BUSINESS ASSOCIATIONS OUTLINE
Fall 2011 – Prof. Lazaroff
THE INTERNAL AFFAIRS DOCTRINE
- Issue: what state’s law applies to the issue?
o The problem: big corps’ principal place of business is not in the state of incorporation.
- “Matters that pertain to the relationships among or between the corporation, its officers, and its shareholders” are
subject to the laws of the state of incorporation.
o Case-by-case analysis
o VANTAGEPOINT VENTURE PARTNERS v. EXAMEN, INC. (p194): issue of whether CA law should be applied
to a DE corporation with regard to how to proceed on a merger, as DE law says separate classes of
shareholders vote as one giant block, while CA law votes by class (Plaintiff owned enough shares to stop the
merger in one class, but not as a giant block).
Voting on merger was internal issue to be determined by law of state of incorporation.
Improper statutory constructions violating Internal Affairs Doctrine raise Due Process issues.
o FRIESE v. SUPERIOR COURT (p201): trading of shares by corporate insider of DE corporation subject to CA
law. CA court deciding. Arg: trading of public shares affects more than internal corp: affects public
(deterioration in confidence in market.)
Where an arguably-internal act affects the public interest, might not be internal.
Would an unwise merger affect the public interest?
o PRITCHARD / FRANCIS cases? (other cases where unclear which law should be applied.)
Fiduciary duties owed by directors/officers/etc. to shareholders.
Voting on corporate transactions.
But not: e.g., tortuous conduct affecting a third party.
o Policy of Internal Affairs Doctrine: inconsistency between states uncertainty for investors/counsel.
FORMING A CORPORATE ENTITY
- Issue: was the corporation properly formed?
- A corporation may be formed for ANY LAWFUL PURPOSE.
o At one point, political/economic/social concerns limited corporations to specific funding or purposes.
- Don’t need seed funding – DE: sufficient to state that corp is formed for “a lawful purpose”.
o But: undercapitalization may be a problem. [Equitable subordination].
- A corporation’s life begins with the FILING of a CERTIFICATE OF INCORPORATION.
o Won’t be tested on the particulars: just ask whether the statute was followed.
o Lawful to extent they do no conflict with statute or articles of incorporation.
o Generally cover inner-workings of corporation: voting, committees, etc.
o Shareholders: have inherent right to adopt and amend bylaws (BoD generally can’t).
- ULTRA VIRES:
o Doctrine: if corporation not properly formed, then its actions are void/voidable. Rare.
CONSTITUENCIES IN A CORPORATION AND THEIR SOURCES OF POWER
- BOARD OF DIRECTORS:
o “BOARD SHALL MANAGE”: derives authority to manage corporation from statute after being elected by
shareholders -- does not act as an agent of shareholders. Appoints, monitors, oversees officers, etc.
o Close corporations may completely eliminate (or “sterilize”).
o DEFAULT VOTING: quorum: simple majority of authorized directors; simple majority of quorum can act.
Can change, up to and including unanimity. But risk of deadlock.
o Generally: role in “board shall manage” model limited, but by statute can vote on fundamental changes:
Plans of merger, acquisition statutes might require higher percentage
o DEFAULT RULE: quorum: simple majority of shares; simple majority of quorum can act.
Can change, up to and including unanimity (especially with close corporation). Risk of deadlock.
Big corporations might want to lower quorum downward, due to difficulty of getting quorum.
Minimum quorum: some states say 1/3; some have no minimum. (Desire to prevent paralysis).
o ELECTION OF DIRECTORS
Generally, elected every year.
General rule: plurality wins; some states (including CA) require majority if uncontested.
o STRAIGHT VOTING: Number of shares is number of votes for each open seat.
E.g.: 100 shares, 8 spots. Can’t vote 800 times for one candidate.
E.g.: 1,000 shares available, one shareholder has 501 shares, 8 open spots. Can vote 501
shares for each spot, control Board election.
o CUMULATIVE VOTING: Total votes= # of shares times # seats. Can allocate votes to any candidate.
(Basically, a straight up-or-down vote for each spot).
Some state constitutions give right to vote cumulatively. Default is that cumulative
voting optional (including DELAWARE).
E.g.: 7,200 shares total, 8 spots open. One shareholder goes “all in” with 808 shares to
one seat. Rest of shares can’t spread out to defeat this shareholder.
Formula to determine # votes necessary to control one Board seat: X = [[
[(Shares times N) +1] / [ Directors + 1 ]+1
Staggering cumulative voting can reduce its effectiveness. OK unless prohibited by
BOHANNON (AZ): state constitution protected cumulative voting. As long as
cumulative voting not completely defeated, OK to increase proportion needed
to win seat via staggering. Not defeated here by electing three at once.
CRAIGSLIST (DE): Shareholders want to keep eBay out of Boardroom (3 Board
spots). Broke up voting to 3 classes, eliminating eBay’s ability to use its 28%
stake to elect anybody – eliminated cumulative voting by staggering. But DE
had no requirement of cumulative voting; no requirement of minority
representation on Board.
Policy: states don’t require minimum number of directors, so cumulative
voting won’t have any impact on small Board (e.g., 2 or 3 members). Nobody
will want to buy company if staggered voting: don’t want to get stuck with
2/3rds of old board. You buy because you think you can do a better job.
o REMOVAL OF DIRECTORS
NB: directors not ‘agents’ (derive authority from statute), but removal without cause gives
shareholders significant say over
Common law: in absence of statute to contrary, shareholders have a right to remove director for
cause. ‘Cause’ is fact-dependent (e.g., criminal behavior, breach of fiduciary duty, etc.).
Removal without cause:
By statutory authorization.
By provision in bylaws (if state permits).
Cumulative voting exception: if staggered voting in effect, can only remove for cause.
(i.e., if you vote enough shares against removal that would have been required to elect,
cause is required.)
o CONFLICTS BETWEEN SHAREHOLDERS’ VOTES AND DIRECTORS’ RIGHT TO MANAGE
“The Board shall manage, except as provided in the certificate or by statute.” Statutory authority
from legislature gives Board the power to act, not an agency relationship with shareholders.
Potential options to resolve: BJR for ord business decision, SCHNELL approach, BLASIUS
(compelling justification) approach.
Board cannot engage in conduct solely for self-perpetuation in office.
SCHNELL: BoD advances date of elections by month in order to undermine insurgent
candidates. Not an ordinary business decision (so no BJR deference) because it
implicates shareholder’s right to vote.
BLASIUS: Cert. of Incorp. permits 15 BoD seats, company has 7. New shareholder
(Atlas) wants to add 8 and then turn company stock into debt and pay out high yields to
shareholders, which would be unhealthy for company in long run. Current BoD adds
two seats to BoD (preventing Atlas from being able to get majority).
o Court looks to “primary purpose” of decision (prof doesn’t like) to see whether
there was a compelling justification, determines BoD acting for primary
purpose of interfering w/vote. Unclear what would justify interference.
o MERCIER v. INTER-TEL: OK for BoD to delay vote on merger they proposed, as
stockholders were going to reject it (against stockholders’ interests); Delayed
to give more time to consider the proposal; Directors would have lost jobs
anyway (no loyalty breach)
Shareholders cannot use bylaws to bypass the BoD but can set out rules/procedures to reach
decisions. Bylaws should not mandate how the BoD should decide specific, substantive issues.
CA, Inc. v. AFSCME (p285): using bylaw to require reimbursement to shareholders for
proxy contests violated BoD’s fiduciary duties: failed to provide a fiduciary out for BoD
to reject improper reimbursements. Proxy contest expenses is a proper subject for a
bylaw, but not as written.
o Appointed by Board of Directors. Manage the day-to-day operations of the company.
Duties are articulated within bylaws or board resolutions.
o Issue: can an officer bind the company? What if no clear articulation of authority? Determine not by
statute or board resolutions/bylaws. Determine by principles of agency.
Basic analysis: 1) bylaw/resolution permitting? 2) past acts of company to allow? 3) acts of 3rd
party w/company in past without repudiation?
Express: statutory articulation, board resolution, bylaw specification, internal
employment manuals, oral representations to officer, of officer’s duties.
Implied: manifestations from the principal (the corp) to the officer.
o E.g., Co. tells officer to replace carpets in office. Not expected to do it himself.
Apparent authority: not actual authority (but can often coincide with actual authority).
Would reasonable third party dealing with the corporation think the agent had auth?
o E.g., officer had years of auth to make $100k+ loans. Bank president removes
officer’s auth; officer loans long-term customer $100k. Reasonable basis from
past contact. Officer might be liable to corp, but corp liable to customer.
o Ordinary vs. Extraordinary matters: President has apparent authority to bind
corp to contracts made in usual and regular course of business, but not to
contracts of extraordinary nature. More room for Pres than VPs, as courts
recognizing that VP title can be more symbolic than functional.
Economic magnitude of act in relation to assets & earnings
Amount of risk
Time span of action’s effect
Cost of reversing action
Act that must be by BoD by statute? E.g., dec of dividends.
E.g., extraordinary: creation of long-term or significant debt,
reacquisition of equity securities, significant capital investments,
significant business combinations, disposition of significant business,
entry into important new lines of business, significant acquisitions of
stock in other corps, actions foreseeably exposing corp to significant
VPs: title more symbolic than functional, so 3rd parties can rely on
for small transactions.
Closely-held corps: apparent authority applied more broadly.
General partnership: in ord. course of business, partners can bind.
If no disaffirmance or K is ratified (e.g., company subsequently adopts through proper
channels), K will be valid retroactively to date made. Knowingly retaining benefits of
transaction = bar.
SHAREHOLDER INFORMATIONAL RIGHTS
o State laws requiring disclosures to shareholders were not an adequate means of getting information to
shareholders. Supplemented by Federal law.
1934 Act in response to Great Depression, lack of information.
§14: SEC authority “as necessary or appropriate to protect investors” can prescribe rules to
protect public or public investors.
§10(b) talks about “as necessary or appropriate” but also refers to “manipulative or
deceptive devices” (fraud).
[NB: won’t be tested on form and filing requirements of proxy solicitations].
o Three avenues: state common law, state statutory law, Federal proxy rules.
- STATE COMMON AND STATUTORY LAW
o At common law, shareholders can inspect shareholder lists, books and records if they can articulate a
proper purpose relating to economic interests as a stockholder. Some states may impose a different
burden by statute (e.g., DE’s higher burden for books and records).
Standing: reasonably related to interests as a shareholder. (Not, e.g., CEO’s medical records)
SAITO (p343): Interests may include activities pre-dating purchase of stock. E.g., to
propose reforms or address a continuing wrong.
Books and records:
Shareholder lists: who record owners are, how many shares they have, etc.
o DE: flips burden: corporation must show you have improper purpose.
Proper purpose: discerning and taking action against corporate misconduct, ascertaining value of
one’s stock, evaluating corporate performance.
Improper: acquiring shareholder list to sell to competitor/charity, inspection right used
to harass company, getting proprietary info to sell, etc.
o HONEYWELL: bought stock just to convince company not to manufacture
munitions, wanted to communicate with other shareholders. Not a proper
purpose relating to economic interest as stockholder.
Court can condition use – allowing disclosure for limited purpose, prohibiting others.
SAITO: DE court put higher burden on P to discover books/records: must show with
“rifled precision” what’s desired.
o SEINFELD v. VERIZON: when alleging corporate wrongdoing, must allege a
credible basis to infer mismanagement in order to have proper purpose.
Third party possession: Some states (e.g., DE §220(b)) permit shareholders of Company A to get
records of subsidiary B if A has possession of records or could attain through exercise of control.
o Inadequacy: can be prohibitively expensive if corporation resists through litigation, delays access to info.
DE, e.g., doesn’t require corps to provide regular financial statements as a matter of course.
E.g., SAITO (requiring showing with “rifled precision” which books/records desired),
SEINFELD (must allege a credible basis to satisfy proper purpose requirement when
alleging corporate malfeasance).
- FEDERAL PROXY RULES
Jurisdiction: §12 Companies: $10 million in assets + 500+ people
NB: if exam says “stock regularly traded on NYSE” or “traded on a public securities
exchange”, assume it’s a §12 company.
If it’s a §12 company, then §§ 13 and 14 apply. A violation of a rule promulgated under
these statutes is a violation of the statute.
§14 enabling language?
As applied to §14(a)(8) (requiring inclusion of shareholder proposals):
As applied to §14(a)(9) (false/misleading statements):
o Falls better within language protecting shareholders from false/misleading
proxy statements with respect to material issues is important.
o SHAREHOLDER PROPOSALS
§14(a)(8): shareholder proposals included at company’s expense.
Private right of action is implied.
No Action letters from SEC?
Conflict with BoD’s right to manage? Not really: Congress’ intent was to increase
corporate democracy, these don’t require the BoD to actually do anything.
POLICY: shifts costs of proposals from shareholders to company (/other shareholders)
in order to increase corporate democracy. Most proposals are social/ethics in nature
and don’t pass, but still increases democracy by bringing issues to attention of BoD.
o Vehicle for increasing corporate social responsibility.
PRE-REQUISITES: The proposing shareholder must:
Own shares in a §12 company
Continuously held $2,000+ in market value OR 1%+ of company’s securities
For 1+ year before submitting the proposal.
o Limited to 500 words, including statement;
o Can’t submit more than one proposal per year.
THIRTEEN EXCEPTIONS: proposals can be excluded where: (5+7 give rise to most litigation). Only
need to know three:
1) IMPROPER UNDER STATE LAW: Proposal conflicts with state law.
o CA, Inc. v. AFSCME (p285): using bylaw to require reimbursement to
shareholders for proxy contests violated BoD’s fiduciary duties: failed to
provide a fiduciary out for BoD to reject improper reimbursements. Proxy
contest expenses is a proper subject for a bylaw, but not as written.
NB: subsequent DE statutes permit corporations to make
reimbursements, but don’t provide fiduciary ‘out’, so unclear
whether AFSCME legislatively overruled.
o NB: if non-binding (phrased as saying BoD should look into something, not
do), more likely to be OK.
5) RELEVANCE: Proposal relates to operations of company accounting for less than 5%
of company’s assets at end of most recent fiscal year and less than 5% of earnings
[objective prong] and is not otherwise significantly related to the company’s business
o “significantly related” significant policy concerns.
o LOVENHEIM v. IROQUIS BRANCH: though geese accounted for less than 1%
of business, proposal concerning forced-feeding of geese had to be included
because it raised serious social/ethical concerns.
7) Ordinary Business Exception (Management Function Exception)
o The more you can link it to social policy, more likely will have to be included.
Significant policy, economic, or health/safety concerns.
“Make more red cars,less yellow cars” ordinary, but “make more
hybrid cars for environment reasons” raises serious policy concerns.
o ROOSEVELT v. Du PONT: Manufacture of CFCs: shareholders want CFCs
phased out one year earlier than planned ordinary business decision. CFCs
were still going to be manufactured in meantime without exceptions.
Compensation for ordinary workers ordinary business decision.
Violence/profanity on TV, or leading roles on TV for minorities:
CO: ord business dec made by executives (not even BoD).
Who is hired/casted is ‘ordinary’
OTHER EXCEPTIONS: illegal; personal grievance/special interest (redress of personal
claim or grievance against CO, or designed to benefit shareholder); relates to election.
o FALSE OR MISLEADING STATEMENTS
§14(a)(9): designed to ensure that information required in annual reports and proxy statements
is complete and accurate.
Where there is a proxy solicitation (he’ll be clear on this on exam) [or statement in
annual/quarterly reports?], it is a violation to make a statement which, at the time it is made, is
materially misleading either by omission or misstatement.
“There has to be an omission or misstatement of material fact. A material fact is a fact which is
important enough that there’s a substantial likelihood that a reasonable shareholder would
consider it important. Doesn’t have to change vote or investment decision, but it does have to rise
to that level. In many cases, it can be determined as a matter of law, but in many it’s a gray area
where a trier of fact has to determine it.”
NB: even if there’s no remedy under §14 (e.g., no transaction causation), there may be a remedy
for, e.g., breach of duty of care.
o SMITH v. VANGORIK: experienced directors approved buyout without becoming
adequately informed. [Unsure if there was no transaction causation in this case].
“Would” standard: whether there’s a substantial likelihood that a reasonable
shareholder would (not might) consider the information important. [NORTHWAY]
o Doesn’t have to actually change the vote: just be important.
o ALI: same standard: subst likelihood reas. investor would consider important.
o SANDBERG: directors’ opinion that shares had a “high value” and “fair price”
at $42 (shareholders allege it’s worth $60). Potential material facts: that
director actually holds opinion; that stock price is fair and high and $42.
Though materiality established, no transaction causation: didn’t need votes.
Must be material as to a fact. Opinions/beliefs aren’t really facts,
but when stated by a BoD member, expected to have basis in fact.
“Soft” issues: balance probability and magnitude
o e.g., projected earnings, possible merger, pending lawsuits…
o BASIC v. LEVENSON: merger sufficiently definite to be material?
o TEXAS GULF SULFUR: potential ‘motherlode’ based on initial mineral core test
would be important, given magnitude and probability.
PRIVATE CAUSE OF ACTION:
BORAK: USSC: §14(a) implies private right of action.
o Unclear whether some level of scienter is required in private causes of action
[what about gov’t enforcement?]
§14(a)(9) is silent on scienter. (But §10(b)(5) does).
SANDBERG: USSC declines to address. Suggests it’s something more
than strict liability or negligence, but never requires it.
GERSTLE (2nd Cir.): negligence suffices. [NB: mere typo = negligence]
SHIDLER (8th Cir.): no strict liability, as innocent misstatements are
not what Congress was trying to prevent.
ADAMS (6th Cir.): requires scienter when applied to outside
o Possible standards:
Strict liability: would encompass even innocent misstatements.
Negligence: would encompass a lot, even typos.
o TRANSACTION CAUSATION:
Plaintiff must prove materiality and that the material misstatement
or omission was an essential link in the transaction. (Like reliance).
MILLS (p387): material omission (moving shareholders
didn’t state that they also controlled BoD of corp
recommending merger) was essential link because moving
shareholders only controlled 54% of stock, needed 66% to
approve, so had to convince at least some shareholders.
SANDBERG (p~404): controlled 85% of votes, didn’t need
to solicit remainder of proxies. No transaction causation.
o Shame facts: Majority rejects arg that causation
because BoD would’ve been embarrassed, and
truth might have shamed controlling
shareholders not to go forward.
o Sue facts: recognizes potential loss of statutory
remedy, but doesn’t address.
Even if votes unnecessary, transaction causation may be proved if
the Plaintiff lost a state remedy as a result
E.g., appraisal remedy or statute of limitations.
WILSON (p404): Plaintiffs were duped into approving
merger (BoD sought approval even though shareholder
controlled overwhelming amount of votes), thereby losing
a right to have an appraisal (availability of remedy
conditioned on having voted against the merger.)
o LOSS CAUSATION
Proving economic loss.
- GENERAL RULE: shareholders, directors, and officers are not personally liable for corporate
obligations, but remain liable for personal torts. It is exceptionally rare that personal liability
will be imposed.
o Rationale: allow investors to take risks.
o Pre-incorporation transactions
RULE: Unless a corporation has been formed, one cannot act as its agent (e.g., “future president”).
The corporation cannot be bound prior to its formation, but can later ratify (by accepting benefits)
or adopt (by formal resolution) the contract. Whether the promoter remains liable depends upon
the intent of the parties in the K and the conduct of the corporation once formed.
Best practice: don’t enter into any business prior to forming the corporation.
FOUR POSSIBILITIES FOR LIABILITY:
Promotor is sole obligor on the K
o GOODMAN: Goodman proposes to renovate building owned by DDS, who
knows his corp hasn’t yet formed. No express intent to release promoter.
Where K intended to be performed pre-incorp, suggests K is with promoter.
Novation: Corp. expressly adopts K and releases obligor
Mutual liability: corp expressly adopts, doesn’t release promoter, become co-obligors.
No K: irrevocable offer available to corp.
o POTTERY WAREHOUSE: K: “Jane Vosler, president for a corp yet to be
formed” promoter not bound because all parties to K knew corp not yet
formed, P didn’t require promoter to sign agreement in individual capacity,
but named as president of future corporate entity (shows intent).
o R.2d Agency §326: if one acts for entity all involved know incomplete or non-
existent, creates irrevocable offer corp can accept once formed. Not a K yet.
o PIERCING THE CORPORATE VEIL
Limited liability is hallmark of corporate form. Shareholders generally aren’t liable, on
theory they will be encouraged to take risks, form corps, employ, create products, etc.
Courts have equitable discretion to ‘pierce the corporate veil’ (or “disregard the
corporateness”) and hold officers/BoD/shareholders or parent company of a wholly-
owned subsidiary liable for corporate acts; to prevent fraud or further equity.
o NB: if wholly-owned subsidiary, can go after parent co, not its shareholders.
Rationale: if you abuse corporate privilege, won’t be treated as separate.
Incorporating to limit liability is, itself, not enough.
RULE STMT: “There is such a unity of interest and ownership that the individuality, or
separateness, of such person and corporation has ceased, and that the facts are such
that an adherence to the fiction of the separate existence of the corporation would,
under the particular circumstances, sanction a fraud or promote injustice.”
o FRAUD: easy case to pierce veil, but difficult to establish. If shareholder
didn’t commit fraud, is it fair to hold them liable?
FACTOR-BASED PIERCING RULE (“Alter Ego” and “Disregard of the Corporate Entity” theories):
RULE: corp entity will be disregarded & veil of limited liability pierced if two req’s met:
o 1) There is such unity of interest, undue dominion/control, and ownership
that separate personalities of the corporation and the individual (or parent
corporation and wholly-owned subsidiary) no longer exist; AND
o 2) adherence to fiction of separate existence would lead to inequitable result
NB: Laz: this is superfluous: if you have first step, always inequitable.
o 3) UNLESS, had opportunity to do due diligence and failed to discover
Contracts? Whether this is a third prong is unclear.
POLAN: If would be reasonable to expect party entering
the K (e.g., bank/lender) to do due diligence, failure to
discover undercapitalization = assumes the risk. (Wouldn’t
make sense for, e.g., small contractor on small K– no
time/resources to research).
K’s: easily inequitable (unjust enrichment)
PEPPERSOURCE: preventing CO’s from having assets to
recover by spending assets on himself satisfied 2nd prong.
Involuntary interaction. No opportunity for due diligence.
FACTORS: where no fraud; no one factor determinative; diff courts weigh differently.
o LACK OF CORPORATE FORMALITIES
FLETCHER v. ATEX [KODAK]: followed formalities. No indication of
undue dominion/control (e.g. didn’t need permiss to enter into K)
PEPPERSOURCE: no meetings, no articles of incorp, runs companies
out of same office w/same phone lines and expense accounts.
Independent operation of BoD (but overlap alone isn’t
enough – undue dominion/control [KODAK]).
Maintaining separate bank accounts.
o But: OK to siphon if records account who owns.
But: close corporations generally don’t have to follow.
o INADEQUATE CAPITALIZATION: CO engaged in behavior exposing it to liability
without adequate cash/insurance to account for those risks.
ATEX [KODAK]: CO maintained $0 balance in all subsidiary accounts,
but kept accounting records of profits, moved $ to pay claimants.
Unclear whether inadequate capitalization, alone, is enough:
MINTON v. CAVANEY (CA): pool case, zero cap’n because
of shareholder. Case read to say inad. cap. enough, but
suggests only where active participant in conducting corp
affairs. Passive shareholders might not be liable
SLOTTO (9th Cir.): says inadequate cap, alone, is enough.
Factor goes to inequity: can seriously prejudice claimants.
Look to whether company operated so that it can’t earn profit, or is
used solely as supplier of raw materials for parent corp with no
intent to ever make profit, e.g.
NB: just because capital depleted through normal business
does not mean undercapitalized – not req’d to recapitalize.
What if CO has insurance required by law, but it’s not enough?
Arg: appropriate capitalization should be commensurate
with the risks of the business; consider other businesses.
E.g., WALKOVSKY v. CARLTON: cab companies had
minimum insurance; not enough to tie to shareholder.
PEPPERSOURCE: inadequate capitalization because SH ‘borrowed’
o COMMINGLING OF FUNDS OR ASSETS: treating as personal piggy bank.
Factor goes to inequity.
PEPPERSOURCE: [major factor]: SH borrowed from corp w/o interest
FLAHIVE [LLC context]:failure to segregate funds of separate entities
o UNDUE DOMINION/CONTROL
E.g., domination of BoD, micro-managing.
ATEX [KODAK]: no indication of undue dominion/control. Only one
shared Director; mere overlap in BoD doesn’t show domination.
o SUBSIDIARY HELD OUT AS INTERNAL DIVISION/DEPARTMENT OF PARENT
Did P think they were dealing with parent company?
FLETCHER v. ATEX [KODAK CASE]: promotional docs describing Atex
as a “subsidiary”, “division”, and “agent” of Kodak resulting from a
“merger” did not indicate Atex was a “single economic entity”.
o FLETCHER v. ATEX [KODAK CASE]: Atex, wholly-owned subsidiary of Kodak.
Followed corporate formalities. Kodak kept $0 balance in all subsidiary
accounts, but kept accounting records of profits and moved money back to
pay claimants. No indication of undue dominion/control over Atex’s decision-
making (e.g., didn’t need permission to enter into this K). Promotional
materials wouldn’t be enough to mislead P’s into thinking they were dealing
with Kodak, didn’t show companies operated as “single economic entity”. Veil
o PEPPERSOURCE: no meetings, no articles of incorp, runs companies out of
same office w/same phone lines and expense accounts, “borrows” from corp
interest-free for personal expenses, didn’t have personal bank account. No
effort to separate himself from the company financially.
o WALKOVSKY v. CARLTON (NY): principal shareholder owns stakes in multiple
cab companies, each owning two cabs and each carrying minimum amount of
liability insurance required by state law ($10k). Pedestrian injured tort case
(involuntary interaction with company). None of 10 companies had existence
of its own. Might be enough to tie cab companies together, but no plead facts
indicating the shareholder operated business in his personal capacity.
o MINTON v. CAVANEY (CA): director/secretary of corporation personally liable
for tort drowning where subsidiary rented pool, had no assets (lease revoked
for nonpayment of rent), never functioned as corporation. Zero assets
undercapitalization was enough to pierce veil. But: piercing permissible
treat assets as own and add/withdraw capital at will
hold selves out as being personally liable for debts of corp, or
provide inadequate capitalization and actively participate in conduct
of corp affairs.
Suggests passive shareholders wouldn’t be liable.
TYPES OF CORPORATIONS
o Origin: people wanted contractual nature of the general partnership, and benefit of limited liability, but
didn’t want to have to comply with onerous burdens of major corporations (meetings, filings, etc.). Manage
the affairs as if a general partnership, but to outside world be treated like corporation for liability purposes.
But, these small businesses want to impose restrictions that might interfere with the board-shall-manage
model, or restrict the transferability of shares. Nobody wants Ghadafi to be able to buy into their business.
o Statutory setup:
DE: separate statutory section for close corporations
CA: defines close corporation (35 or fewer shareholders; articles of incorporation explicitly state
it’s a close corporation), but no separate subchapter – sprinkled throughout.
NY/Model Act: no separate close corp status, but optional provisions for close corps.
o Failure to form (strictly comply with statutory provisions) as close corp? Will agreement among
shareholders still be valid? Cases in conflict:
RAMOS (CA): liberal approach: will enforce the agreement.
NIXON (DE): if you don’t elect to be part of separate subchapter, don’t expect the benefits of it
- PLANNING DEVICES
Each of the four planning devices creates conflicts with one-size-fits-all corporate statutes RE:
voting own shares, electing board to manage independently, voting requirements, and free
transferability of shares.
Planning devices are optional.
NB: do statutory analysis first; if no strict compliance with statute, use old cases.
o SHAREHOLDER AGREEMENTS ON HOW TO VOTE SHARES (SHAREHOLDER POOLING)
Desire to get shareholders to agree on how they’ll vote their shares.
Policy tension with one-size-fits-all approach: wasn’t clear whether such agreements
were permitted (splitting votes from the shares).
Rule: Legislatures have clarified, by statute, that:
Two or more shareholders may agree, in advance, on how their shares will be voted.
May designate third party as holder of an irrevocable proxy to vote in accordance with
Does not run afoul of voting trust statutes.
o DE §2(18)(e): agreement in writing and signed by shareholders may designate
how shares will be voted and can provide any procedure agreed to.
o NY §§620, 609(f): agreement in signed writing, can provide any procedure;
proxy need not have an interest in the company (the agreement suffices).
o CA §706: all shareholders must agree, but applies to any corp (not just close).
RINGLING: “Ladies’ agreement”: women agreed by K on how they would vote for directors, one
decides not to abide. Agreement specified other attorney would serve as arbitrator, make binding
decision, but shareholder still won’t abide. Argued separated vote from equitable ownership,
which was only permitted if for an irrevocable proxy or fit voting trust statute. Court upholds
agreement, as shareholder would simply have to vote as arbitrator told her (vote not separated).
ABERCROMBIE: 10 years later, DE Supreme Court says there’s a voting trust.
o AGREEMENTS LIMITING DIRECTORS’ DISCRETION
Controversial: intent is to interfere with board, conflicting board-shall-manage model.
Shareholders don’t have day-to-day management rights (unlike general partnership).
o Even if shareholders agreed by K to vote for each other, wouldn’t prevent
ganging up on each other at board level.
COMMON LAW: could make agreements, but couldn’t completely sterilize the board.
McQUADE: agreement by portion (but majority) of shareholders to use “best efforts” to
continue electing each other would be OK. However, tried to agree in advance on
functions reserved for directors: who officers are, their salaries. McQuade would not
have bought stock absent promise of further employment. But agreement
unenforceable – impinged too much on BoD, who derive pwr from statute, not SH’s.
CLARK v. DODGE: agreement by all (two) SH’s: Dodge (75%) would appoint Clark as
manager in perpetuity, give 25% profits, while he was “faithful, efficient, and
competent”. Permitted: not completely sterilizing BoD; difficult to distinguish from
McQUADE: maybe because BoD discretion to fire if not faithful, efficient, competent?
GALLER v. GALLER: agreement between husband and wife to pay dividends and
continue salary upon death of either; upheld by IL S.C.: treats close corps as sui generis
despite statute at time, suggests similar to partnerships: stock not commonly available.
LEGISLATIVE RESPONSE: because courts steered away from the statutory schemes generally
applying to corporations when applied to close corporations, legislatures imposed statutory
schemes, thereby avoiding case-by-case analysis.
NY: close corp if articles of incorporation explicitly state, no stocks listed on public
exchange; if all shareholders agree, can agree in certificate of incorp, up to and including
CA: close corp is one consisting of 35 or fewer shareholders and articles explicitly state
it’s a close corp; written agreement among all shareholders can go as far as completely
o Failure to strictly comply with statutory scheme: courts may still uphold
DE: only requires majority of shareholders to agree (written agreement).
MODEL ACT: can completely sterilize or even eliminate BoD, if unanimous approval.
[NB: duties of care, loyalty, etc., inherited by SH when they step into shoes of BoD]
o AGREEMENTS MODIFYING QUORUM/VOTING REQUIREMENTS
Default rule: quorum is simple majority of shares entitled to vote or BoD members, etc.
Problem: public corporations want to lower quorum/voting for efficiency, while close
corps want to raise it to protect interests and act like a partnership when there is
unequal equitable ownership. Creates risk of deadlock.
See also: CLASSIFIED STOCK: separating economic investment from voting rights. E.g.,
one party invests 80%, but shareholder investing 20% doesn’t want to get railroaded, so
require both classes of stock to make decisions.
o Similar to making supermajority/unanimous voting requirement.
KENTON HOTEL (NY): agreement requiring unanimity conflicted with corporate
democracy, which presupposes simple majority quorum/voting.
o Abrogated by SUTTON (NY): if an agreement/certificate specifies a
supermajority, can only amend agreement/certificate with a supermajority,
notwithstanding statutory min. 2/3rds to change supermajority requirements.
o PLANNING FOR OWNERSHIP CHANGES: RESTRICTIONS ON TRANSFERABILITY
Default rule is that shares are freely transferable, but close corporation means few
shareholders, active involvement in management, no ready market for transferability.
Want people to have benefits of harmonious relationship among themselves (like
partnership) , while limited liability to outside world. Makes close corp more similar to
partnership by restricting who can buy in.
o Allowing buy-out provisions = liquidity for SH when limited market.
o Conspicuous notation requirement: to be enforced against the purchaser,
there must be conspicuous notation on the face of the stock.
o Inapplicable to involuntary transfer: eg, sheriff’s sale after creditor judgment.
But still restricts recipient of sale’s right to transfer.
RIGHT OF FIRST REFUSAL
Definition: First refusals prohibit a sale of stock unless the shares have been first offered
to the corporation or other shareholders on same terms offered by the third party.
o Counterintuitive: limited market for close corp shares.
o Impractical: if other SH don’t want to be partners w/offeror, price might be
too high for SH’s to meet disharmony. Company might not like that bargain
o But most favorable to SH.
Definition: First options prohibit transfer of stock unless shares have first been offered
to corp or other shareholders at a price fixed under the terms of the option, which could
be based on a fixed price, an appraisal, or a formula.
o Different than first refusal: sets a price or method of determining a price. First
refusal takes the price from the offeror provided by the current SH.
o Option price might be incredibly lower than any fair assessment would value.
Courts won’t impose own judgment for bargain of the parties.
HOLLAND: $75k option for stock, but stock actually worth 3x as
much. Tough: bargained for it and took the risk.
MATHER’S ESTATE: option for $1/share, but valued at $1k+/share.
LITTLAND v. ALLEN: wholesaler bought stock from one of his
customers, corp had option to buy back at original sale price. Still
reasonable: attendant benefits of maintaining business relationships
o If company sets value, might be unfair or look bad. If independent
assessment, might be too high for company to afford.
REASONABLE CONSENT RESTRAINTS
Definition: Consent restrictions prohibit the transfer of stock without permission of the
corporation’s board or shareholders. Generally permissible under statute, and upheld if
not manifestly unreasonable: serves legitimate purpose and not an absolute restraint.
o Factors of reasonability of restraint: corporate size, degree of restraint,
method used to determine price. Merely describing procedures to be used is
permissible; restrictions which are fraudulent, oppressive, or unconscionable
are impermissible. Blanket right to deny transfer for any reason probably
FBI FARMS: restriction based on blood is reasonable, serving
legitimate purpose of keeping business in the family.. Restriction is
“reasonable if it is designed to serve a legitimate purpose of the
party imposing the restraint and is not an absolute restraint on
alienability”. Court ignore BOD’s failure to make restriction in
articles, bylaw, or shareholder agreement (here, by resolution).
o Least favorable to SH: sets no price, sale contingent on consent of BoD/SH’s.
o PLANNING FOR OWNERSHIP CHANGES: MANDATORY BUYOUTS
Agreements that Corp or remaining SH’s have opportunity to purchase SH’s stock if
given circumstance occurs, even if SH doesn’t want to part with stock.
o Often arises in termination, death, divorce in family-owned corp, retirement.
o Generally enforced even if buy-back price lower than actual value.
o Split in courts: if parties got what they bargained for, should courts intervene
on concept that fiduciaries should be held to higher standard and operate on
GALLAGHER v. LAMBERT: employee joins company, buys in to stock. Fired three weeks
before fulcrum date (before fulcrum: would have used book price), so employee got
$89k instead of $3 million. Not a ‘freezeout’ as minority SH because specifically planned
for and didn’t secure K for himself requiring termination for cause.
o NEMEC: redemption option allows company to buy back shares. Shortly
before expected merger, CEO tells employee “easy moral decision” not to
redeem shares before merger, but does anyway, resulting in $600/share
windfall to corp. No breach of implied covenant of good faith/fair dealing or
fiduciary duty: won’t trump the K parties got what bargained for. 3-2 case.
Dissent: won’t allow if “arbitrary and unreasonable” (unclear what’s
This still looks like self-dealing: giving self the difference
JENSON v. CHRISTENSEN & LEE: unjust discharge (for no reason) of employee-at-will
triggered buyback at lower price material conflict of interest of directors because
they stood to gain from termination (unjust enrichment). When controlling
shareholders are also directors, there might be conflict of interest.
JORDAN v. DUFF & PHELPS: trouble with wife and mother-in-law prompts employee at-
will SH to decide to move, leave company. Company doesn’t disclose impending merger
which increased value of shares. Easterbrook: can’t breach duty to disclose to SH just
because he’s employee at-will, still violates duty to him as a SH. Easterbrook, Posner
disagree on whether corp could have just fired him: Court here: would have violated
implied contractual duty, as employment at-will is still contractual.
- DISPUTE RESOLUTION TECHNIQUES
o DISSOLUTION FOR OPPRESSION
Dissolution is legal end of a corporation, a legal concept. Contrast: liquidation is an
economic concept (paying off creditors, distributing remainder to equitable owners).
Discretionary remedy: won’t be applied if operates to benefit of one party.
o Traditionally used at deadlock; now reluctant to use against profitable corps.
o WOLLMAN v. LITTMAN: 50-50 deadlock not always grounds for dissolution,
especially when liquidation would go entirely to only faction which can use it.
o Parties will often resolve disputes other ways to avoid dissolution.
Use as planning device: agreement to dissolve at will or upon a condition precedent
Rationale: limited market to sell shares, can’t sell or change direction of Corp.
Alternatives: appointment of provisional directors or custodian; arbitration.
o NB: where states don’t have equitable relief through dissolution, fiduciary
duty concepts serve as sort of parallel: both focus on reasonable expectations
of minority SH.
DISSOLUTION FOR DEADLOCK
Some statutes limit to 50-50 deadlock, but most recognize deadlock resulting from
supermajority or veto limitations.
DISSOLUTION FOR OPPRESSION
Recent development, allowing for judicial intervention, dissolution if majority (or veto-
power) wielded ‘oppressively’ or with ‘persistent unfairness’ even when no deadlock.
o Not limited to illegal conduct (i.e., breach of fiduciary duty).
KEMP & BEATLEY, INC.: Court construes NY statute permitting dissolution on illegal,
oppressive, fraudulent actions – illegal/fraud defined by law, oppression isn’t.
Oppression found when Corp changes longstanding policy on paying dividends to stock
owners, limiting only to employed stock owners, after employees leave. Reasonable
expectation of sharing profits even if not employed. Rejects arg that this was business
decision to be left to BoD.
o TEST: Conduct ‘oppressive’ when it defeats reasonable expectations of
OBJECTIVE: conduct substantially defeats expectations that,
objectively viewed, were both reasonable under the circumstances
and central to SH’s decision to join venture.
SUBJECTIVE: what majority SH’s knew or should have known
minority SH’s reasonable expectations to have been at beginning of
Can include a series of act or a single act.
Does not include conduct permitted by agreement, articles of
incorp, or bylaws.
o Allows less-disruptive equitable remedy targeting wrongdoing instead of
Cancellation of bylaws, articles of incorp
Ordering a buyout.
o McCALLUM: buyout of terminated CEO’s stock at inadequate price was
oppressive. CEO was lured to stay at company with stock, as opposed to
employee without significant management role. Remedy: buyout at adequate
price. Not reinstated (rare for courts to reinstate management).
DIFFICULTY OF VALUATION IN CLOSE CORPS: difficult to value stock in close corporations due to
RE: Dissolution: especially difficult when no previously-agreed process to set value.
Control premium or minority discount? Whether a control premium should be granted
o Depends on statute.
o If dissolution, liquidation all shares get same (no control premium).
o Why reward inequitable conduct by majority?
CHARLAND: RI statute requires “fair value” from appointed appraiser. Mandatory
buyout of minority after officials engaged in illegal conduct. Should not create windfall
for wrongdoers by applying discounts for minority share or lack of marketability.
FRIEDMAN: court approves discount for marketability, because ‘fair value’ considers
what a willing purchaser in arms-length transaction would offer for the corp.
o APPOINTMENT OF CUSTODIAN/PROVINCIAL DIRECTOR
Allows corp to keep running, avoiding dissolution or buyout beneficial to tax
collectors, suppliers, contractors – and corp!
Custodian: has all powers of a receiver, controls all corporate affairs (more than Prov.
Dir.), except cannot wrap up affairs/liquidate assets of corp. Power until court orders.
Provincial Director: impartial, unrelated appointee who helps to avoid deadlock by
providing tie-breaking vote. Has powers of director until deadlock broken.
o Turns over business to a stranger: may result in unexpected votes, defeating
expectations of shareholders;
o Disrupting supermajority/veto power agreements undermines purpose of
holding a chip in negotiating, impacts pre-planned balance of power.
o Prior agreement? Unclear if would violate public policy for parties to agree in
advance not to seek one of these remedies.
Alternative remedy allowing uninterested party to make recommendations or binding decisions.
Because BoD may be sterilized in close corps, not offensive to “board shall manage”
model to turn over decision-making to third party in context of close corporations.
LANE: binding arbitration permissible in context of close corporation.
Criticism: turns over authority to possible stranger, few avenue of appeal, expensive.
o FIDUCIARY DUTIES
Fiduciary relationship in close corps is a dispute-resolution device used as a fallback
where there has been a failure to or lack of corporate planning.
Courts recognize illiquidity problems in the context of close corporations and, through
application of fiduciary principles, provide a remedy which does something other than
liquidate the company.
No unified approach:
Borrow from partnership law: Regardless of planning or statute, some states will apply
o Rule of Equal Opportunity: majority must give minority equal opportunities.
Shareholders of close corp owe essentially same fiduciary duties as partners.
Remedies: return, with interest, money disgorged, or offer same
deal to minority shareholder.
DONAHUE: majority shareholder receives $800/share (not argued
that this is unfair price) buyback from corp; court borrows from
partnership law: corp had fiduciary duty to offer same buyback rate
to minority SH. No open market for these shares, so corp offering
25% of value to minority shareholder essentially a freezeout.
Created market for selves, using treasury for personal gain.
o ‘freezeout’ here is inequitable, but nothing
wrong with ‘control premium’ for majority share.
o One-time deal, not ongoing management
decisions (e.g., decision to hire uncle as lawyer)
o Legitimate Purpose Test
Majority group have legitimate purpose for its action against the
WILKES: Four SHs incorporate with unwritten
‘understanding’ they’d divide work. Wilkes not re-elected
officer, stops getting money. Not a one-shot transaction
like DONAHUE – ongoing management. Denying
employment to minority shareholder can be pernicious
(frozen out with nothing being paid back, since all profits
were being paid out as salary), especially if invested
w/understanding of continued employment.
E.g., employee-SH drunk/incompetent, not frozen out
MAROLLA: induced to come work for company, asked to
invest. Fired for no legit reason, but was an at-will
employee -- and was paid fair price for shares. Wasn’t
treated differently than any other shareholder – fiduciary
duty doesn’t extend to at-will employment relationship,
just SH relationship. Not all employment terminations
where shares involved = breach.
If legit purpose, is there a less harmful alternative?
SMITH: minority shareholder essentially ‘freezes out’
majority with veto power, but had a legitimate purpose in
refusing to pay our dividends: wanted to re-invest in
company (and doing so was in accordance with planning
device). But refusal to compromise led to violation of IRS
codes (breaking the law), leading to legal expenses and
fines. Could have compromised.
Apply standard ‘fairness’ test of fiduciary duty: if planning devices not utilized, no
equitable relief, act as if there were a K.
o NIXON: employee shareholder buyback better than non-employee
shareholder buyback, no unfairness (could be good reason to treat employees
differently); could have negotiated better agreement.
POTENTIAL EXAM QUESTIONS RE: CLOSE CORPORATIONS
- Generally: tries to work in some question RE: close corps, typically policy-type question.
- Example 1: Practical Advice
o In forming close corp, one SH asks you what he should do to protect himself, especially concerned with
others ganging up on him.
o Planning devices and how they might be used to protect
Employment: requiring just cause terminations
o Advise on how dispute resolution methods may be applied, but proper planning devices should prevent.
- Example 2: Legislative Counsel
o Assume you’re legislative counsel. Statutes have general corps code, but no special provisions for close
corps. What recommendations would you make for dealing with close corps and why?
o Planning devices
o Alternative remedies
Planning devices might still result in conflict
o DEFINITION: An association of two or more persons to carry on as co-owners a business for profit forms a
partnership, whether or not the persons intend to form a partnership.
Intent is irrelevant
Relationship is largely contractual (corporations are largely statutory).
Liability: Partners are personally liable for all tortuous or contractual debts of the partnership
which arise during the ordinary course of the partnership.
o Entity/aggregate theory: RUPA treats partnerships as entities, allowing them to be sued.
Treatment as entity does not negate personal liability of partners.
Only impact is on joinder/naming parties.
o INTERNAL AFFAIRS: RUPA: law of state in which partnership has chief executive office governs internal
o NB: corporations can form partnerships. “Person” includes corporations under RUPA.
o Good: few mandatory requirements to establish a partnership. Downside is exposure to personal liability.
- Forming or Identifying a General Partnership
GP’s can be formed with no formalities and no filing. Partnership status depends on factual
characteristics of relationship.
No intent necessary – can form w/o intending. If indicia of partnership there, partnership formed.
o Express or Implied Partnership Agreement:
Partnership may be found where the relationship between two or more persons evidences an
agreement, either express or implied, to place their money, effects, labor, and skill in a lawful
business with the understanding that a community of profits will be shared.
An inference of law based on established facts.
Cannot avoid becoming partnership by calling the relationship something else. Must avoid
entering position of joint control.
o Four-part test: In absence of express partnership agreement, some courts use four-part test.
Agreement to share profits
Receipt of share of profits prima facie evid, unless to pay debt, wages, or loan interst.
Agreement to share losses
A mutual right of control or management of the business
MARTIN v. PEYTON: no partnership where investor loaned capital to struggling
businessman, able to review books and veto investments. Couldn’t propose own ideas
and was simply ensuring security of investment. Don’t want to discourage lenders.
LUPIEN v. MALSBENDEN: partnership in construction of car. Investor used personal
checks to buy equipment, had physical control over premises, total involvement.
A community of interest in the venture
Existence of joint tenancy, tenancy in common, tenancy in entirety alone not enough
- PARTNERS’ RIGHTS AND LIABILITIES
Default: each partner has full, equal governance and voting rights in management, not based on
proportion of investment. (Unlike corporations, where shares = variable voting power).
Statutes RE: partnerships set default rules, which can be modified by agreement.
Partnership law largely contractual, unlike corps, where statute can’t be abrogated by K.
o Informal agreements: might include oral or course-of-conduct K’s.
UPA §18(h): no act violating partnership agreement may be done absent consent of all
o SUMMERS v. DOOLEY: partner hires replacement employee over objection of
co-partner. Co-partner not liable to partner for expenses in hiring.
RUPA §103: partnership agreement governs, but agreement can not:
o Restrict access to books and records;
o Eliminate duty of loyalty;
EXCEPT: can ID types of acts that don’t violate duty of loyalty, if not
EXCEPT: after full disclosure of material facts, partners may authorize
act/transaction otherwise violating duty of loyalty
o Unreasonably reduce duty of care
Can prescribe varying standard to determine, so long as not manifestly
o Eliminate obligation of good faith & fair dealing
EXCEPT: can prescribe standards by which performance of obligation is to be
measured, as long as not manifestly unreasonable.
o But see: DELAWARE: Partnership, LLC, and LLP agreements can completely eliminate
(or expand or restrict) fiduciary duties, but can’t eliminate implied covenant of Good
Faith & Fair Dealing. Allows participants to run businesses competing with the entity.
AUTHORITY TO BIND THE PARTNERSHIP
Generally: can bind if transacting business as agreed by partners (actual authority) or
appears to third party to carry on partnership business (apparent authority).
Actual auth: partners have mgmt authority, can make decisions binding partnership.
o Voting: majority vote of partners for ordinary partnership matters, but if
extraordinary or in contravention of agreement requires unanimity.
Apparent auth: will not give partnership claim against 3rd party, maybe against partner.
o UPA: Partner may bind partnership by act “for apparently carrying on in the
usual way the business of the partnership.”
Unclear: is “business” that of similarly-situated partnerships (same
line of business), or just this partnership?
o RUPA: Partner may bind partnership by act “for apparently carrying on in the
way” (i) the partnership business or (ii) business of the kind is carried out. Not
just business of the particular partnership. Expands apparent authority.
[What would a third party think a person in partner’s line would have auth to do?]
Knowledge of third parties: apparent auth limited if 3rd party:
o UPA (Broader): actual knowledge/notification or should have known from
facts and circumstances implied notice or duty to inquire.
o RUPA (Narower): limits to actual knowledge/notification. Not implied, even if
3rd party has some reason to question the apparent authority.
§303: Statement of Partnership Authority: partnership may specify
a grant or limitation of auth, limitation of transfer of real property.
Grant of authority: conclusive in favor of 3rd party even
absent actual knowledge of statement, unless actual
knowledge of lack of authority.
Limitation: only effective upon actual knowledge or notice
o Except: limitation on real property effective
against all persons if certified copy filed in real
property recording office.
RNR INVESTMENTS: partnership to acquire vacant land and build
house. Partners agreed on $650k loan, but partner gets $990k loan,
exceeding scope of actual authority. Partnership bound: bank had
no actual knowledge of limitation and was within scope of ordinary
business. No duty to inspect scope of actual authority.
NORTHMON v. MILFORD PLAZA: partners may intervene to prevent
contemplated transactions, notwithstanding a binding-partner’s
apparent authority. 99-year lease would be extraordinary anyway:
would last longer than partnership (per partnership agreements).
o LIABILITY: partners are personally liable for debts of the partnership. However,
Each partner entitled to equal share of profits, chargeable with equal share of losses where
partnership assets insufficient to cover obligation. (UPA/RUPA).
Aggregate status: partnership not an entity in most respects; aggregate of its members.
Differentiation between K and tort liability:
o Torts: jointly and severally liable. (can recover from any partner, in full)
o K/other debts: jointly liable. (resp. of D’s to recover from each other)
Entity status: treated as entity procedural implications (e.g., joinder).
Eliminates distinction between torts, other debts: all partners jointly and severally liable.
Exhaustion theory: partnership assets must be exhausted before a partner’s own assets reached.
o FIDUCIARY DUTIES OF PARTNERS
GENERALLY: Parners owe fiduciary duties to other partners, partnership.
UPA §21: very limited: “Every partner must account to partnership for any benefit, and hold as
trustee any profits derived without consent of the other partners from any transaction connected
with formation, conduct, or liquidation of partnership or from any use of its property”
RUPA §404: sets out in detail the fiduciary duties of partners:
Duty of Loyalty: Limited to three things:
o 1) account to partnership and hold as trustee any property, profit, or benefit derived
by partner in conduct and winding up of affairs, or derived by partner from use of
partnership property, including appropriation of a partnership opportunity.
o 2) refrain from dealing w/partnership as or on behalf of a party with adverse interest
o 3) refrain from competing with partnership before dissolution of partnership.
o Agreement: can specify acts which won’t breach DoL, but can’t eliminate DoL.
o MEINHARD v. SALMON: Gerry (LL) leases building to Salmon for 20 years. Salmon forms
partnership with Meinhard: Meinhard invests, but Salmon runs management. Near end
of lease, Gerry (LL) offers Salmon new lease, more land, more money. LL had no duty to
approach Meinhard, but Salmon owed duty to disclose to give chance to compete for
lease – benefitted at expense of his partner. 2nd lease substantially related to 1st.
“Joint adventurers, like copartners, owe one another, while enterprise
continues, duty of finest loyalty. Many forms of conduct permissible at arm’s
length are forbidden to those bound by fiduciary ties. A trustee is held to
something stricter than morals of market place. Not honesty alone, but the
punctilio of an honor the most sensitive, is then the standard of behavior.”
Duty of Care:
o DoC to partnership/partners in conduct and winding up of partnership business is
limited to refraining from engaging in grossly negligent or reckless conduct, intentional
misconduct, or knowing violation of law.
o Agreement: can modify, but can’t unreasonably limit DoC.
NB: “unreasonably limit” is same question as “manifestly unreasonable”
Good Faith and Fair Dealing:
o Shall discharge duties to partnership/partners and exercise rights consistently with
obligation of GD&FD.
o Agreement: can specify acts which won’t breach GF&FD, as long as not manifestly
Limitations on Modification: agreement can set forth certain acts which won’t violate
- TRANSFERABILITY OF INTEREST
o Generally: While corporate stock ownership is largely freely transferable, governance rights in a
partnership cannot be transferred absent unanimous consent of partners.
o Nor may someone join a partnership absent unanimous consent. (UPA §18(g))
o BUT: can transfer economic interest, as long as governance rights not transferred.
BAUER v. BLOMFIELD: Bauer loaned partner $800k, secured by “right, title, and interest” in
profits of the partnership, with consent of all partners. After default, Bauer receives
income/distribution. Partners later divert money without consulting Bauer. OK: assignment of
profits (even w/unanimous consent) didn’t make Bauer partner.
e.g., limited partnerships, limited liability companies, limited partnerships. NB: only tests maybe 10% on exam.
LIMITED LIABILITY COMPANIES
- LLCs GENERALLY
o Non-corporate entity formed under special statutes, combine elements of corporate and partnership law.
o Started in 1970s in WY, attempt to avoid flow-through taxation (taxation of owners directly) by IRS.
o Disfavored because body of law less developed, less predictable than corporate law.
Unclear what to do when statutes silent. E.g.:
FLAHIVE: analogizes to piercing of corp veil. Courts had long pierced corp veil when statues silent.
WOLFF: legislature knew how to provide for derivative suits (had done in corp statutes); court
permits in LLC context because derivative suits were originally court-created doctrine.
- CHARACTERISTICS OF LLCs
o Limited liability for “members” (owners) (like corp)
o Extensive freedom to structure internal management by K (like GP, but without personal liability)
o Unlimited number of members (unlike, e.g., close corp. in CA: 35)
No limit to number of classes of members – can include ‘legal’ persons (e.g., trusts).
- FORMATION OF LLCs
o Highly variable requirements between states.
o Can be formed by a single person.
o Must file articles of organization (unlike GP, like corp.), varies by state, but detail:
Name of LLC
Address of principal place of business
Name/address of agent for service of process
Names of initial members or managers
Expected duration of LLC
o Operating Agreement: agreement among members concerning conduct of its affairs.
- MANAGEMENT OF LLCs
o Two types of LLCs:
Member-managed: members (owners) manage
Majority/CA: default unless otherwise in articles of incorp or op agreement (varies by state)
Authority [analogy to partnership]: each member has power to bind for act apparently carrying on
business of LLC.
o If unusual/extraordinary, remaining members can confer actual authority.
o Members can withdraw authority from other members.
o Contravention of auth/agreement binding, but member must indemnify LLC for loss.
Manager-managed: managers (who might not be members) manage.
Authority [analogy to corp law]: only managers have actual or apparent auth. Can allocate power.
o [NB: Delaware says both managers and members have authority to bind]
o Voting: Split defaults:
Per capita [default]: one vote per member, regardless of investment
Pro rata: vote share depends on investment
Vote thresholds: default is simple majority
Statute might require unanimity to amend articles of incorp or op agreement.
- MEMBERS’ RIGHTS IN LLCs
o Distributions: In absence of agreement to contrary:
Corporate-style (majority): default is distribution pro rata (per contribution).
Partnership-style (minority): default is distribution per capita (one per member).
o Inspection of books and records: members entitled to access books/records. Some statues require proper purpose.
o Transferability: some JDXs only permit transfer of financial interest (like partnerships), others permit transfer of both
financial and governing interest.
- LIABILITY OF LLCs
o Members/managers not personally liable for LLC’s debts, obligations, or liabilities.
o Piercing LLC’s veil: In absence of fraud, to hold member personally liable, Plaintiff must show [FLAHIVE]:
Such unity of interest and ownership that individuality or separateness of member/mgr and LLC has ceased
Apply PEPPERSOURCE-type factors.
NB: have to follow LLC formalities, not corp formalities.
AND: facts are such that adherence to separate existence of member/mgr and LLC would, under the
particular circumstances, sanction fraud or promote injustice.
FLAHIVE: court permits piercing by analogy to corp law (statutes silent on issue). No reason in law/policy to
treat LLCs differently than corps – wouldn’t be protected if formed as corp.
- FIDUCIARY DUTIES IN LLCs
o [FINISH WHEN HAVE DONE FIDUCIARY DUTIES OF CORPS GENERALLY – p89 of notes]
- Exam Questions:
o “Outline, for a jurisdiction that does not have one, an LLC statute.”
Know the variations:
Operating agreement can alter. In absence of agreement to contrary, provide defaults.
Management type: member-managed (partnership) or manager-managed (corp)
Voting: per capita (p-s) or pro rata (corp)? Threshold to amend arts of incorp (p-s)?
o Distribution: pro rata (corp) or per capita (p-s)?
o Inspection of books/records: proper purpose requirement?
o Transferability: split interests (corp) or only financial (p-s)?
o Create operating agreement for LLC:
Look to size/goals. If small, go towards provisions similar to partnership. If big, go corp.
- Generally: A partnership with one or more general partners and one or more limited partners.
o “Limited” refers to limited liability of limited partners. Default approach also limits their auth/mgmt rights.
o An entity may be a partner – statute includes more than natural persons.
Often large company will be general partner, sell limited partnership interests.
o Difference with General Partnerships:
General partner has all obligations of ownership, limited partners providing capital on investment
basis, little authority (if any) in determining how business conducted.
o Four statutes: three still used by different states.
1916: Uniform Limited Partnership Act [ULPA (1916)] (no longer used)
1976: Revised Uniform Limited Partnership Act [RULPA (1976)]
1985: Amendment to Revised Uniformed Limited Partnership Act [RULPA (1985)]
2001: Limited Partnership Act [ULPA (2001)] (CA + 16 other states)
- Formation of Limited Partnership: must file certificate of limited partnership with SoS..
- Limited Partners in Limited Partnerships
o Definition: LP = “person admitted to the limited partnership as limited partner in accordance with the
o Rights/powers of Limited Partners
Authority to bind: limited partners have no right or power to bind limited partnership.
(Analogous to corporate shareholder).
Voting rights: RULPA (1976): partnership agreement can grant all/some limited partners vote
(either per capita or pro rata). Default is no voting rights.
o Personal Liability of Limited Partners
Generally: Limited partner not liable for debts/obligations of the limited partnership.
Third parties typically have to seek remedy against limited partnership as entity.
General Partners remain personally liable for obligations.
Exceptions: Limited partner personally liable where:
Also a General Partner; OR
Limited partner acting in substantially the same capacity as a General Partner
o RULPA (1976): If substantially same capacity, essentially strict liability.
Actual knowledge of LP’s participation in control only required if not
acting in substantially same capacity.
GATEWAY POTATO: LP oversaw daily operations of limited
partnership “Substantially same” as GP; liable even though
creditor never spoke with LP, only GP.
o RULPA (1985): §303(a): no liability unless participates in control of business
Only liable to 3rd parties who, based on LP’s conduct, reasonably
believe (s)he’s a GP. (So some contact/actual knowledge necessary)
Safe harbor: §303(b) not “in control” where contractor, agent,
employee, consulting, attending mtg., making proposals.
o RULPA (2001): LP not liable at all, regardless of participation.
o Policy issue: creates “moral hazard”: if shielded against liability, less inclined to exercise care for
others. Counterarg: other types shield liability – why force into another form?
- FIDUCIARY DUTIES IN LIMITED PARTNERSHIPS
o Directors of Corporate General Partner owe Fidicuary Duty to Limited Partnership’s Limited Partners
NB: the corporate GP also owes fiduciary duties to limited partners.
GATEWAY POTATO: probably didn’t sue GP because was corp with limited assets, so went after LP
USACafes: duty owed to limited partners by directors of the corporate General Partner. Directors
of GP essentially paid off by buyer of the Limited Partnership (via loans, payments, promised
employment when the partnership changed hands, etc.) so that buyer could get unfairly low price
to buy Partnership assets. To extent directors of the corporate GP controlled partnership
property, owed fiduciary duty to limited partners.
o Altering Fiduciary Duties through Limited Partnership Agreement
GOTHAM PARTNERS: OK to contract for different allocation of risks under fiduciary duty principles.
DE: Partnership, LLC, and LLP agreements can completely eliminate (or expand or restrict) fiduciary duties,
but can’t eliminate implied covenant of Good Faith and Fair Dealing. Allows partners to run businesses that
might compete with the partnership, LLC, or LLP.
RULPA: Can ID acts which won’t violate duty of care/loyalty, or prescribe varying standard to determine, so
long as not manifestly unreasonable. Can’t eliminate DoC/DoL or GF&FD.
NB: if agreement provides “entire fairness” – not far off from the default rule anyway.
NB: after full disclosure of material facts, partners may authorize act otherwise violating DoL.
LIMITED LIABILITY PARTNERSHIPS
- Generally: Function same as General Partnerships, but no partners (including GPs) liable except for own torts.
- Creation: Unlike General Partnerships, LLPs must register with state. (Like Limited Partnerships).
- Liability: No partners are vicariously liable for the LLP’s obligations. (Not shielded from own misconduct).
LIMITED LIABILITY LIMITED PARTNERSHIPS
- Generally: Function same as Limited Partnerships, but no partners (including GPs) liable except for own torts.
- Creation: Unlike General Partnerships, LLPs must register with state. (Like Limited Partnerships).
- Liability: No partners are vicariously liable for the LLP’s obligations. (Not shielded from own misconduct).
DUTIES APPLYING TO ALL CORPORATIONS
DUTY OF CARE
With grant of legislative power to manage comes duty of care.
Relates to how management exercises oversight of the business
o High burden: directors are not insurers of the company. Personally responsible when they act in an
unreasonable manner [but… opposed to ordinary, prudent director standard?]
Difference between being negligent in gathering information (e.g., PRITCHARD) and making
decision (just has to be rational).
Act in subjective good faith and decision not wildly irrational?
- STATUTORY APPROACH OF DUTY OF CARE
o Standard to be applied is unclear. Negligence or gross negligence?
Statutes appear to codify negligence standard (“ordinary, prudent person”), but some courts
require gross negligence.
Gross negligence is negligence with an epithet attached. Unclear what it means. Willful
and wanton misconduct? Sufficient knowledge of likely result of conduct?
Plain language of NY/CA statutes negligence standard.
OBJ: normal, prudent director
SUBJ: must act in subjective good faith:
o no conflict of interest
o not approving illegal act.
ALI/Model Act reflect what courts actually do: not literally applying statutes, but following BJR.
- BUSINESS JUDGMENT RULE:
o Succinctly-stated: Though statutes provide a negligence standard to be applied to the decisions of
directors, courts have applied a “gloss” over them, formulating the business judgment rule. Where a
director is financially-disinterested and follows a process of becoming reasonably well-informed about the
transaction, her decision will be subject to an extraordinarily deferential review based on a judicially-
created standard called the “business judgment rule”.
o PROCESS PRONG:
Breach in process prong no BJR deference. Burden on director to prove essential fairness.
Succinctly-stated: A director’s decision must be reached in good faith using a reasonable process
to become reasonably appraised of the decision under the circumstances, and must actively
acquire a working understanding of the business and the transaction.
Good faith required: Must reach decision in good faith.:
Honest: subjective belief that the decision is in the best interest of the company.
No conflict of interest: If conflict (or financially interested) DoL issue.
Not approving illegal act – DUTY TO ACT LAWFULLY
o Cannot exercise sound business judgment if decision is to break the law.
o MILLER: AT&T decision not to collect $15 million bill to DNC, theory of getting
in good graces. Deciding not to collect a debt might be rational sometimes,
but failure to enforce claim violated Federal campaign finance law.
Reasonable process prior to making decision. If not breach, won’t be shielded by BJR
Standard: Courts generally apply ‘reasonableness’ standard (higher than rational basis)
o But: negligence or gross negligence? Unclear.
Process: Reviewing materials yourself or relying (as statute permits) on others within
hierarchy who have knowledge of the finances/transaction.
DUTY TO BECOME INFORMED
o Must actively acquire rudimentary understanding of the business and
Don’t need to be a maven, but become informed.
PRITCHARD: Total failure to become informed when sons were
taking ‘loans’ they couldn’t pay back, depleting cash-on-hand to
point of insolvency. Failure was substantial factor in damages.
SMITH v. VAN GORKUM: enormous amount of expertise, relied on
CEO who had a lot of stock (so poor price would hurt him, too – but
no evidence he actually made a ‘report’ to rely on) poor decision in
price of stock at merger (even though offer was higher than public
trading price). Mere sophistication not enough.
NB: Sale of company is a big transaction. Small
transactions don’t need the same level of inquiry.
TECHNICOLOR: agreement to sell company at $23/share presented
to BoD at hasty meeting, BoD approves agreement and recommends
to SH’s that they accept. Breach of DoC: no search for alternative
buyers, no reasonable basis to assume better offer could be
expected after agreement signed, and directors didn’t know of
impending sale until they arrived at meeting. Directors had burden
to show price was “entirely fair”.
DUTY TO MONITOR CORPORATE AFFAIRS AND EMPLOYEES
o Stay informed: attend meetings regularly, monitor performance of officers.
o For breach of DoC for failure to monitor, Plaintiff burden to show:
1. Dirs knew or should have known violations of law occurring;
2. Dirs took no steps in good faith effort to prevent/remedy;
3. Failure was proximate cause of damages.
CAREMARK: if notice of violations of law by subords, duty to install
monitoring system. Even if monitoring system doesn’t work, absent
a showing of bad faith (or “irrationality”) in setting it up, no DoC
breach. Would be DoC breach if took no steps – a la PRITCHARD.
o PROCEDURAL PRONG:
BUSINESS JUDGMENT RULE:
Judicial “gloss”/interpretation of the statutes
R: Directors will only be liable for a reasonably informed, good faith decision if there
is no rational basis for the decision, objectively and subjectively viewed.
Standard: RATIONAL BASIS
o So unreasonable it amounts to bad faith or recklessness incapable of
explanation. A decision can be unreasonable, yet still rational. Higher
standard than gross negligence.
o Not merely good faith/bad faith test, which would insulate insane decisions
made in good faith.
o Negligence? No taking risk is part of well-informed director’s job.
o SELHEIMER: managers poured almost all of corp’s funds into development of a
single plant they knew couldn’t be operated profitably.
Rationale: if directors well-informed, unlikely to have breached DoC.
o Deference: risk is necessary in business and not all decisions will turn out well.
o Remedy: if SH’s don’t like judgments, sell stock or vote management out.
AMERICAN EXPRESS: standard lower if no pecuniary interest and reasonably well-
NB: for BJR, must first have decision made, subj. good faith, no conflict of interest.
o Remedy: If BJR doesn’t apply, transaction must have been “entirely fair”
Where BoD makes informed decision, not enough to allege the decision itself was
o AMERICAN EXPRESS: BoD could have saved $8 million in taxes by selling stock
worth $4 million; instead, distributed as dividend in kind to SHs. Rational
basis: was accounting decision which let report as income, not as loss, keeping
AmEx share price high. Summary judgment!
DoL: 4 Dirs had financial incentive, but 16 independent dirs voted.
Exceptions to BJR:
Interference with shareholder rights.
o E.g., GLASSIUS.
- CAUSATION: He doesn’t want us to address on exam. (But just note it, maybe).
o DE: rebuttable presumption of causation. Once gross negligence standard met, D bears burden to prove
fairness of transaction.
- EXCULPATORY PROVISIONS FOR DUTY OF CARE BREACHES
o Optional provision in Articles of Incorporation to eliminate/limit personal liability in damages for breaches
of DoC by directors.
Can’t prevent injunctive relief.
Doesn’t apply to Duty of Loyalty breaches, Bad Faith actions, or conflict of interest transactions.
Doesn’t protect officers – just directors.
o Reaction to SMITH v. VAN GORKUM
CONSIDERATION OF NON-ECONOMIC FACTORS IN DECISION-MAKING
- Corporation may be formed for any lawful purpose, but primary objective is maximizing profits.
o But maximizing profits not necessarily good for everyone. Maximizing corporate share value is not the
same as maximizing shareholder wealth, in the long run.
BLASSIUS: stockholding company wants to stack BoD to incur a lot of debt, pay out a lot to
shareholders immediately. By turning equity into debt, would put company at risk later.
- Consideration of other ‘constituencies’ / humanitarian concerns / risky investments
o Most statutes (including Model Act §302 on p720) permit donations. Some states set a cap.
ALI: §2.01: company may take into account ethical considerations and may donate reasonable
amount for philanthropic purposes. (ALI is like Restatement)
“Reasonable” used by most statutes. Great deference to BoD under BJR (making decision on
informed basis, don’t have financial/conflicted interest).
DODGE v. FORD: “A business corporation is organized and carried on primarily for the benefit of
the stockholders.” Reducing price of cars in order to benefit public and incidentally provide profit
to stockholders different than providing profit and incidentally helping public.
BARLOW (p256): more modern view: corp donates $1,500 to Princeton, shareholders complaint
it’s ultra vires. Corporations in unique position to make large donations.
o Risky investments
BJR: if BoD pursuant to authority by statute to manage makes a decision that it believes in good
faith to be in the best interest of company, has taken steps to become informed about material
facts, and has no interest/conflict, courts will generally defer.
o “Other Constituency Statutes”: most statutes say it is not a violation of duty of care to take account of
community considerations: e.g., plants being closed down, employment opportunities, etc.
But: Delaware has no such statute, resulting in conflicting rulings.
REVLON: concern for other constituencies is OK when addressing takeover threat, but
must be “rationally related benefit accruing to the stockholders.”
CRAIGSLIST: protecting community-service oriented corporation did not provide any
benefit to stockholders (including eBay). As for-profit corporation, duty was to
maximize profits for shareholders (who craigslist voluntarily accepted money from).
DUTY OF LOYALTY
o R: Implicated when director or officer has pecuniary interest in a transaction. However, because
officers/directors may have valuable resources of benefit to the corporation, the conflict of interest may be
cured through use of cleansing techniques. Absent cleansing, the director has the burden of demonstrating
total fairness in the transaction, or the DoL is breached.
o Types of DoL situations:
Self-interested transactions: dir/officer stands on both sides of transaction, directly or indirectly.
Corporate Opportunity Doctrine: does corp have better equitable claim to this
Competition with the Corporation
Use of Corporate Assets or Information
o Cleansing Techniques:
Disinterested Director Approval
Disinterested Shareholder Approval
- SELF-INTERESTED TRANSACTIONS
o Where director or officer stands on both sides of the transaction, directly or indirectly, the DoL is implicated
Direct: transaction between the corporation and the director/officer.
Indirect: transaction with family member, another corporation director involved with, etc.
o Old rule: Voidable at will by corporation.
o Modern rule: OK if cleansing techniques used. Burden shift to P to prove unfairness or waste, unless
cleansing technique not used or ineffective burden on Dir. to prove total fairness.
o Default rule: BoD fixes compensation of Directors and can grant stock options.
DE: Unless bylaws or certificate say otherwise, BOD fixes compensation of directors. Unless fraud
in the transaction, determination of BoD is conclusive.
ALI: OK if:
Compensation fair when approved;
o But: difficult to prove fairness, even when high compensation.
Cleansing by BoD BJR;
Cleansing by SH not waste.
o Difficult to challenge on basis of fairness: placing value on employment is difficult.
Unless shareholders deceived as to value of stock options.
TYSON I: Spring-loaded options (option grants just before company releases positive
information) deceived SHs: more valuable than on face when approved by SHs. Would
be OK to backdate, because value is clear to SHs.
- CORPORATE OPPORTUNITY DOCTRINE:
o Dir/officer is taking an opportunity that should, in the first instance, belong to the corporation. Does the
corporation have a greater equitable claim to the opportunity?
Dir/officer should offer to corp first. If rejected, can take.
o LINE OF BUSINESS TEST:
Business opportunity is that which:
Corp financially able to take;
In line of corp’s business;
Corp would expect it to be offered;
Officer/director will be brought into conflict with corporation;
o ALI APPROACH: offers cleansing procedure if there’s a corporate opportunity:
Director or senior executive becomes aware:
o Connected with performance as exec/dir or offeror would reasonably expect
it to be offered to corp;
o Through use of corp info or property, if resulting opportunity one that
dir/exec should reasonably expect to believe would be of interest to corp;
Senior executive knows is closely related to a business in which corp is engaged or
expects to engage.
NB: doesn’t say anything about financial ability to undertake the opportunity.
1) First offers opportunity to corp;
2) Opportunity rejected by corp; and either:
o A. Rejection of opportunity is fair to corp;
o B. Rejected in advance by disinterested directors
UNLESS: if senior executive, rejected by disinterested superior
Must meet BJR
o C. Rejected in advance or ratified by disinterested shareholders
Must not be waste.
o HARRIS: deprived company of two opportunities by purchasing real estate surrounding company’s golf club.
o PABLO: usurped corporate opportunity by not disclosing commission in real estate transaction. Company
could have negotiated lower commissions from brokers.
o NB: BoD must exercise DoC in evaluating.
- USE OF CORPORATE ASSETS OR INFORMATION: also somehow breaches DoL
- COMPETITION WITH CORP
o Generally: Dirs/officers can’t advance own pecuniary interests by competing with corp.
o Competition: selling similar products – same market, similar pri
o BUT: Ali permits in limited circumstances:
1) Benefits to corp outweighed by harm. E.g., prestige/expertise of director;
2) No reasonable foreseeable harm to corp from competition.
Is the product interchangeable? Same market? Similar quality products? Similar price?
Cross-elasticity of demand: if one company raised price, would there be movement to
Might be different in internet age: can sell products anywhere.
3) Competition authorized by BoD after full disclosure BJR
4) Competition authorized by SHs after full disclosure not waste.
- CLEANSING TECHNIQUES
o Threshold requirements:
General rule: Failure to disclose conflict or the terms of the transaction is breach of DoL, even if
underlying transaction fair.
ALI: Dir. must disclose (1) conflict of interest and (2) relevant material facts of transaction.
If incomplete disclosure of material facts, DoL breached even if transaction is fair.
o DISINTERESTED DIRECTOR APPROVAL:
Interaction with Duty of Care: when BoD considering, must follow DoC. Can’t simply approve
because it would help out a fellow director – or maybe corp. doesn’t need it at all. But can’t turn
down a great offer, either.
NY: disinterested approval means vote without participation of interested director.
Policy: “I’ll scratch your back, you scratch mine” – know each other, might even be related.
Cannot approve transactions with majority shareholder
COOKIES FOOD PRODUCTS: majority shareholder alleged to have collected excessive
fees in transactions between company and his own companies. BoD not truly
disinterested because SH able to control most (if not all) of BoD.
o DISINTERESTED SHAREHOLDER APPROVAL:
Policy: problem of collective action: SH’s might not know if really fair, little motivation to
o EFFECT OF CLEANSING:
IF EFFECTIVE CLEANSING: burden shifts to Plaintiff to prove:
Some JDXs: Director must still prove substantial fairness.
o Most protective of SH interests, but what motivation to cleanse if would have
to prove fairness either way? (BoD approval is probative of fairness)
ALI/CA: waste (if SH approval) or unfairness (BoD). Less deferential than BJR, less
demanding than substantial fairness
o LEWIS (2nd Cir.):
DE: more than unfairness: waste (if SH approval) or violation of BJR (irrational decision
o Would protect even unfair decisions, so long as well-informed and rational.
o Waste: Company gets nothing in exchange, or consideration so inadequate
nobody could say it was sound business judgment.
IF NO CLEANSING OR INEFFECTIVE CLEANSING:
Director has burden to demonstrate total fairness in transaction, or DoL breach.
o Needed by company?
o Price fair?
o Fair process of approval (no arm twisting, e.g.)?
NB: breach of DoC by BoD in cleansing = ineffective.
DUTIES OF CONTROLLING SHAREHOLDERS
A. Generally: Controlling shareholders owe a fiduciary duty to minority shareholders. However, difficult in cleansing because
controlling shareholders often able to vote in all or at least a dominant portion of the board.
1. Majority shareholder?
a. A ‘majority’ SH is one who can control outcome of a SH vote.
b. SH can be ‘controlling’ even though doesn’t have 50%+ shares. Whether controlling = question of fact.
c. ALI: presumed control at 25% shareholding.
2. Challenger to transaction must show SH got something minority did not.
3. SHORT RULES RE: TRANSACTIONS WITH MAJORITY SHAREHOLDER:
i. Controlling shareholders owe a fiduciary duty to the minority at all times
ii. If they engage in a self-dealing transaction (on both sides of the transaction – majority gets something from
minority), then an intrinsic fairness standard applies (SINCLAIR)
(1) Sinclair: parent-subsidiary:
(a) High-dividend policy: depleted value of company, but SH’s got proportionate share of
all dividends. Passed BJR.
(b) Parent’s allocation of projects to other affiliates: weren’t corporate opportunities for
subsidiary in first place. BJR.
(c) Subsidiary’s failure to enforce K’s with other affiliates of parent: self-dealing
intrinsic fairness test.
iii. Otherwise, the business judgment rule applies
B. SALE OF CONTROL
1. Absent certain special circumstances, a controlling shareholder is free to sell and the purchaser is free to buy at
whatever price they negotiate. No duty of providing equal opportunity (as in close corps)
2. EXCEPT: FORESEEABLE LOOTING
a. Looting = stripping the company of its assets, bailing.
b. Seller liable when it’s apparent that buyer was going to breach duty of good faith and fair dealing.
i. Factors of foreseeability:
(1) Liquidity: fixed assets (e.g., buildings) difficult to loot.
(2) Wants immediate access and/or immediate resignation of all executive personnel.
(3) Gross excessiveness of price – beyond a control premium
c. EXCEPT: Naked Sale of Corporate Office buying stock of director/officer in exchange for promise to resign
immediately: A director or officer is not free to promise to sell his job without an accompanying sale of voting
i. Brecher v. Gregg: 4% not enough to control. President resigned.
ii. Essex Universal Corp. v. Yates: enough shares to be a ‘controlling shareholder’ sold. OK – that’s ancillary
sale of corporate office. Shouldn’t have to wait until next election to get the guy out if you can force him
o “Makes it illegal to employ “in connection with the purchase or sale” of a security any “manipulative or
deceptive device or contrivance” in contravention of the SEC rules. The Court has decided that this
language makes 10b an anti-fraud statute (not a level-playing field statute) and therefore requires intent.
Even if the rules can be read to go further, no violation of 10b can occur without the requisite scienter.”
Trading on information which is not public knowledge.
§10(b) applies to more than just §12 companies.
Requires scienter -- §14(a) does not.
Insider can begin trading when there has been effective public disclosure.
- BASIC ELEMENTS
o 1) MATERIAL MISREPRESENTATION OR OMISSION
Certain information: whether reasonable person would attach importance in determining his
choice of action in the transaction in question. [BASIC v. LEVENSON]
Soft information: balance of probability of information becoming true and magnitude of such
information if it were true.
TEXAS GULF SULFUR: drilling of core samples
Preliminary merger negotiations
o BASIC v. LEVENSON: material misstatements in press releases saying they
weren’t involved in merger negotiations.
o 2) SCIENTER
Private action: Plaintiff must plead scienter with particularity (PLSRA):
Specify each statement alleged to be misleading
State with particularity facts giving rise to strong inference D acted with scienter.
o Inference be at least as compelling as any competing innocent inference.
o Some courts say evidence of motive/opportunity relevant, but never enough
alone – need direct or strong circumstantial evid, too.
Intent of statute is not to say recklessness not enough.
Scienter required: an intent to deceive, manipulate, or defraud on part of D satisfies sc. req.
Recklessness qualifies; negligence not enough; but specific intent not required.
Recklessness controversial, but definition: “Extreme departure from the standards of
ordinary care, and which presents a danger of misleading buyers or sellers that is either
known to the defendant or is so obvious that the actor must have been aware of it”
Trading on basis of: you must both know of non-public information and act with requisite
scienter. If you think it’s public info, can’t have intent to defraud.
TEXAS GULF SULFUR: suggested scienter unnecessary, overruled by HOCHFELDER.
HOCHFELDER: USSC requires scienter.
o 3) IN CONNECTION WITH PURCHASE OR SALE OF A SECURITY
Interpreted very broadly.
Private actions: only buyers and sellers have standing.
“I would have sold” or “I would have bought” don’t count.
BLUE CHIP STAMPS: pessimistic prospectus. P’s only potential buyers = no standing.
ZANFORD: Stockbroker tricks elderly guy and mentally challenged daughter to give him
discretion over stock accounts, intending to misappropriate money. The eventual selling
of securities was connected to the fraudulent act (getting access).
Defendants do not need to have bought or sold.
o 4) TRANSACTION CAUSATION
SEC does not need to prove any form of causation. Only applies to private plaintiffs.
“Fraud on the market” theory: if the statement was made publicly, everyone has standing to sue
if it affected the stock price. Presumption that market absorbs all material information, so
misstatement or omission means the market price is incorrect.
Means that P does not have to prove individual reliance.
Creates rebuttable presumption of both transaction causation and loss causation.
[BASIC v. LEVENSON]
o Rebut by showing P knew all facts or had agreement to sell/buy.
In cases of failure to disclose, reliance on the silence presumed only when there was a
duty to disclose.
Rebut transaction causation by showing P would not have changed positions had he known all
o 6) LOSS CAUSATION
Plaintiff bears burden.
Aka proximate cause: Causal connection between misrepresentation and loss.
Must show that the statement caused the loss: a foreseeable consequence of the misstatement
Look to whether price dropped considerably after disclosure of truth.
o Compare with entire industry: same drop?
- LIABILITY OF AIDERS AND ABETTORS
o Can’t base private claim on aiding and abetting. But SEC can still go after it.
o To recover from the aid/abetting company, have to show that the company satisfied all elements as the
STONERIDGE: vendors dealing with fraudulent scheme w/cable company. However, did not make
any statements to investors silence case. Had no duty to disclose. No reliance by investors on
what they did, even though they participated in the scheme meant to boost stock price.
MEYER BROWN: law firm participated in making statements connected with fraud. However,
statements weren’t attributed to the firm (not ID’d as the source of docs, even though they
helped prepare them) no reliance.
- FAILURE TO DISCLOSE / SILENCE CASES
o S10(b) addresses fraud, so Rule 10(b)(5) must address fraud
o It is not fraudulent for anybody merely to use material undisclosed information with scienter to benefit
o Silence can only amount to fraud where there is a duty to speak.
People who trade in a silence case based on undisclosed information only violate 10b–5 when
that person has a duty to disclose based on a fiduciary or other relationship based on trust and
confidence, which duty does not automatically arise based on the mere possession of nonpublic
CHIARELLA: financial printer uses information from reports he was printing to invest in companies
about to report a merger. No duty to shareholders of the company was trading in silence.
USSC declines to address whether he breached a duty owed to his employer.
A duty to disclose arises from a fiduciary duty or similar duty of trust and confidence.
o TIPPER-TIPPEE LIABILITY
Tippee assumes fiduciary duty to shareholders of corp not to trade on nonpublic info
Only when tipster has breached his duty to shareholders by disclosing and
Tipper only breaches this duty by disclosure for personal gain or reputational benefit.
Tipee knows or should know there has been a breach.
Aka: tippee knows about the improper motive.
Unless tipster has breached, looks like mere possession of info not fraudulent.
DIRKS: insider whistleblower discloses information to securities analyst, who tells clients. Analyst
owed no duty to shareholders because whistleblower’s disclosure was not for personal gain.
o MISAPPROPRIATION THEORY
Theory outlaws trading on the basis material nonpublic information by a corporate outsider in
breach of a duty owed not to a trading party, but to the source of the info.
Liable if breach duty to source of information (aka “fraud on the source”).
Though not trading in stock of the source of info, it’s still “in connection with” the fraud.
Establishing duty to source:
o Relationship is one invoking an expectation of trust. Doctors, lawyers,
o Agreement to keep confidential or pattern of sharing confidences.
E.g., driver of car service source regularly uses where there’s an
understanding of confidence vs. random cab driver
o O’HAGAN: D learns of info through role as lawyer, but owed no duty to the
company he traded in. Liable under misappropriation theory.
Curing through disclosure: can cure by disclosing intent to buy/sell to the source.
o ROCKLADGE: wife cured fraud with respect to tipping her brother by
disclosing to husband her intent to tip her brother. But did not cure fraud
committed when she induced husband to give private info because she had a
pre-existing arrangement with her brother to tip him at the time she told her
husband she’d keep quiet.
Contrast with O’Hagan: he just used information he gained; didn’t
get the info by deception.
SHORT SWING TRADING
o Private enforcement only. SEC does not prosecute.
o Strict liability. No scienter.
- Class of persons:
o Director or Officer
Only on one side of transaction, excluding sales/purchases made before becoming director or
o 10%+ shareholder
On both sides of transaction (sale and purchase).
- Action: buys and sells (or sells and re-buys) stock in own corporation within period of 6 months and makes profit.
o Definition of profit:
Match highest sale price with lowest purchase price for as many shares as match up.
o Exception: involuntary transfers (e.g., court ordered transfer).
- Result: conclusively presumes insider trading, strictly liable.