, a director is not liable if she meets the business judgment rule (BJR). BJR: A court will not second-guess a business decision if it was made in good faith, was informed, and had a rational basis. You are only in trouble if it is irrational or you are grossly negligent You must be prudent, and prudent people do appropriate homework Look for: Did they deliberate? Did they analyze? D. Duty of Loyalty 1. Burden on Defendant because BJR does not apply in cases involving conflict of interest. a. Can be gross or egregious, but usually more subtle than that. 2. Duty of loyalty standard [Must state this in your answer] a. A director owes the corporation a duty of loyalty. b. She must act in good faith and with a reasonable belief that what she does is in the corporation's best interest. 3. *Interested Director Transaction
a. Any deal between the corporation and one of its directors or another business of the director’s. b. Example: Martha is a director of XYZ, Inc. She sells wreaths to the corporation. That is an interested director transaction. Is Martha in trouble? (1) State the duty of loyalty standard. Interested director transaction will be set aside UNLESS the director shows: (a) (1) the deal was fair to the corporation when entered, OR (b) (2) her interest and the relevant facts were disclosed or known and the deal was approved by either of these: (i) Majority of disinterested directors (ii) Majority of disinterested shares (not shareholders) (c) Note: In some states, defendant has to show fairness even if the deal was approved by one of these groups. c. Special quorum rules: Interested directors might count toward quorum OR quorum may be majority of disinterested directors or shares. d. Directors can set their own compensation, but it must be reasonable (1) If excessive, it's waste of corporate assets, and a breach of the duty of loyalty 4. Competing Ventures. a. Example: Sharon is a director of Ozzie's Music Co. She can also serve on the board of directors of Home Depot because it does not compete with Ozzie's. But can Sharon start her own music company? (1) State the duty of loyalty standard. (2) Director cannot compete directly with her corporation. (a) You are a fiduciary! To do so would be a breach of the duty (3) Remedy: Constructive trust on profits, and possibly damages for any harm to Ozzie’s Music. 5. Corporate Opportunity (Aka: Expectancy). a. Example: Cheatem is a director of C Realty Corp., which develops condo projects. Cheatem learns of some land that has been zoned for condos and buys it for himself as an investment. What are C's rights, if any, against Cheatem? (1) State the duty of loyalty standard. (2) *Director cannot USURP a corporate opportunity That means the director cannot take it until he: (a) (1) tells the board and (b) (2) waits for the board to reject the opportunity. b. Defined: (1) Best Definition: It is something that the corporation has an interest or expectancy in. (2) Other possible definitions: (a) Some courts say it=s anything necessary to the corporation. (b) Some say it=s anything in the corporation's business line. c. Is the company's financial inability to pay for the opportunity a defense? (1) Probably not. d. Remedy: (1) If Cheatem still has it, he must sell it to the corporation at his cost. (2) If Cheatem has sold it at a profit, the corporation gets the profit (this is a Constructive trust.) E. Other State Law Bases of Director Liability 1. Ultra vires acts. Responsible officers and directors are liable for ultra vires losses. 2. Improper loans. a. Example: Curly, Moe and Larry are directors of C Corp. The board of directors votes to lend Curly $100,000 of corporate funds. (1) In some states, such a loan must be approved by majority of shares. (2) In many states, such loans are OK if the board finds that it is reasonably expected to benefit the corporation. b. Sarbanes-Oxley Act prohibits most loans to executives in BIG registered publicly traded corporations. (unlikely to be tested on this Act) 3. Improper distributions.
4. Securities liabilities. 5. Which directors are liable for all the things directors be liable for? a. *General rule = A director is presumed to have concurred with Board action unless her dissent or abstention is noted in writing in corporate records. (1) “In writing” means (a) (1) in the minutes or (b) (2) in writing to the corporate secretary at the meeting or (c) (3) registered letter to the corporate secretary immediately after the meeting. (2) Cannot dissent if voted for the resolution at the meeting. b. Exceptions. (1) Absent directors are not liable. (a) Note: Some states they have to dissent in writing after learning of the action the board took. (2) *Good faith reliance on: (a) (a) Book value of assets or (b) (b) Opinion of a competent employee, officer, professional, or committee of which the director relying was not a member, OR (c) (c) Financial statements by auditors. (d) Note: Must have a reasonable belief in the competence of the persons providing such info. (i) Must be good faith reliance! F. Officers 1. Important: Officers owe the same duties of care and loyalty as directors 2. Status: Officers are agents of the corporation. So they can bind the corporation by acts for which they have authority to bind it. a. How there may be authority (1) Actual (given in articles, bylaws, or by board act). (2) Apparent (where the corporation holds the officer out as having authority to bind it, so thirdparties rely on it). (3) Inherent (or implied), which is by virtue of the office held. (a) Classic Example: President has inherent authority to enter contracts binding on the corporation in the ordinary course of business. (i) Secretary can keep records; treasurer maintains funds. 3. Traditionally, must have a president, a secretary and a treasurer. (Rarely tested) a. Can also have others. b. Today, generally no limitation on holding multiple offices simultaneously. 4. Selection and removal. a. Officers are selected by and removed by the directors. Directors also set officer compensation. (1) Example: The directors of Viagra Co. appoint Bob Dole as president. What happens if they fire him from the presidency? (a) Bob's gone, although the corporation may be liable for breach of contract damages. (i) He may get money, but he will not get the job back! (ii) Look for a cross-over question with Contracts here b. Shareholders hire and fire directors, but directors hire and fire officers. (1) Keep in mind: Generally, then, shareholders do NOT hire and fire officers. G. Indemnification of Directors and Officers 1. Fact Pattern 1: Person sued in capacity as officer or director has incurred costs, attorneys’ fees, maybe even fines, a judgment or settlement; she seeks reimbursement from the corporation. a. 3 possible categories (1) No indemnification; i.e., when is corporation barred from indemnifying? (a) If held liable to the corporation or held to have received an improper personal benefit. (i) If either is true, then the corporation cannot pick up the tab for her. (ii) Must be actually found to be the case, not just alleged. (2) Mandatory indemnification; i.e., when is a corporation required to indemnify? (a) Split in authority:
(i) In some states, if she was wholly successful (on the merits or otherwise) in defending the action (must win a judgment on all causes of action) (ii) In others, to the extent she was successful (to the extent that she wins on each cause of action (3) Permissive indemnification; i.e., when is a corporation permitted to indemnify? (a) Situations: (i) Anything not satisfying 1 and 2 above. (ii) *Watch for settlement. (b) Eligibility standards = She must show she acted in good faith and with the reasonable belief that her actions were in the company's best interests. (i) This is the duty of loyalty! (c) Who determines eligibility? (i) Disinterested directors or disinterested shares or independent legal counsel. 2. Fact pattern 2: Notwithstanding these rules, court where director or officer was sued can order indemnification if it is justified in view of all circumstances. a. Usually limited to costs and attorneys= fees (not including any judgment against the director or officer). 3. Fact Pattern 3: Articles can provide for limitation or elimination of liability for damages, but not for breach of the duty of loyalty, intentional misconduct or wrongful personal benefit. a. In some states, such provisions are available for directors only, not officers. 4. Fact Pattern 4: Corporation can purchase insurance for director or officer liability.
IV. SHAREHOLDERS (*Also very important on the Bar)
A. Holding Shareholders Liable for the Acts or Debts of the Corporation 1. General Rule: A shareholder is not liable for the acts or debts of a corporation. But a court might pierce the corporate veil (PCV) and hold shareholders personally liable if both of these things are true: a. (1) they have abused the privilege of incorporating AND b. (2) fairness requires it. c. PCV standard: Most courts will PCV to avoid fraud or unfairness. (Never automatic) (1) Always include this phrase in your answer 2. Alter ego (identity of interests). a. Example: (1) Facts: (a) X and Y are the shareholders of C Corp. (b) X is also the chief executive officer. (c) X commingles personal and corporate funds, uses the corporate car as his own, and uses the corporate credit card to pay for personal purchases. (2) Can a creditor of the corporation who has been unable to collect its claim (this meets requirement for unfairness) from the corporation collect from either X or Y? (a) Start with general rule (shareholders not liable for acts or debts of corporation). (b) Then PCV standard. (i) Here a court MIGHT PCV if X's failure to respect the separate corporate entity harmed creditors. (ii) Sloppy administration generally is not enough for PCV, but here X treated the corporation as his alter ego by treating the corporation and personal assets as interchangeable. If that harmed the creditors, the court may pierce the corporate veil. (iii) If PCV, only X would be liable. Y has done nothing wrong. 3. Undercapitalization. a. Example: S is a shareholder of Glowco, Inc., G, a corporation that hauls and disposes of nuclear waste. G does not carry insurance. G has an initial capitalization of $1,000. V is injured when one of G's trucks melts down. Can V sue S? (1) Say general rule first (2) PCV standard.
(a) Here a court MIGHT PCV because the corporation was undercapitalized when formed. (i) Why? Because shareholders failed to invest enough to cover prospective liabilities (this is undercapitalization!) 4. If you get a piercing hypo… a. Remember (always say this): courts are generally more willing to PCV for a tort victim than for a contract claimant. b. Also, watch for PCV in a related corporation situation, e.g., where a parent corporation forms a subsidiary to avoid obligations (Rare on the Bar) c. As an alternative to PCV, the court may subordinate any shareholder debt to any creditors. B. Shareholder Management of Corporation [Rare on Bar] 1. Public policy says that the board of directors (not shareholders) manages a corporation. 2. Shareholders have always been allowed to enter agreements to vote their shares to elect each other to the board of directors. a. But an agreement as to what they would do once they are on the board violates the public policy that management is vested in the board to exercise independent judgment. b. So at common law, no agreement among shareholders could affect management. c. Today, though, some shareholder agreements can relate to management if: (1) (a) no minority shareholder objects, (2) (b) it will cause no harm to public or creditors AND (3) (c) it involves a minor management issue. 3. *Shareholders can manage corporation directly, however, in a close (or "closely held") corporation. a. In most states, to do this, the articles must provide it's a close corporation and a unanimous shareholder agreement must provide for shareholder management. (1) Then, the corporation need not have a board. (a) The shareholders run the corporation. b. *Managing shareholders owe the duty of care and the duty of loyalty. c. Defined: A close corporation has few shareholders and the shares are not publicly traded. d. *Shareholders in a close corporation owe each other fiduciary duties. (1) Watch especially a controlling shareholder who oppresses minority shareholders. (a) A court may be willing to help the minority shareholder, since there is no public market for the shares (so the minority shareholder cannot just get out by selling shares). 4. Licensed professionals, including lawyers, medical professionals, and CPAs, may incorporate as a professional corporation. [look at later; unlikely to be tested on] a. The name must include the designation professional corporation or professional association or an abbreviation of one of those. b. The shareholders must be licensed professionals and generally the P.C. may practice only one profession. c. The P.C. may employ non-professionals (not to render professional services). d. The professionals and the P.C. remain personally liable for their own malpractice or misconduct in rendering professional services. e. Shareholders are generally not liable for each other's malpractice or for corporate obligations. f. Generally, the rules governing regular corporations apply to the P.C. C. Shareholder Derivative Suits 1. *Should think about this issue whenever a shareholder is a plaintiff (ask if it is this type of a suit) 2. In a derivative suit, a shareholder is suing to enforce the corporation’s claim, not her own personal claim. a. Always ask: could the corporation have brought this suit? If so, it is probably a derivative suit. (1) Example: S, shareholder of C Corp., sues X for breaching its contract with C Corp. Derivative suit? (a) Yes, because C Corp. could sue X. It is the corporation=s claim. (2) Example: S sues the board of directors of C Corp. for usurping corporate opportunities. Derivative suit? (a) *YES duty of loyalty (and care) are owed to corporation. (i) A breach hurts the corporation
(3) Example: S sues board of directors of C Corp. for issuing new stock without honoring her preemptive rights. Derivative suit? (a) No this is a direct suit, for S’s personal claim. 3. Consequences of a successful derivative suit a. *Generally, the recovery in any successful derivative suit goes to the corporation. b. Example: S, a shareholder of C Corp., sues X for breaching its contract with C Corp. The court finds a breach of contract and awards damages of $50,000. (1) Who receives the $50,000? (a) C Corp (2) *What does S receive? (a) Costs and attorneys= fees, usually from the corporation. (b) After all, the shareholder conferred a benefit on the corporation by suing and winning. c. Sometimes a court might allow a shareholder to recover directly if a recovery by the corporation would simply return money to the bad guys. (1) Example: Close corporation with three shareholders (each holding one-third of the stock). One of them engages in a competing venture, thereby breaching the duty of loyalty to the corporation. (a) If a judgment against the bad guy goes to the corporation, essentially one-third of the recovery goes to the bad guys. 4. The consequences of an unsuccessful shareholders' derivative suit a. Can S still recover costs and attorneys' fees? No b. Is S liable to X for its costs and attorneys= fees? Yes, if he sued without reasonable cause. c. Can other shareholders later sue X on the same transaction? No. Because of res judicata 5. The requirements for bringing a shareholder derivative suit a. Stock ownership. (1) The person bringing suit must have owned stock at the time the claim arose OR (2) Have gotten it by operation of law (e.g., inheritance or divorce decree) from someone who did own stock when the claim arose. (3) Also, must own the stock throughout the litigation. b. Must also make a written demand on directors that the corporation bring suit UNLESS demand would be futile. (1) Often will be because the directors are going to be the defendants. c. Usually must plead with particularity. d. Shareholder can be required to post security (bond) for costsCto avoid strike suits. e. Disinterested directors can move to dismiss the derivative suit if they find it is not in the corporation’s best interest (e.g., low chance of success or cost of litigation would exceed recovery). (1) Court can scrutinize whether the directors making the recommendation are truly disinterested and, if so, dismiss. (2) In some states, the court will also make an independent determination of whether dismissal is in the corporation’s best interest. 6. Litigation. a. The corporation must be joined initially as a defendant. Though the suit asserts the corporation's claim, the company did not do sue, so it is joined as a defendant. b. Defenses. (1) Substantive defenses that could have been raised against the corporation (a) e.g., X claims a Statute of Frauds defense because there was no written agreement with C Corp. (2) Plaintiff disqualification defenses (a) Board of directors claim that S knew of, assented to, and benefitted from ultra vires activities of corporation. (3) **No dismissal or settlement without court approval (most important of the 3) (a) Court can give notice to those who would be affected, and get their input on whether dismissal or settlement should be approved. D. Voting
1. Who votes? a. General rule = record shareholder as of record date has the right to vote. (1) The record shareholder = the person shown as the owner in the corporate records. (2) The record date is a voter eligibility cut-off (a) Example: C Corp. sets its annual meeting for July 7 and record date for June 6. S sells B her C Corp. stock on June 25. Who is entitled to vote the shares at the meeting, S or B? (i) S because she owned it on June 6th (even though by the time the meeting roles around S no longer owns the stock) b. Exceptions to the general rule that record owner on record date votes. (1) *The corporation does not vote treasury stock even if it was the record owner on the record date. (2) Death of shareholder. (a) Example: S owns stock in C Corp.; S is the record shareholder. After the record date, S dies. (i) Can S=s executor vote the shares? Yes (3) Proxies. (a) A proxy is a: (i) (i) writing (fax increasingly OK; e-mail OK in some states), (ii) (ii) signed by record shareholder, (iii) (iii) directed to secretary of corporation, and (iv) (iv) authorizing another to vote the shares. (b) Classic Example: On February 2, 2004, S sends a letter to secretary of C Corp. authorizing Gomer Pyle to vote her shares. (i) Can Gomer vote S's shares at the 2004 annual meeting in July? Yes. This is exactly what a proxy is This is totally different than director voting where no proxy is allowed. (ii) Can Gomer vote S's shares at the 2005 annual meeting? No. A proxy is good for 11 months, unless it says otherwise. (iii) What if, prior to the 2004 meeting, S writes to the secretary of C Corp. that she now wants Ethel Mertz to vote her shares at the 2004 meeting? This is okay. She has revoked Gomer’s proxy and that’s fine. (iv) Can S revoke her proxy even though it states that it is irrevocable? Yes. (c) Example of irrevocable proxy: S sells B her shares after the record date but before the annual meeting. S gives B an irrevocable proxy to vote the shares at the annual meeting. (i) Can S revoke this proxy? No, because (1) it says irrevocable and (2) the proxyholder has some interest in the shares other than voting. This is a proxy coupled with an interest, this is the only irrevocable proxy. Here, the interest is ownership. But it could be an option, pledge, etc. c. Voting trusts and voting agreements. (1) Example: X, Y, and Z own relatively few shares of C Corp. They decide that they can increase their influence on corporate policy by block voting, i.e., voting alike. (2) Requirements for voting trust. (a) Written trust agreement controlling how the shares will be voted; (b) Copy to corporation; (c) Transfer legal title of shares to voting trustee; (d) Original shareholders receive trust certificates and retain all shareholder rights except for voting (e) Good for a maximum of 10 years (3) Requirements for voting (pooling) agreement. (a) Can shareholders enter into voting agreements? Yes (b) What is required? in writing and signed (c) Are voting agreements specifically enforceable?
(i) There is a split here all over the country 2. Where do shareholders vote? a. *There are two ways shareholders can take a valid corporate act: (1) unanimous written consent of the holders of all voting shares, or (2) a meeting (held anywhere) that satisfies quorum and voting rules. b. Annual meeting: to elect directors. If not held, a shareholder can petition the court to order one. c. Special meeting (1) Can be called by: (a) (a) the Board, (b) (b) the president, (c) (c) the holders of at least 10 percent of the voting shares or (d) (d) someone else as provided in the articles. (2) Example: A proper person calls a shareholder meeting to remove an officer. (a) OK? No because that is not a proper shareholder purpose (shareholders do not remove officers; only directors do that) (i) If this was to remove a director, that would be okay (shareholders can do that) d. *Notice requirement must give written notice to every shareholder entitled to vote, for every meeting (annual or special). (1) Contents of the notice: (a) Always must tell them when and where and (i) Must state purpose. (ii) Why is statement of purpose important? *Because that is the only business that can be transacted at that meeting. (2) Consequence of failure to give proper notice to all shareholders -- action taken at the meeting is void unless those not sent notice waive the notice defect. (a) How does waiver occur? Two ways… (i) Express -- in writing and signed any time; or (ii) Implied -- attend the meeting without objection. 3. How do shareholders vote? a. There must be a quorum represented at the meeting. (1) *Determination of a quorum focuses on the number of shares represented, not the number of shareholders. (a) Generally, a quorum requires a majority of outstanding shares. (2) Examples: X Corp. has 120,000 shares outstanding. X Corp. has 700 shareholders. What or who constitutes a quorum? (a) Need at least 60,001 shares (because we need majority of the outstanding shares) (b) Generally, shareholder quorum is not lost if people leave the meeting. (i) This is different than director voting! (c) Can the articles of X Corp. provide that a quorum requires that 90% of the outstanding shares be represented at the meeting? (i) Yes. It can be moved up or down, except that it can never be fewer than one-third of the shares entitled to vote. b. If quorum requirement is met, a majority may act to bind the corporation unless the articles or the bylaws require higher vote. (1) But majority of what? Shares present or shares actually voting? (a) Traditionally, needed majority of the shares present at the meeting. (b) Modern trend says need majority of the shares that actually vote on the proposal. (2) Example: X Corp. has 120,000 shares outstanding. 62,000 shares are represented at the meeting, but only 50,000 shares vote on a particular proposal. How many shares must vote for the proposal for it to be accepted by the shareholders? (a) Traditional answer – At least 31,001 because you need a majority of the shares present. (b) Modern trend answer – All we need is at least 25,001 because all you need is a majority of those that actually vote. 4. How and when do shareholders use cumulative voting?
a. Defined: Each shareholder is entitled to a number of votes equal to the number of his voting shares multiplied by the number of directors to be elected. (1) The total number may be divided among the candidates in any manner that the shareholder desires, including casing all for the same candidate. (2) This moves away from the one share-one vote paradignm b. Cumulative voting is only available in voting for directors. (1) It is a device to give small shareholders a better chance of electing someone to the Board. (2) Generally, this right to vote cumulatively exists in most states only if the articles explicitly provide. E. Stock Transfer Restrictions 1. Example: Kato is a shareholder of Famous For No Reason, Inc. His stock is subject to a stock transfer restriction that requires him to offer it first to the corporation (this is a right of first refusal). Kato sells the stock to Paris Hilton in violation of the agreement. a. Action against the transferring shareholder. (1) Look to the validity of the restriction. (a) Stock transfer restrictions will be upheld provided they are reasonable under the circumstances (not an undue restraint on alienation). The right of first refusal is OK, assuming the corporation offers a reasonable price. (b) These are very common in the close corporation b. Action against the transferee of the stock. (1) Even if the restriction is reasonable and thus valid, it cannot be invoked against the transferee unless either (a) it is conspicuously noted on the certificate or (b) the transferee had actual knowledge of the restriction. F. The right of a shareholder to inspect and copy the books of the corporation 1. Standing: who can demand access? a. Traditional view, must (1) Have owned stock at least six months or (2) Own at least five percent of the outstanding shares. b. Modern trend: any shareholder. 2. Procedure: written demand stating a proper purpose, which means related to her role as a shareholder. a. In be hostile to management 3. What are the consequences if the corporation does not allow inspection after proper demand? a. Shareholder moves for court order. b. If successful, also generally recovers costs and attorneys= fees incurred in making the motion. 4. Note: Directors do not have to make this showing; they automatically have access to the books G. Distributions 1. Defined: Payments to shareholders a. Can be dividend or b. Can be to repurchase shareholder's stock or c. To redeem stock (force sale to corporation at price set in articles) 2. *Distributions are to be declared in the Board=s discretion. it is up to the board a. An action to compel declaration of a distribution is tough to win. (1) Can win only on a very strong showing of abuse of discretion. (2) For example, if the corporation consistently makes profits and the board refuses to declare a dividend while paying themselves a bonus. 3. Which shareholders get dividends? (Preferred, Participating, Cumulative, Common) – Rarely tested a. Examples: The board of directors of C Corp. decides to declare dividends totaling $400,000 Who receives dividends if the outstanding stock is: (1) 100,000 shares of common stock. (a) $4 per share (2) 100,000 shares of common and 20,000 shares of preferred with $2 dividend preference. Preferred means pay first. (a) 20,000 preferred shares multiplied by $2 preference equals a total preference of $40,000.
That is paid first. (b) That leaves $360,000, which goes to the common shares. (i) Because there are 100,000 of those, each common share gets $3.60. (c) 100,000 shares of common and 20,000 shares of $2 preferred that is participating. [*Participating means pay again] (i) So these 20,000 shares get paid first (because they are preferred) and also get paid again (because they are participating). (ii) Work the preferred aspect same as in hypo #2: 20,000 shares multiplied by $2 equals $40,000 total preference. Pay that first. That leaves $360,000, as in hypo #2. Here, the $360,00 gets divided by the 120,000 shares. That works out to $3 a share (that’s all the common gets). Preferred participating gets $5 a share because they get paid twice. $2 in their preferred capacity $3 in their participating capacity (3) 100,000 shares of common and 20,000 shares of $2 preferred that is cumulative (and no dividends have been paid in the three prior years). (a) Cumulative means add them up. A cumulative dividend accrues year-to-year. (b) So the corporation owes the cumulative holders for the three prior years, plus this year (when the dividend was declared). (i) That means the corporation owes them four years= worth of a $2 preference. (ii) Four years multiplied by $2 equals $8 per share. So the corporation owes $8 to each cumulative preferred share. (iii) There are 20,000 such shares. Times $8 we owe them = $160,000. Pay this first. Leaves $240,000. That goes to the common 100,000 of those, so they get $2.40/share 4. *For any distribution (dividend, repurchase, redemption), which funds can be used? a. Earned surplus -- generated by business activity. (1) How is earned surplus computed? All earnings minus all losses minus distributions previously paid. (2) How can earned surplus be used? Distributions (this is an ok fund for distribution) b. Stated capital -- generated by issuing stock. (1) Capital surplus is also generated by issuing stock, so when we have an issuance, the consideration will be allocated between "stated capital" and "capital surplus." (2) Can stated capital be used for distributions? No. never (3) How is stated capital computed? (a) Example: C Corp. has issued 10,000 shares of $2 par stock for $50,000 and 4,000 shares of no par stock for $70,000. (i) On the par stock: $20,000 is stated capital and $30,000 is capital surplus. The par value is stated capital The excess goes into capital surplus (ii) On the no-par stock: The board allocates between the two funds. c. Capital surplus -- also generated by issuing stock. (1) How is capital surplus computed? Payments in excess of par plus amounts allocated on a no-par issuance. (2) Can capital surplus be used for distributions? Yes. If you inform the shareholders 5. A nimble dividend a. Defined: one paid out of current earnings when there is not sufficient surplus for a dividend. b. Many states do not allow these.
6. *Corporation can make distribution even though it lost money last year; a. Corporation cannot make distribution if it is insolvent or if the distribution would render it insolvent. (1) Insolvent = Unable to pay debts as they come due. (a) Some states say also insolvent if assets are less than liabilities (and liabilities include liquidation (or dissolution) preferences). 7. *Directors are personally liable for unlawful distributions, as are shareholders who knew the distribution was unlawful when they received it. a. In some states, director liability here is strict; in some, directors are only liable if the distribution is made in breach of a duty. b. Remember, however, directors= possible defense of good faith reliance. (1) Such as relying on what the financial people told you.
V. FUNDAMENTAL CORPORATE CHANGES (Not as important as Fact Patterns 3 and 4 on the Bar)
A. Characteristics of Fundamental Corporate Change 1. Unusual occurrences, so they require: a. Board of director action AND b. Approval by a majority of the shares entitled to vote. (different than shareholder voting discussed above) 2. Possibility of dissenting shareholder right of appraisal. a. The right of appraisal = the right of a shareholder to force the corporation to buy her shares at fair value. b. When will a shareholder have a dissenting shareholder right of appraisal? (1) Actions by corporation to trigger right -- any of these: (a) merger or consolidation; (b) transfer of substantially all assets not in the ordinary course of business; transfer of shares in a share exchange. (2) Actions by shareholder to perfect right: (a) Before shareholder vote, file with the corporation written notice of objection and intent to demand payment; (b) Abstain or vote against the proposed change; AND (c) After the vote, make written demand to be bought out. c. If the shareholder and the corporation cannot agree on fair value of the shares, the court may appoint an appraiser. (rarely tested) d. Some states do not grant the right of appraisal if the company’s stock is listed on a national exchange or has a large number of shareholders (e.g., 2,000 or more). (also rarely tested) B. Amendment of the Articles 1. Board of director action and notice to shareholders. 2. Shareholder approval. a. Need a majority of those shares entitled to vote 3. If approved, file amended articles with Secretary of State. 4. There are no dissenting shareholder rights of appraisal a. But if the amendment harms a class of stock, the amendment must be approved by the shares of that class itself as well as by the overall majority of all shares entitled to vote. (1) This is class voting. C. Mergers [B, Inc. merges into A Corp.] OR Consolidations [A Corp. and B, Inc. form C Corp.] 1. Board of director action (both corporations), and notice to shareholders. 2. Shareholder approval (generally both corporations). a. Need a majority of the shares entitled to vote. b. No shareholder approval required in Ashort-form@ merger, where a 90 percent-or-more owned subsidiary is merged into a parent corporation. (rarely tested) 3. If approved, file articles of merger (or consolidation) with Secretary of State. 4. *Remember: There is a dissenting shareholder right of appraisal a. Generally for:
(1) shareholders of both companies in a regular merger and consolidation and (2) shareholders of subsidiary in short-form merger. 5. *Effect of merger or consolidation: a. The surviving company succeeds to all rights and liabilities of the constituent companies. (1) This makes sense because the constituent corporation disappeared. (2) So a creditor of that corporation can sue the survivor. D. Transfer of all or substantially all of the assets not in the ordinary course of business or share exchange (share exchange = one company acquires all the stock of another) 1. *These are fundamental corporate changes for the transferring corporation only. a. They are not fundamental corporate changes for the buying corporation. b. Example: S Corp. wants to sell all of its assets to B, Inc. or B, Inc. wants to buy all the shares of S Corp. Each corporation has 12,000 shares outstanding. 2. Board of director action (both corporations), and notice to selling corporation’s shareholders. 3. Approval by transferring corporation’s shareholders. a. Number of shares of S Corp. that must approve the sale? (1) At least 6,001 (need a majority of shares entitled to vote) b. Number of shares of B, Inc. that must approve the sale? (1) NONE! They don’t vote because it is not a fundamental change for the buying corporation 4. There are dissenting shareholders= rights of appraisal a. But only for shareholders of the transferring corporation only. (1) It is not a fundamental corporate change for the buyer 5. File articles of exchange in share exchange. a. Usually, no filing in transfer of assets. 6. *Generally, acquiring company is not liable for debts of the acquired company unless the deal says otherwise or unless the company purchasing assets is merely a continuation of the selling corporation. a. This makes sense, because the corporation that sold its assets still exists, so a creditor can still sue it. E. Dissolution 1. Voluntary a. Board of directors resolution and approval by a majority of the shares entitled to vote, or b. Unanimous written shareholder agreement. c. After either of these, file articles of dissolution and give notice to creditors. 2. *Involuntary (by court order). a. *Shareholder can petition because of: (1) (1) *director abuse, waste of assets, misconduct; or (2) (2) director deadlock that harms the company; or (3) (3) shareholder deadlock and failure for at least two annual meetings to fill a vacant board position. (4) Alternative to dissolution: court may order buy-out of the complaining shareholder (especially in close corporation). b. Creditor can petition because: (1) the corporation is insolvent and the creditor either has an unsatisfied judgment against the corporation or (2) the corporation admits the debt in writing. 3. *How to dissolve: After filing articles of voluntary dissolution, or after court order of involuntary dissolution, corporation stays in existence to wind up. a. Winding up: (1) (a) gather all assets, (2) (b) convert to cash, (3) (c) pay creditors, and (4) (d) distribute remainder to shareholders pro-rata by share unless there is a dissolution (or liquidation) preference. (a) Liquidation preference = Works like a dividend preference; pay first. (i) Must explain on exam what kind of preferred stock you have (?)
VI. SECURITIES CONSIDERATIONS (**Very popular on the Bar)
A. Terminology: Securities are Investments 1. Debt = Investor lends capital to the corporation, to be repaid (usually with interest) as specified in the agreement. a. Can be secured by corporate assets (1) Secured = mortgage bond (2) Unsecured = debenture 2. Equity = Investor buys stock, and has an ownership interest in the corporation. This status carries various rights, e.g., to inspect records, bring derivative suits. 3. Debt security can be made convertible or redeemable in instrument. Equity security can be made convertible or redeemable in articles. a. Redemption = Aforced sale to the corporation. b. Conversion = Gives the security holder the right to convert it, e.g., debt to equity or one class of stock to another. 4. Put option = an option to sell securities at a set price. Call option = an option to purchase securities at a set price. B. State Law Liabilities (common law stuff – tested often) 1. Sale of Controlling Shareholder's Interest. a. Controlling shareholder = one with a majority of shares or a minority in a situation that gives working control over the corporation, e.g., parent corporation. (1) Because this person's stock carries control, she can sell it for more than its value simply as ownership of that portion of the corporation. (a) The extra is called a "control premium." (b) Selling for a control premium is OK, unless there is some other factor involved. b. *Increasingly, courts impose duties on the controlling shareholder, owed to the corporation and to minority shareholders, especially in these situations: (1) Sale to looters. (a) Controlling shareholder is liable if she sells to looters without making a reasonable investigation of the buyer. (b) Liable for damage caused to the corporation, including amount looted and other harm, e.g., damage to earnings. (c) Watch for facts that would put a reasonable person on notice that the buyer could be one who loots the corporation. (2) Disguised sale of corporate asset. (a) Buyer pays a premium to the controlling shareholder so she can get her hands on an asset of the corporation. (b) *Controlling shareholder has no right to sell a corporate asset. (c) All shareholders should share in the premium. (d) Often comes up on exam with looting. (3) Sale of a board position. (a) Rule: Fiduciary cannot get paid to relinquish her position. (b) Watch for controlling shareholder selling her control shares and then resigning from the board along with her pals. (c) It's OK for the new controlling shareholder to elect new directors. It is NOT OK for the controlling shareholder to relinquish her position so we will disgorge the seller’s profit. 2. Controlling shareholder cannot subject minority shareholders to detriment. a. Especially a problem in a close corporation. (1) Courts may protect the minority shareholder because there is no public market for the stock, so a disgruntled minority shareholder cannot simply sell her shares. b. Fraud. (1) Common law fraud may apply to misrepresentations in the sale of stock, allowing suit by the defrauded buyer or seller. (2) This covers the overt lie, but not the half-truth or failure to disclose.
(3) If just a failure to disclose, see below… c. Nondisclosure of "special facts." (1) Many courts impose upon directors and officers an affirmative duty to disclose "special facts" in a securities transaction with a shareholder (or maybe a non-shareholder). (a) What are special facts? (i) Those a reasonable investor would consider important in making an investment decision. (2) Who can sue? (a) Shareholder with whom the insider deals. (b) Some say a prospective shareholder may sue. (3) Measure of damage: (a) Difference between the price paid and the value of the stock a reasonable time after public disclosure. (4) In some states, the corporation can sue the insider to recover profits she made in market trading on inside information. C. Federal Rule 10b-5: Aimed at Deceit 1. Defined: makes it illegal to use any fraudulent scheme in connection with the purchase or sale of any security. a. Elements: (1) Instrumentality of interstate commerce. At some point, the transaction must employ an instrumentality of interstate commerce, e.g., telephone, mail or if deal goes through national exchange. (2) Possible defendants: "any person" (human or entity). (a) Company that issues a misleading press release (b) Buyer or seller of securities who misrepresents material information. (c) Buyer or seller of securities who fails to disclose material inside information (i) Only comes up when there is a duty to abstain or disclose comes from relationship of trust and confidence with shareholders of the corporation (d) Tipper and tippee. (i) Tipper: Passed inside information in breach of a duty to corp. AND Benefitted. Making a gift to someone else or enhancing a reputation is enough (ii) Tippee Traded on the tip AND Knew or should have known that the information was improperly passed. (3) Possible plaintiffs: (a) SEC (b) Private buyer or seller of securities. (4) Possible "bad acts" by defendant: (a) Misrepresentation of material information. (b) Nondisclosure of material inside information when duty to disclose exists (i) This duty comes from relationship of trust and confidence with shareholders of the corporation. This means insiders cannot trade on secrets. They must abstain or disclose so everybody's on the same footing. (ii) This duty is imposed on insiders and temporary insiders. They have a relationship of trust and confidence with the shareholders of the corporation. (c) Tipping (passing along material inside information for a wrongful purpose). (5) The bad act must be in connection with the purchase or sale of any security. (a) That includes DEBT OR EQUITY SECURITIES. (6) Materiality.
(a) The misrepresentation or omission must concern a material fact one that a reasonable investor would consider important in making an investment decision. (7) Scienter. (a) Defednant must have an intent to deceive, manipulate, or defraud. Recklessness may suffice. Negligence does not suffice. (8) Reliance is said to be a separate element (as in fraud cases). (a) But reliance is presumed in cases of nondisclosure and public misrepresentation. 2. Hypos a. Jim is a director of X Co., and has learned that the corporation has developed a new machine that will revolutionize the market. The corporation's stock is now selling at $10 per share. Internal reports indicate the stock will go to $50 within weeks of the announcement of the new machine. Paul, a shareholder, calls Jim on the telephone to complain about the corporation and says he wishes he had never bought the stock. Jim offers to buy Paul's stock for $20 per shares. Paul sells to Jim. After the public announcement, the stock goes to $50. (1) Can Paul sue Jim under 10b-5? Yes (a) Element 1? Because of the telephone (b) Element 2? Jim is an insider with inside information who failed to disclose (c) Element 3? Paul is a seller of a security (d) Element 4? Jim traded on inside information (e) Element 5? Equity securities (f) Element 6? It is a material fact (the fact that the stock will go up 5 fold in a matter of weeks is material) (g) Element 7? Jim had an intent to deceive (trading on inside info and didn’t disclose) (h) Element 8? Paul did rely on Jim’s silence. But remember, reliance is presumed in nondisclosure cases. (2) Damages: The difference between price paid ($20) and the price a reasonable time after the news went public ($50). (a) So $30 per share. (3) Notice, on this hypo, if we were asked about common law liability, we could discuss the special facts doctrine. It would be met here. (a) In fact, if we did not have an instrumentality of interstate commerce, and thus could not use Rule 10b-5, special facts might be the only theory to use. b. Widget Corp. issues a press release that Buffett has expressed an interest in acquiring a major block of its stock. The release fails to indicate that it is Jimmy Buffett and not Warren Buffett who is interested. Because of this press release, Duffy does not sell his Widget stock. (1) Does Duffy have a 10b-5 cause of action? (a) Duffy did not buy or sell (see element 3). All he did is hold what he had. (b) Anyone who bought or sold because of the press release could sue c. Laura, a lawyer for X Co.[classic insider], learns that X Co. is planning to merge with Y Corp. She telephones her son-in-law Joe about this, and urges him to buy X Co. stock. Acting on the tip, Joe buys the stock. (1) Any violations of Rule 10b-5? Yes (2) *Laura is a TIPPER because: (a) (1) she passed inside information in breach of a duty to X and (b) (2) she benefitted. How did she benefit? (i) Making a gift to someone else or enhancing a reputation is enough (3) *Joe is a TIPPEE because (a) (1) he traded on the tip and (b) (2) knew or should have known that the information was improperly passed. d. If, in above hypo, Laura learned of the merger and bought stock in Y Corp., maybe no violation of Rule 10b-5 because she (as an insider for X Co. owes no duty to Y Corp. (1) But many courts would hold L liable under the "misappropriation" theory. (a) In a criminal case, the Supreme Court adopted the misappropriation theory. The Court did not address whether the theory applies in a private case.
(2) If you get a fact pattern like this, think about this misappropriation theory. Might as well throw it in. e. D is a director of C Corp. While waiting for a concert to start, D tells her husband about a new, secret processing method that C Corp. has just developed. Bobbitt, who is sitting in the next row, overhears the conversation and buys C Corp. stock on a national exchange. (1) Any violations of 10b-5? NO (a) At worst, D was merely negligent, which is not enough for 10b-5 liability. (i) Negligence is never enough (2) So D is not a tipper. She had no scienter and gained no benefit. (3) UNDER 10B-5, IF THERE IS NO TIPPER, THERE CANNOT BE A TIPPEE. D. Section 16b: Aimed at Speculation by Directors, Officers & Ten Percent Shareholders 1. Defined: This federal law provides for recovery by the corporation [so it could be a derivative suit] of profits gained by certain insiders from buying and selling the company's stock. The theory is that it is bad for market confidence to have these insiders buying and selling their own corporation’s stock. a. Different than 10b-5 in that it imposes strict liability. 2. When does 16b apply? a. Only applies to Reporting corporations. They are: (1) Listed on a national exchange OR (2) At least 500 shareholders and $10 million in assets. (3) Registered per section 12 of the Securities Exchange Act of 1934. b. Type defendant. (1) Director (either when she bought or sold) or (2) Officer (either when she bought or sold) or (3) Shareholder who owns more than 10 percent both when she bought and sold. (a) To determine if she is above 10 percent, take a snapshot of what her ownership level was immediately before the event. (i) S owns no stock and then buys 12 percent. Is that purchase covered? NO, because immediately before the event, she was at zero percent. (ii) S owns 12 percent and then buys 5 percent more. Is that purchase covered? Yes, because immediately before the event, she was above ten percent. (iii) S is at 17 percent and sells it all. Is that sale covered? Yes, because immediately before the event, she was above 10 percent. c. Type transaction (1) Buying and selling stock within a single six-month period (short-swing trading) (a) [Fraud is not required. No requirement of inside information.] d. The defendant must have bought and sold equity securities (stock). (1) Not dealing with debt securities here. 3. What happens when 16b applies? a. All profits from such “short-swing” trading are recoverable by the corporation. (1) *If, within six months before or after any sale, there was a purchase at a lower price, there is a profit. (a) So it's a profit even if you buy after you sell, so long as you buy at a lower price than that at which you sell. b. *Example: D is a director of Acme, Inc., which is a reporting corporation [keys you into the fact that it is a 16b question]. In 2002, D bought 700 shares of Acme stock for $10 a share. In January 2004, D sold 700 shares for $6 [so far she’s losing money]. In March 2004, D bought 200 Acme shares for $1 a share. (1) What result? (a) Doesn't seem like there's a profit but there is a $1,000 profit under 16B. D owes the corporation $1,000. (i) This is strict liability. There is no defense (b) KEY TO 16b = cut through all the facts and focus on the sale. (i) Here, the sale was January 2004, D sold at $6. (2) Did she buy at less than $6 within 6 months before the sale in January 2004?
(a) No. She did nothing. (3) Did she buy at less than $6 within 6 months after the sale in January 2004? (a) Yes. In March, she bought at $1. Considered a profit at $5/share (i) How to we get to $1,000? (b) Multiply $5 profit times 200 shares. Why 200? (i) Because that is the largest number of shares that she both bought and sold within the six-month period. (ii) She sold 700 shares within the six months, but she cannot be held for profit on all 700 shares, because she only bought 200 shares within that period.