I.   Introduction, Choice of Entity
     a. Subject in General
            i. Classification by business form naturally breaks into two
                   1. Unincorporated Associations: Other than a general
                        partnership all other business associations require formal
                        filing of documents.
                             a. Proprietorships
                             b. Partnerships: UPA (1914), revised 1994 adopted by
                                 almost all states.
                             c. Limited Partnerships: ULPA, most states adopted
                             d. New Forms (Post 1990)
                                     i. Limited Liability Company
                                    ii. Limited Liability Partnership
                                    iii. Limited Liability Limited Partnership
                   2. Corporations: MBCA, to be used as a model for state
            ii. Developments during the last decade have greatly increased the
               attractiveness of unincorporated forms of business for closely held
           iii. New Developments
                   1. The universal recognition of new unincorporated business
                        forms that grant the advantage of limited liability for all
                        owners of the business, particularly the LLC
                   2. Changes in the Internal Revenue Code income that permit
                        unincorporated firms in effect to elect how they are to be
           iv. Statutes
                   1. State Statutes
                             a. Each state has its own corporation statute

                        b. Model Business Corporation Act (MBCA)
                           represents current thinking on what a corporate
                           statute should look like.
                        c. DE, CA, NY do not follow MBCA
                        d. Same statute applied to mom & pop corporation as
                           applies to General Motors
                        e. Focus of state statutes: rights, obligations, and
              2. Federal Statutes
                        a. Securities Act of 1933, Securities & Exchange Act
                           of 1934
                        b. Apply to publicly held corporations: involves
                        c. Focus: an informed marketplace emphasizes
                           disclosure, letting market forces play out.
b. Taxation of Partnerships and Corporations
       i. Proprietorship: A proprietorship is not a separate taxable entity.
          Its income or loss is reported on the proprietor’s personal income
          tax return.
      ii. Partnerships: The income or loss from the partnership is allocated
          among the individual partners in accordance with the partnership
          agreement. Each partner must then include in his or her personal
          income tax return the amount of each item so allocated.
     iii. Corporations
              1. C Corporation
                        a. Generally, a corporation is taxed as an entity
                           distinct from its owners
                        b. I.E.: It must pay income taxes on any profits that it
                           makes, and generally shareholders do not have pay
                           income tax on the corporation’s profits until the
                           profits are distributed.

                       c. Double Taxation: When the corporation does make
                          distributions to shareholders, the distributions are
                          treated as taxable income to the shareholders even
                          though the corporation has already paid taxes on its
             2. S Corporation
                       a. S corporations are taxed on a modified conduit basis
                          that is similar in many respects to that applicable to
                               i. The corporation files a return showing the
                                     earnings allocable to each shareholder.
                              ii. The shareholder must include this amount in
                                     his or her personal income tax return.
                             iii. That amount is includible whether or not
                                     any distributions are made by the
                       b. Eligibility for S treatment: To be eligible for S
                          corporation treatment, corporations must have fewer
                          than 75 individual shareholders.
             3. Minimizing Corp. Tax
                       a. File an S Corp. election
                       b. Instead of cash distribution of dividends use fringe
c. Limited Liability
       i. Historically, the corporation was the business form that minimized
          the likelihood that the entrepreneurs would be personally liable for
          debts of the business should it fail. HOWEVER, its lack of
          flexibility and adverse tax treatment increased its cost to owners of
          closely held businesses.
      ii. New types of business forms permit limited liability to be
          introduced into unincorporated entities that combine limited

                liability and partnership tax treatment: LLCs, LLPs, and limited
                partnerships with corporate general partners.
            iii. The importance of limited liability depends primarily on possible
                exposure to tort liability.
            iv. An individual or partner routinely obtains considerable protection
                against individual liability simply by the purchase of insurance.
            v. Doing business in a limited liability form avoids individual
                responsibility for these often-substantial liabilities in theory.
                However, the other parties to such contracts are usually
                sophisticated and well understand the implications of limited
                liability; if they are concerned about the possibility that a limited
                liability entity may not have adequate resources to meet its
                obligations they will demand personal guarantees.
            vi. To the extent a LLC looks like a partnership or corporation will
                determine its liability and the authority of its agents.
      d. Comments on Delaware Corporate Law
             i. 50% of the companies on the NYSE are incorporated in DE.
            ii. DE corporate law serves as a “federal” model that many states use.
            iii. DE has a specialized court that only hears corporate law; a large
                body of law has been created that provides guidance and precedent
                that is lacking in other states.
II.   Partnerships
      a. Establishing a Partnership
             i. A partnership can be created through just a handshake or oral
            ii. HOWEVER, a written partnership agreement helps to clarify
                     1. It may avoid future disagreements over what the
                          arrangement actually was.
                     2. The written agreement is readily proved in court.

        3. It may focus attention on potential trouble spots in the
            relationship which may be unnoticed in an oral agreement.
        4. The Internal Revenue Code treatment of partnerships
            permits partners by agreement to allocate the tax burdens
            among themselves within limits, and a written agreement is
            clearly desirable where advantage of such provisions is
        5. UPA contemplates that upon the death or retirement of a
            partner, the business is either to be disposed of or the
            interest of the deceased partner is to be purchased by the
            partnership or by the other partners. It is usually sensible
            for the partners to agree on what should happen in advance
            of such an event, and such provisions should be in writing
            since they may affect surviving spouses, executors, and
            others who are strangers to the agreement and are
            unfamiliar with their rights.
        6. A partner may wish to lend rather than contribute specific
            property to a partnership. A written agreement clearly
            identifying that property is contributed and which is loaned
            is necessary to protect the partner’s interest in the loaned
        7. Where real estate is to be contributed as partnership
            property or the agreement includes a term of more than one
            year, a written agreement may be necessary to comply with
            the statute of frauds.
        8. It’s advantageous to the attorney: not only may it justify a
            higher fee but also it places suggestions and advice in
            concrete form so that there is less possibility of
iii. Joint Venture
        1. It’s a partnership for a specific task/transaction.

                                 2. Example: construction of an office building.
                        iv. General Partnership
               b. Sharing of Profits and Losses
                         i. Rule: Absent any writing profits and losses are divided equally
                             (Richard v. Handly p. 33).
                        ii. Rule: The respective rights and duties of partners or joint ventures
                             cannot be determined until the terms of all agreements between
                             them have been ascertained. (See Richert v. Handly p. 30)
                       iii. A written agreement allows the profits and losses to be divided in
                             numerous ways
                                 1. Flat Percentage Basis
                                 2. One or more partners may be entitled to a fixed weekly or
                                      monthly “salary.”
                                 3. Percentage basis with the percentages recomputed each
                                      year on the basis of the average amount invested in the
                                      business during the year by each partner.
                                 4. Fixed percentage rate
                                 5. ETC.
                        iv. In a partnership all partners are jointly and severally liable for the
                             legal obligations of the partnership.
                                 1. As a partner you have the right to indemnification.
                                 2. Every partner must be served in a civil action1 otherwise
                                      the suit can be dismissed.
                        v. According to the 1994 UPA when a plaintiff sues the partnership,
                             they must exhaust the partnership assets before going after the
                             individual partners.
               c. Management and Authority
                         i. The state in which the partners reside is the state whose law
                             governs the partnership’s activities.
                        ii. Authority, UPA § 9

    Non-joint/non-severally liable claim

1. Actual Authority:
       a. Definition: The words or actions of the principal
          authorize the agent to act on behalf of the principal.
       b. Types:
              i. Implied
              ii. Express
             iii. Incidental
       c. Rule: The acts of a partner, if performed on behalf
          of the partnership and within the scope of its
          business, are binding upon all copartners. (See
          National Biscuit Company v. Stroud)
       d. Revoking Actual Authority
              i. Partnership of 2 people:
                       1. Actual Authority can be revoked by
                          dissolution of the partnership and
                          giving notice to others about it.
                       2. It can also be revoked if one partner
                          buys out the other partner (assuming
                          there are only two partners).
                       3. A partner cannot be stripped of
                          his/her authority since there are only
                          two partners. Every partner has an
                          equal vote in a partnership and here
                          the partners will be deadlocked.
              ii. Partnership with 3 or more people:
                       1. In this situation the partners can vote
                          to strip a partner of his/her authority.
                          HOWEVER, you can still bind the
                          partnership by using apparent
2. Apparent Authority

a. Definition: The principal creates an impression in
   the minds of 3rd parties that his/her agent can act on
   behalf of them (the principal).
b. It’s not enough for an agent to say he has authority.
   The principal(s) must do something to create an
   impression in third parties.
c. Rule:
        i. If you act within the scope or apparent scope
           of your authority it will bind the partnership.
           (See Smith v. Dixon)
       ii. Reasoning: It’s not a 3rd party’s duty to
           figure out the relationship in the partnership.
d. Ask what type of authority is it?
        i. Actual Authority or Apparent Authority?
       ii. If it’s apparent authority, does the act of a
           partner fall within the scope of the business?
               1. Is it the general product/service part
                   of the business?
               2. Are the goods excessive?
      iii. How do I revoke it?
e. In Rouse v. Pollard p. 46, the Court said the
   investment behavior is outside the scope of
   behavior for a law firm.
        i. D had no actual authority.
       ii. No apparent authority either
               1. Law firms in NJ normally don’t
                   normally engage in this type of
               2. Investment in mortgages is outside
                   the scope of the law firm’s business.

                           iii. If the partners had knowledge but said
                                nothing then it looks like apparent authority
                                is created.
                            iv. Also the Court said P’s reliance was
                     f. It doesn’t matter whether or not the action is illegal.
                             i. Actual authority can bind the partnership.
                            ii. The same can occur with apparent authority.
             3. Vicarious Liability
                     a. Roach v. Mead
                             i. Facts: The attorney gave negligent legal
                                advice. The advice falls within the scope of
                                the business (at least the Court thought so).
                                The other partners were held vicariously
                                liable for the attorney’s negligent acts.
                            ii. Rule: Each partner is responsible to 3rd
                                parties for the acts of the other partner when
                                such could reasonably have been thought by
                                the third party to fall within the purpose of
                                the partnership.
                           iii. The attorney should have allowed the client
                                to seek a second legal opinion because of a
                                conflict of interest.
                     b. Reconciling the Roach case and the Rouse case
                             i. Rouse case: reasonableness of P’s
                            ii. Roach case: nature of the legal advice
d. Duties of Partners to Each Other
       i. UPA § 21
      ii. Meinhard case p. 54
             1. Covers fiduciary duty

             2. Partners have a broad responsibility toward each other.
             3. The Court assumed there was no fraud. It was near the end
                 of the 20-year lease period. M had a right to compete in the
                 venture. The Court didn’t like the fact that S had an
                 advantage as manager of the business. S should have put
                 M on equal ground.
     iii. Fiduciary Duty: joint adventurers owe to one another, while their
          enterprise continues, the duty of finest loyalty, a standard of
          behavior most sensitive. A partner has a duty to inform the other
          partner(s) of the perks/ventures that involve the partnership.
      iv. Question to Ask
             1. Is a transaction incident to the partnership?
      v. It seems like the manager is held to a higher standard than the
          passive investor
      vi. Can the fiduciary agreement be waived?
             1. It can’t be totally waived by agreement. UPA 1994 won’t
                 allow it.
             2. It can be limited in some aspects by contract.
e. Partnership Dissolution
       i. Dissolution:
             1. Dissolution is a change in the legal relationship caused by
                 any partner ceasing to be associated in the carrying on of
                 the business.
             2. Dissolution terminates actual authority.
             3. BUT apparent authority can only be terminated by notice.
                     a. Therefore, send letters to all 3rd parties (creditors
                         and business associates) and publish that your
                         partnership is at an end.
      ii. “Winding Up” Period:
             1. Steps in this period
                     a. Settling of Accounts

                             b. Payment of Debts
                             c. Payment to Partners
                     2. There is a heightened duty toward creditors and partners
                         during the windup phase.
             iii. Termination of the Partnership:
                     1. Partners are still liable for their past actions.
                     2. If a partnership continues to do business after it has been
                         formally dissolved, the noncontinuing partner or his
                         representative may elect to receive his share of the profits
                         earned by the firm after the date of its dissolution.
                             a. See Cauble v. Handler p. 78
                                     i. The assets should have been liquidated on
                                         market not book value.
                                     ii. P gets the market value of her late husband’s
                                         interest in the partnership AND a choice
                                         between the interest on the assets belonging
                                         to her husband or a slice of the profits
                                         because the other partner is still using her
                                         husband’s interest to continue the business.
             iv. Right v. the Power to Dissolve
                     1. Rule: A partner who has not fully performed the
                         obligations imposed on him by the partnership agreement
                         may not obtain an order dissolving the partnership. (See
                         Collins v. Lewis p. 75)
III.   Limited Liability Companies and Other Business Forms
       a. General Information
              i. Alternatives to partnerships and corporations
             ii. Benefits: Tax treatment like a partnership and limited liability like
                 a corporation.
       b. Limited Liability Partnerships (LLPs)
              i. See p. 36

      ii. This form was created as a result of the savings & loan crisis.
     iii. Characteristics: Any partner not directly involved or having direct
          oversight duties will not be held liable for tort liabilities.
              1. Narrow Shield: only protects against tort claims
              2. Broad Shield: protects against all liabilities (i.e. contract
                  claims & tort claims).
     iv. LLPs have the same fiduciary duties as general partnerships.
c. The Limited Partnership
      i. Consists of general and limited partners (LPs).
      ii. LPs are not liable as long as they play a passive role in the
     iii. When will LPs be exposed to liability?
              1. See Continental Waste System, Inc. v. Zozo Partners p. 121
                      a. D is not a LP because of:
                               i. Improper filing
                              ii. D had managing authority. He acted like a
                                  general partner.
     iv. Limited partners can’t bind the partnership
      v. A general partner has a higher fiduciary duty than the limited
     vi. In re USACafes, L.P. Litigation
              1. Fiduciary duty owed by the directors of the corp. (USA) to
                  the limited partners.
              2. The directors essentially conduct the business affaires of
                  the corp. (the general partner). The directors argued that
                  the liability should stop at the general partner’s assets and
                  not the directors’ assets.
              3. The Court said that since the directors are in charge of the
                  general partner, they owe a duty to the limited partners.

                                 4. The Court doesn’t address the directors’ duty when the
                                     shareholders’ goals conflict with those of the limited
               d. Limited Liability Limited Partnership (LLLP)
               e. Limited Liability Companies (LLCs)
                         i. An LLC has a combination of corporate and partnership benefits.
                        ii. Benefits
                                 1. No restrictions on terms of management structure.
                                 2. The LLC can be run directly by the members OR through a
                                     board of directors.
                       iii. Downside
                                 1. People are still unclear about how the structure is run.
                                 2. It costs more to file the forms for a LLC. You need a tax
                                 3. Different states have different laws on LLC.
               f. Review of Federal Tax Issues
                         i. Corporations: Taxation on business earnings. The shareholder
                            distributions of dividends are taxed again as personal income. This
                            does not apply to S Corporations (SCORPs)(see p. 151).
                        ii. Partnerships: If it is run like a corporate structure, then it will be
                            treated as one in terms of taxation.
      IV.      Formation of a Corporation
               a. The Process of Incorporation2
                         i. Decide where you want to incorporate.
                                 1. Delaware or home state.
                        ii. Pick a name
                                 1. It can’t be similar to another corporation’s name.
                       iii. Select and Identify an agent and their office
                       iv. Shares
                                 1. How many shares of stock?

    Many people use corporation service companies when incorporating in an outside state.

             2. What will be the stock’s par value?
             3. Set out the differences in the stock shares
      v. Names of director(s)
             1. Number of directors
             2. The names can be in the charter or can be determined at a
                 later date.
      vi. Creation of the By-Laws
     vii. Addition of Opt-In Provisions & Opt-Out Statutes
             1. Opt-In: The provision must be in or it doesn’t apply.
             2. Opt-Out: The provision must be specifically excluded or
                 it’s automatically assumed in.
    viii. First Meeting
      ix. Check the Charter and By-Laws
             1. You are bound by these
             2. Restated Charter: Integrate the original certificate with any
b. The Ultra Vires Doctrine
       i. It means “beyond the powers” of the corporation.
      ii. Old Rule: If a corporation enters into a contract and the charter
          does not authorize it then the corporation can void the contract.
             1. Purpose: It protects shareholder interests.
     iii. New Rule:
             1. Charters are now construed very broadly.
             2. Corporations can have general-purpose clauses.
c. Premature Commencement of a Business
       i. Three Ways to Lose Limited Liability
             1. Defective filing
             2. Promoting the Corporation
             3. Piercing the Corporate Veil
      ii. Promoters

1. Definition: A promoter is a person who undertakes to form
   a corporation and procure for it the rights, instrumentalities,
   and capital by which it is to carry out the purposes set forth
   in its articles of incorporation. The promoters usually act
   as the incorporators. However, acting as an incorporator is
   not necessary to make one a promoter, their capacities are
   separate and distinct relationships to the corporation.
2. If you are a promoter of a corporation you could be held
   liable because the promoter is viewed as an agent of the
3. Stanley case p. 225
       a. Rule: A promoter will be liable on a contract he
           entered into on behalf of a corporation yet to be
           formed unless the other party agreed to look to
           some other person or fund for payment.
       b. The promoter is liable for contracts signed by him
           for the corporation to be formed.
       c. There are three exceptions to this rule:
               i. The contract is treated as an option which
                   can be accepted by the corporation when it
                   is formed, and the promoter agrees to form
                   the corporation and give it the opportunity to
              ii. A novation with the corporation assuming
                   the promoter’s liability and replacing him in
                   the contract.
              iii. The promoter remains liable even after
                   formation but only as a surety.
4. In Stanley, D should have waited until the corporation was
   up and running. He also should have used the correct
   corporate signature.

               a. Incorrect Method
                            Joe Smith
                            President, XYZ, Inc.
               b. Correct Method
iii. Defective Incorporation
        1. MBCA § 2.04 Liability for Pre-incorporation Transactions:
           All persons purporting to act as or on behalf of the
           corporation knowing there was no incorporation is jointly
           and severally liable for all liabilities created while so
        2. Robertson v. Levy (p. 236)
               a. The charter is defective—forgot to pay fee, sign it,
                     so the corporation does not exist.
               b. Difference from Boss case
                         i. Boss: both parties knew of the defect,
                            liability on the promoter
                        ii. Robertson: Only Levy knew the corporation
                            was not yet formed but continued to act as
                            though it was incorporated. Robertson knew
                            nothing. Levy, runner of the business, held
                                1. Agreement between Levy and
                                2. Articles filed, no certificate
                                3. Lease signed (neither knew of
                                4. Rejection of articles

                                                                    5. Levy executes note (Levy knew of
                                                                          defect, not Robertson)
                                                                    6. Certificate of incorporation issued
                                               c. De jure v. De facto Corporation
                                                              i. De jure: Corporation by law; followed the
                                                                 rules of incorporation, etc.
                                                          ii. De facto: Corporation, but not by law,
                                                                 considered corporation of followed these
                                                                 prerequisites, unless challenged by state.
                                                                 Using this doctrine, Robertson would not
                                                                 have a claim if:
                                                                    1. Valid law under which corporation
                                                                          could be organized
                                                                    2. Attempt to organize there under
                                                                    3. Actual user of the corporate
                                                                    4. Good faith
                                                          iii. Court holds: De facto corporation is no
                                                                 longer a defense.
                                               d. Prior to modern rules: the rationale for the de facto
                                                              i. To be incorporated, secretary of state would
                                                                 do a substantive review which would take a
                                                          ii. While waiting to hear, parties would engage
                                                                 in business although they were not officially
                                               e. TODAY under the rules3 NO justification for the de
                                                       facto rule because:

    The old rule is still in effect in a few states.

                                      i. Incorporation happens much more quickly,
                                         no waiting period.
                                    ii. Much more simplified process
                                   iii. If the corporation is in good standing, a
                                         certificate of incorporation will be issued the
                                         day the papers are filed.
                             f. Levy held personally liable because the corporation
                                was not yet formed.
                                      i. Even though Robertson did not ask to secure
                                         personal liability.
                                    ii. There was no injury to Robertson as a result
                                         of the misfiling.
                                   iii. Appears to be giving Robertson (P) an
                                         unjustified windfall.
                             g. De Facto doctrine still exists
                                      i. Large corporations with many subsidiaries
                                         must pay franchise taxes to operate in states
                                         other than their state of incorporation.
                                    ii. Must pay them promptly or their charter will
                                         be revoked.
                                   iii. De facto doctrine is used to prevent liability
                                         in these situations.
V.   Piercing the Corporate Veil
     a. General Doctrine
            i. Ignores corporate structure and places liability on the shareholder
               (Bartle and Dewitt demonstrate the difficulty in achieving
               consistent results).
           ii. Happens most often in closely-held corporations
           iii. Corporate existence will continue after veil piercing
           iv. Does not mean all shareholders are liable, only those implicated in
               the action.

v. When is piercing appropriate?
       1. Fraud (can be less than tort fraud)
       2. Alter Ego (no separation)
               a. Mere Instrumentality Doctrine: the shareholders are
                  using the corporation for their own ends.
               b. Enterprise Liability: occurs if there are different
                  corporations operating together with mixed assets.
       3. Didn’t follow corporate formalities
vi. Bartle v. Home Owners Coop. (p. 250): shareholder is the parent
    of the wholly-owned subsidiary
       1. No piercing the corporate veil—no liability
               a. Parent was a non-profit; sub was for a profit created
                  to build low-income housing for war veteran
                  members of the non-profit parent.
               b. P was trustee in bankruptcy for the sub, trying to
                  recover from the parent shareholder.
               c. Generally, subs don’t sue parents because their
                  existence depends on the parent but when sub is
                  bankrupt, they are now adverse to each other and
                  the trustee (P) must try to satisfy the sub’s creditors.
               d. No liability for the parent
                         i. No fraud
                        ii. No misleading of creditors
                        iii. Two corporations were always maintained
                        iv. Parent did not deplete the sub’s assets.
                        v. But the creditors did not know that the
                            parent set prices for the sub (at cost
                            housing). This could be close to fraud.
       2. Dissent—there should be liability—corporate veil should
           be pierced

                     a. Same officers and directors of both
                     b. Subsidiary could not make a profit (at cost)—sub
                          could not exist without parent, not really separate
     vii. Dewitt v. Flemming (p. 252)
             1. Not following corp. formalities (e.g. not holding
                 stockholder meetings) will weigh against a defendant in
                 piercing the corporate veil.
             2. Undercapitalization also makes a difference
             3. More importantly is the siphoning off of revenue from the
             4. Absence of records
             5. Deception of Creditors
    viii. When will a Court pierce the corporate veil?
             1. No real clear-cut rules. It’s result oriented.
             2. Pierce the veil to avoid injustice (e.g. misrepresentation,
             3. Factors to Consider
                     a. Failure to observe corp. formalities
                     b. Lack of corp. records
                     c. Undercapitalization
                     d. Co-mingling of assets (e.g. using corp. funds to pay
                          off personal assets)
                     e. Domination or control over the corporation (Alter
                          Ego Theory)
                     f. Element of Injustice
b. Tort Cases
      i. Contract Cases v. Tort Cases
             1. Contract Cases: In contract cases creditors can always ask
                 for a guarantee or no deal. Negotiation is possible, have
                 knowledge of the ability of the corporation to pay,
                 voluntary transaction.

       2. Tort Cases: More of an involuntary transaction on the part
           of the plaintiff did not plan to have to deal with this
       3. So theoretically piercing should occur less with contract
           cases than tort cases. However, they are most often treated
           the same.
ii. Baatz v. Arrow Bar (p. 260)
       1. Tort claim, not contract
               a. P was injured when they got into a collision with a
                   person who had been served drinks at Arrow Bar. P
                   wants to reach Arrow Bar Stockholders.
       2. Majority—no piercing—no liability (S.D. law not very
           favorable towards plaintiffs, S.D. had overturned
           legislation attempting to hold restaurants liable in these
               a. Not Undercapitalized
                          i. Didn’t have dram shop insurance (lawyer
                             will be guilty of malpractice for this)
                          ii. They are running a business to serve
                             drinks—they have adequate capital.
                       iii. The dissent disagrees—they are serving
                             drinks to intoxicated drinkers which is a
                             high-risk enterprise that needs much more
                             capital in the form of insurance. Adequate
                             capital must include capital for liability.
                             Absence of insurance is a problem.
                       iv. Used to be minimum capital requirements
                             for corporations, NO LONGER
                          v. Used to be maximum capital requirements
                             because of a fear of big corporations, NO

                     vi. Why should the courts resurrect these
              b. Ds personal guarantee of the note only confirmed
                  adequate capitalization and was on contract, no tort
              c. Personal business under corporate façade-Alter
                      i. Baatz failed to show any evidence of using
                          corporate funds to pay personal obligations.
              d. The fact that D may have served the drinks himself
                  is not a piercing issue, it would be a tort issue
              e. Failure to follow corporate formalities
                      i. P argues that corporation’s name is
                          insufficient (MBCA § 4.01) because Inc. is
                          not listed on signs or advertising—NO—bad
                          argument-Inc. was listed on all corporate
                          paperwork, etc.
iii. Radaszewski v. Telecom Corp. (p. 266).
       1. Tort claim, P in accident with truck owned by the sub, can
           the parent be held liable? NO, no veil piercing (corporate
           limited liability v. Uncompensated tort victim).
       2. Trying to pierce the corporate veil to reach the parent
           because of the insolvency of the subsidiary.
       3. Three Part Test: To pierce the veil, one must show:
              a. Control, not mere majority or complete stock
                  control, but complete domination of finances,
                  policy, and business practice with respect to the
                  transaction so that the corporation has no separate
                  mind or existence of its own.
              b. Control was used to commit fraud or wrong.
                      i. Telecom
                              1. Undercapitalization

                                     2. Yes, the sub was inadequately
                                        capitalized in the
                                        business/accounting sense.
                                     3. Most capital was in the form of
                                        loans, not equity.
                                     4. Insurance, although their insurer was
                                        insolvent, the amount of insurance
                                        was enough to cover the claims
                                        within the scope of liability to P—
                                        obligation specific—may no have
                                        been enough to cover other claims,
                                        but enough to cover this claim.
                                     5. Should all insurance be treated
                                        equal—low premiums, no good
                                        coverage, high premiums, better
                                     6. Capital requirement is met.
                                     7. Dissent—insurance coverage should
                                        not preclude piercing the corp. veil.
                             ii. Baatz: if it was one of 1000 Arrow Bars (a
                                     1. Majority: NO
                                     2. Dissent: Yes, the “corp. policy” was
                                        to serve alcohol to drunks.
                     c. The control and breach of duty must have
                         proximately caused the injury or unjust loss.
      iv. Undercapitalization alone isn’t enough to pierce the corporate veil.
          You need other factors as well.
c. Liability of Parent
       i. Fletcher v. ATEX, Inc. (p. 273)

                   1. Delaware law applies because that is where Atex is
                   2. To prevail on an alter ego claim under DE law, P must
                              a. That the parent and the subsidiary “operated as a
                                    single economic entity.”
                              b. AND, that an “overall element of injustice or
                                    unfairness” exists.
                   3. There was a cash management system (pooling of ATEX’s
                          and Kodak’s assets) for lower interest rates. However,
                          ATEX still maintained control over its assets
                              a. Good records were kept as well.
                   4. Control over CEO (Hiring and Firing)
                              a. Evidence of parent company’s control over sub.
                              b. However, as long as the boards are separate it
                                    should be OK.
                              c. It’s assumed that the board members will think for
                   5. Whenever you deal with the internal affairs of a corp., you
                          look at the law of the state of incorporation.
                   6. If the sub acts as parent’s agent (if authority exists) the
                          parent could be held liable.
            ii. U.S. v. Bestfoods (handout)
                   1. If you could pierce the corp. veil the parent could be held
                   2. The parent could also be held liable if it is seen as an
VI.   Financial Matters
      a. Debt & Equity Capital
             i. Equity
                   1. Ownership rights possessed by shareholders

                     a. Voting rights
                     b. Financial Rights
                              i. Dividend Rights: entirely discretionary
                             ii. Rights upon liquidation
              2. Equity rights are contained in the articles of incorporation
                     a. Different classes of stock
                     b. Number of stock shares
              3. Stocks are regulated
      ii. Debt
              1. Debt holders are entitled to a specific payment at a specific
              2. Examples of Debt: bank loans, bonds, etc.
              3. Debt holders are entitled to a specific payment at a specific
b. Types of Securities
       i. MBCA § 6.01(b) Authorized Shares
      ii.   MBCA § 6.03
      iii. Two Different Types of Shares
              1. Preferred Shares
                     a. PS holders pay a premium for their shares. In
                          exchange they get first dibs in the liquidation assets
                          after the creditors.
                     b. PS holders get a fixed dividend each year.
                     c. PS holders do not have voting rights
                              i. BUT it can be triggered if the corp. defaults
                                  on the payment of dividends.
              2. Common Shares
                     a. Voting Rights
      iv. Cumulative Dividends
              1. If the corp. does not pay dividends in year 1, the PS holder
                 dividends carry over into year 2, 3, etc.

      v. Redemption Rights
             1. Call Option: corp. forces shareholders to sell shares back
                 to the corp.
             2. Quit Option: shareholders force the corp. to buy back their
      vi. Conversion Rights
             1. Preferred Stock converted into Common Stock
             2. It works the one way but not the reverse.
     vii. Anti-Dilution Rights
             1. Prevents the corp. from reducing your voting rights via the
                 issuing of more shares.
             2. Preemptive rights, Stock Splitting
                     a. Additional stock will be issued to balance out the
                          rights of existing shareholders.
    viii. Watered Stock
             1. Examples
                     a. Discounted stock
                     b. Issuance of stock for property whose value is
                     c. Bonus shares of stock
c. Issuance of Shares
       i. Requirements
             1. The stock (at the very minimum) must have voting rights
                 and liquidation rights.
      ii. Common Shareholders
             1. Voting Rights
             2. Anti-Dilution Rights in most situations (PS holders have
                 this also)
     iii. Preferred Shareholders
             1. Fixed dividend rights
             2. Superior liquidation rights

             3. Redemption rights
                     a. It works the opposite way also (call option)
             4. Anti-dilution rights
     iv. Example: As participating shareholders, C receives $1.25 and they
         participate with the common shareholder dividends. BUT they
         don’t participate fully with the common shareholders. They are at
         least entitled to the $1.25.
        Y1                        Y2
        A $3 cumulative           A $6 cumulative

        B $2 non-cumulative B $2 non-cumulative

        C $1 participating        C $1.25 participating

        Common                    Common

d. Debt Financing
       i. Short Term Financing: loans
      ii. Long Term Financing: securities such as bonds and debentures
     iii. The interest must be paid at a specific time.
     iv. In liquidation, debt holders have a superior right than stockholders
      v. The higher the debt/equity ratio the riskier the investment for the
     vi. Advantages of Debt Financing
             1. You don’t have to raise the money yourself.
             2. If your earnings are high you only have to pay out the
                 specified interest payments and can keep the rest of the
             3. The interest is tax deductible.
e. Preemptive Rights and Dilution

              i. Stokes v. Continental Trust Co. (p. 354)
                     1. Rule: A corporation must allow a shareholder to purchase
                          newly issued stock at the fixed price to allow him to keep
                          his proportionate share of the stock.
              ii. Katzowitz v. Sidler (p. 358)
                     1. Rule: When new shares are offered in a closed corp.,
                          existing shareholders who do not want to or are unable to
                          purchase their share of the issuance are not estopped from
                          bringing an action based on a fraudulent dilution of their
                          interest where the price for the shares is inadequate.
       f. Distributions
              i. Gottfried v. Gottfried (p. 363)
                     1. Rule: If an adequate corporate surplus is available for the
                          purpose, directors may not withhold the declaration of
                          dividends in bad faith.
                     2. The Bad Faith Test: The essential test of bad faith is to
                          determine whether their personal interests rather than the
                          corporate welfare dictate the policy of the directors.
              ii. Dodge v. Ford Motor Co. (p. 367)
                     1. Unlike the previous case there is a huge surplus here.
                     2. There must be a legitimate business reason to withhold
                          dividends when a surplus exists.
VII.   Fiduciary Duties of Officers, Directors and Controlling Shareholders
       a. Duty of Care and the Business Judgment Rule
              i. MBCA § 8.03 Number and Election of Directors
              ii. Basic Principles
                     1. Shlensky v. Wrigley (p. 671)
                             a. Shareholder derivative suit
                             b. There was more money involved in the Dodge case
                                 than this case.

      c. Rule: A shareholder’s derivative suit can only be
         based on conduct by the directors which borders on
         fraud, illegality, or conflict of interest.
      d. In this case there were valid reasons for the refusal
         to install lights in the stadium. D suggested that
         night games in Wrigley Field would have a
         detrimental effect on the neighborhood. D’s
         decision falls within the business judgment rule.
2. Smith v. Van Gorkom
      a. In this case, the directors tentatively approved the
         merger the first time it was presented to them. They
         had no, and requested no, substantiating data
         regarding the feasibility of the $55 per share price.
         No consideration was given to allowing time to
         study the proposal or to gain more information.
         Their actions are not covered by the business
         judgment rule.
      b. Rule: Directors are bound to exercise good faith
         informed judgment in making decisions on behalf
         of the corp.
      c. The directors tried to blame it on their lawyer. The
         Court said that the directors did not reasonably rely
         on the lawyer’s advice.
      d. Active v. Passive Directors
              i. The dissent makes this point.
      e. The Court held all of the directors liable. Everyone
         is treated the same.
      f. In reaction to this decision, the DE legislature
         passed laws which allow corporations to reduce
         director liability (see p. 703)
      g. Corporations also have director insurance.

       3. Business Judgment Rule
              a. Doctrine relieving corp. directors and/or officers
                 from liability for decisions honestly and rationally
                 made in the corporation’s best interests.
              b. As long as the director(s) makes a rational, business
                 judgment no liability occurs.
              c. Courts will grant deference to the corp. directors.
       4. Questions to Ask
              a. Does the director have a duty of care?
              b. If YES, then does the conduct violate the business
                 judgment rule?
iii. Demand Rights
       1. Derivative Suit:
              a. A lawsuit brought by a shareholder on behalf of the
              b. The damage award goes to the corp. not to the
                 individual shareholder.
       2. Delaware View
              a. Demand: Required or Excused?
                      i. Demand is required unless Board action is
                         so self-interested and board acted with gross
                         negligence (Aronson).
                             1. P has the burden of proving that
                                 demand is excused without the
                                 benefit of discovery.
                             2. Nearly Impossible for P to prove.
                     ii. If demand is excused b/c board is interested
                         (highly unlikely)
                             1. Litigation committee’s judgment will
                                 be subject to the two-part test from

              2. Corporation will have the burden.
      iii. When demand is required and refused:
              1. P must show that the decision not to
                  allow the suit to go forward did not
                  conform to the process of the BJ
                  rule. (Basically, same test as New
                  York, Gall case)
              2. This generally what happens because
                  it is utterly impossible to prove that
                  demand was excused based on the
                  Aronson standard.
b. Problems with this
       i. Must be proven without discovery: You are
          not entitled to discovery until you show
          director interest. But you can’t show
          interest until you have discovery.
      ii. Decisions are res judicata, later claims
          precluded, even though P has never had a
          chance to discover (a decision on the
          demand issue is a decision on the BJ rule)
          and suit cannot go forward.
c. Zapata Corp. v. Maldonado p. 713
       i. Facts: P initiated a derivative suit charging
          officers and directors of D with breaches of
          fiduciary duty, but four years later an
          “independent investigation committee” of
          two disinterested directors recommended
          dismissing the action.

      ii. Rule: When the making of a prior demand
          upon the directors of a corporation to sue is
          excused and a stockholder initiates a
          derivative suit on behalf of the corporation,
          the board of directors or an independent
          committee appointed by the board can move
          to dismiss the derivative suit as detrimental
          to the corp.’s best interests, and the court
          should apply a two-step test to the motion:
              1. Has the corp. proved independence,
                  good faith, and a reasonable
              2. AND, does the court feel, applying
                  its own independent business
                  judgment, that the motion should be
d. Aronson v. Lewis p. 721
       i. Facts: The trial court dismissed this
          derivative suit for failure to meet the
          prerequisite of making a demand on the
          Board of Directors to bring the suit.
      ii. Rule: A prior demand can be excused only
          where facts are alleged with particularity
          which creates reasonable doubt that the
          director’s action was entitled to the
          protections of the business judgment rule.
      iii. Was the Board being dominated?
              1. Must show particular facts.
                      a. Merely having a lot of stock
                          alone does not mean the
                          directors are beholden to the

                                 majority shareholders. You
                                 must plead with
                                 particularized facts.
                     2. You must tie things to profit or a
                         direct interest.
            iv. First Prong: Has there been a reasonable
                 doubt that the directors did not use
                 independent judgment in deciding to
                 terminate the litigation?
             v. Second Prong: Is the transaction an exercise
                 of good business judgment?
3. Demand
      a. Definition: Demand is a request by a shareholder to
         the corporation.
      b. Demand Required (DR)
              i. The shareholder has to make the demand or
                 concede making a demand is required.
             ii. If the corp. dismisses the action the BJ Rule
      c. Demand Excused (DE)
              i. Shareholder doesn’t have to make the
             ii. The Test (Zapata case)
                     1. Independent, Disinterested board
                     2. BJ Rule as applied by the court.
4. Purpose and Use of the Demand Requirement
      a. Originally it was to serve an alternative dispute
         resolution function.
      b. But so much litigation involved the demand
         requirement itself that ALI and MBCA now require

      c. A Board is best advised not concede that demand is
         excused because they will be held to the
         independent business judgment of the Court.
      d. If you are a shareholder, you are advised to contend
         that demand is excused because if you make a
         demand on the directors you are conceding that the
         Board is disinterested. And it places things right in
         the hands of the director as subject to the BJ rule.
      e. If P does make demand and demand is refused, P
         tries to challenge this by conducting limited
         discovery. Court held that discovery would not be
         permitted following a refusal of demand (ALI and
         MBCA are a little more accepting of discovery).
      f. MD handles derivative suits through case law, not
         through statutes.
             i. Disinterested Board: BJ rule applies
             ii. Interested Board: BJ does not apply
5. Universal Demand Requirement
      a. Cuker v. Mikalauskas (PA law) p. 734
      b. Facts: PECO Energy Company’s board of directors
         (D) sought to quash two derivative actions initiated
         by its minority shareholders (P).
      c. Court’s Opinion: BJ Rule permits the Board to
         terminate derivative lawsuits.
             i. Structural bias issues are not as strong—
                 officers separate from directors
             ii. Court adopts ALI procedures—if these have
                 been carried out, the BJ rule will apply
                    1. Allows limited discovery by P with
                        respect to the Board’s decision to

                                         2. Evidentiary hearing to determine
                                             whether or not the directors were
                                         3. Written report prepared
                                         4. Assisted by outside counsel or
                                         5. Adequate investigation
                                         6. There is a judicial review
                                iii. Mandatory demand (like MBCA)
                                iv. A much better system for the plaintiff than
                                     the Delaware system. At least it gives the P
                                     some time to discover facts relevant to the
                                     Board’s decision (rather than being forced to
                                     base it on public knowledge like Delaware).
b. Duty of Loyalty and Conflicts of Interests
       i. Duty of Loyalty: A breach of this duty means there was a conflict
          of interest.
              1. BJ rule does not apply to breach of duty of loyalty.
              2. Entails more than conflict of interest transactions and also
                  includes transactions between fiduciaries.
              3. Once sanitization of a transaction has occurred, the BJ rule
                  will be reinvoked and the burden shifts back to P.
              4. Not codified—except for Conflict of Interest at § 8.60-8.63
                  (see below)
                         a. Analytically it is just like the duty of care, but
                         b. Acting in the best interests of the corporation.
      ii. Self-Dealing
              1. Intrinsic Fairness Test
                         a. Marciano v. Nakash p. 102

      i. Facts: Nakashes loaned the corp. money,
         Marciano tried to void the transaction.
         50/50 stock ownership. Deadlock. This is
         why the transaction was not approved.
     ii. Del Statute § 144: Conflict of interest
         transactions will not be voidable if:
             1. Disclosure and authorization by a
                 majority of the disinterested
             2. Disclosure and authorization by
             3. Fair to the corp. at the time
    iii. These facts are not covered by the statute b/c
         the transaction was never authorized by the
         Board b/c of the deadlock.
     iv. The Court goes outside the statute and
         created another way to approve the
         transaction (Intrinsic Fairness Test).
     v. Rule: A transaction by a corporation with
         its insiders will be valid if intrinsically fair.
      i. Factors to be Considered
             1. Motives of the directors
             2. Effect of the transaction on the
             3. FAIRNESS
             4. Approval of non-interested directors
                 and shareholders.

       ii. If there is no independent, disinterested
           committee to decide whether the transaction
           is fair, the court must step in.
c. Sinclair Oil Corp. v. Levien p. 773
       i. Facts: A minority stockholder in Sinven, P
           accused D, the parent company, of using
           Sinven assets to finance its operations.
       ii. Rule: Where a parent company controls all
           transactions of a subsidiary, receiving a
           benefit at the expense of the subsidiary’s
           minority stockholders, the intrinsic fairness
           test will be applied, placing the burden on
           the parent company to prove the transactions
           were based on reasonable business
      iii. Sinclair causes Sinven to pay out more
           dividends than its earnings. Although a lot
           of dividends were paid out, the minority
           shareholders also benefited.
               1. The Intrinsic Fairness Test doesn’t
d. Weinberger v. UOP p. 778
       i. Facts: Claiming that a cash-out merger was
           unfair, P a former minority shareholder of
           D, brought a class action to have the merger
           rescinded. It’s a conflict of interest with
           interested directors. One party withheld key
           information, namely the price study.
       ii. A fairness opinion by an independent party
           is not enough. You have to look at other

                     iii. Rule: When seeking to secure minority
                           shareholder approval for a proposed cash-
                           out merger, the corporations involved must
                           comply with the fairness test which has two
                           basic interrelated aspects:
                               1. Fair Dealings: which imposes a duty
                                  on the corporations to completely
                                  disclose to the shareholders all
                                  information germane to the merger,
                               2. Fair Price: which requires that the
                                  price being offered for the
                                  outstanding stock be equivalent to a
                                  price determined by an appraisal
                                  where “all relevant nonspeculative
                                  factors” were considered.
iii. Corporate Opportunity
       1. Part of the Duty of Loyalty: beyond conflict of interest and
           self dealing
              a. Involves fairness: the burden of proving fairness is
                  on the fiduciary, and the BJ rule does not apply.
              b. Subchapter F of MBCA does not apply to corporate
                  opportunities because the corp. is not a party to the
       2. A breach of corp. opportunity occurs when a fiduciary
           takes a personally profitable business opportunity which
           belongs to the corp.
       3. Purpose: The doctrine is designed to prevent transactions
           where directors gain a secret profit where the corp. should
           have had that opportunity/benefit.
       4. Tests

                      a. Interest of Expectancy: corp. has an interest in the
                      b. Line of Business: directors can’t engage in
                            transactions that compete against the corp.
                      c. Fairness Test
              5. Example: A director’s real estate company sold office
                  space to the corp. at a premium price. The director makes a
c. Insurance and Indemnification
       i. Many states allow corp. to reduce the liability of their directors
              1. Mostly applies to unintentional acts
              2. Duty of care and fiduciary duties
      ii. a
d. Duties of Controlling Shareholders
       i. Majority shareholders have a fiduciary duty to minority
      ii. Donahue v. Rodd Electrotype Co. p. 378
              1. Rule: P had a right to have the corp. repurchase P’s shares
                  just as the corp. repurchased Rodd’s shares.
              2. This seems like a crazy ruling.
              3. Reasons for this outcome:
                      a. Closely Held Corp.
                                i. No ready market to sell the shares.
                               ii. Can’t dissolve the venture like a partnership.
              4. Concurring Opinion
                      a. The majority rule does not apply in other situations
                            (e.g. hiring policy, etc.)
      iii. Other ways to argue the Donahue case:
              1. BJ Rule violation
              2. Conflict of Interest transaction
      iv. Many other states did not adopt the Donahue rule.

 v. Zetlin v. Hanson Holdings, Inc. p. 937
         1. Facts: P contended minority shareholders should share in
            the premium price paid to D for its controlling shares in the
         2. Rule: Minority shareholders are not entitled to share in any
            premium price paid for the controlling shares of a corp.
         3. Controlling shares of a corp. are more valuable than
            minority interests. Control affords the holder the power to
            direct corp. activities and to govern the allocation of corp.
 vi. Debaun v. First W. Bank & Trust Co. p. 938
         1. Facts: D sold the majority shares to a “shady” character
            who later looted corp. assets.
         2. Rule: A controlling shareholder owes a duty to his corp.,
            when selling his control in the corp., of reasonable
            investigation and due care when possessed of facts
            establishing a reasonable likelihood that the purchaser of
            control intends to loot the corp.
         3. What if the buyer didn’t loot the corp.
                a. Could go either way, but the failure to disclose is an
                      important breach.
vii. A controlling shareholder selling his control should:
         1. Inform the other shareholders.
         2. Reduce the risk by reasonable investigation of the buyer.
viii. Perlman v. Feldmann p. 947
         1. Facts: D, a director and dominant stockholder of Newport
            Steel, sold, along with others, the controlling interest of that
            steel manufacturer, to steel users, along with the right to
            control distribution.
         2. Rule: A corp. director who is also a dominant shareholder
            stands, in both situations, in a fiduciary relationship to both

                       the corp. and the minority stockholders if selling
                       controlling interest in the corp. is accountable to it (and the
                       minority shareholders) to the extent that the sales price
                       represents payment for the right to control.
      e. Doctrines (Summary)
             i. Duty of Care
                    1. Directors, shareholders, officers
                    2. The duty is reasonable investigation when appropriate.
                    3. Was proper procedure observed?
            ii. Business Judgment Rule (BJ Rule)
                    1. As long as director(s) actions are reasonable and not self-
                       serving they are shielded from liability.
            iii. Duty of Loyalty
                    1. Prevents self-dealing
                    2. Duty of disclosure to fellow shareholders
                           a. Is there self dealing?
                           b. If Yes, then the Intrinsic Fairness Test applies.
                    3. Demand required v. Demand Excused
            iv. Corporate Opportunity Doctrine
                    1. Another species of the Duty of Loyalty Doctrine
             v. Controlling Shareholder Duties
                    1. Duty of Care
                    2. Duty of Loyalty
                    3. Duty of Reasonable Investigation
VIII. Management and Control of the Corporation
      a. Roles of Shareholders and Directors
             i. Authority of Directors and Officers
                    1. MBCA §§ 8.01, 8.21
                    2. Directors have broad powers, therefore they have a
                       fiduciary duty to the shareholders.

       3. The only way a corp. is bound by a director’s action is if
           he/she has authority.
               a. Actual Authority
               b. Apparent Authority: e.g. the board passes a
       4. A quorum of the board must be present to authorize
       5. Things that have a great impact on the corp. (e.g. a merger)
           a supermajority is required (2/3 of the board).
       6. Baldwin v. Canfield p. 504
               a. Rule: A board of directors has no authority to act
                  except when it is assembled at a board meeting.
               b. This rule of law is no longer valid with the adoption
                  of the MBCA.
       7. Mickshaw v. Coca-Cola Bottling Co. p. 506
               a. Rule: An act of a single director will be binding
                  upon a corp. if it is subsequently ratified or
                  acquiesced in by a majority of the corp.’s directors.
ii. Authority of Officers
       1. MBCA §§ 8.40, 8.41
       2. Checking the Authority of an Officer
               a. By-Laws
               b. Past Resolutions
               c. Prior Conduct
       3. Black v. Harrison Home Co. p. 513
               a. Facts: President made a transaction without
                  specific authorization. The bylaws suggest the
                  president may have the power, but it is severely
                  curtailed by the board.
               b. Rule: The president of a corp. (or any officer) has
                  no authority to execute contracts on behalf of the

                  corp. in the absence of a bylaw or a resolution of the
                  board of directors permitting him to do so.
        4. Lee v. Jenkins Brothers
               a. Rule: As long as the acts are part of the ordinary
                  authority of an officer, the acts are binding on the
               b. Ordinary Act v. Extraordinary Act
                       i. Look at the impact the act has on a corp.
                      ii. Has the corp. received a benefit?
        5. Drive-in Dev. Corp. p. 522
               a. Rule: Statements of a corp. officer, if made while
                  acting within the scope of his authority, are binding
                  upon the corp.
               b. Once you get a copy of certified resolutions there is
                  authority. In this case the corp. secretary falsified
                  the resolution and the other party reasonably relied
                  on it.
iii. Shareholder Authority
        1. Shareholder powers
               a. Ability to Elect Directors
                       i. Plurality vote
               b. Ability to Remove Directors
                       i. With or without cause
               c. Ability to Amend the Bylaws
                       i. Directors also have this ability except for
                             powers relating to the director position
               d. Approving Merger Transactions
                       i. Veto power only
               e. Conflict of Interest Transactions
        2. McQuade v. Stoneham p. 401

       a. Facts: 3 shareholders agree they would use their
          best efforts to:
               i. Keep directors in office
              ii. Vote for each other as directors
             iii. Set the salary of officers & officer selection
       b. #iii is the problem. This authority falls into the
          discretion of the officers.
       c. Rule: The point of a corporation is to have these
          different levels of authority. Agreements
          eliminating these levels of authority are therefore
          invalid. You must operate consistent to corp.
       d. Some courts have reduced the strictness of the
          McQuade decision.
               i. Clark v. Dodge p. 405: Arbitrary Test
3. Galler v. Galler p. 407
       a. Rule: Close corporations will not be held to the
          same standards of corp. conduct as publicly held
          corporations in the absence of a showing of fraud or
          prejudice toward minority shareholders or creditors.
       b. In the real world close corporations are more like
          partnerships. Without shareholder agreements the
          minority shareholders have no recourse (i.e. can’t
          sell their shares on an open market).
4. Zion v. Kurtz p. 417
       a. Rule: A shareholder’s agreement requiring
          minority shareholder approval of corp. activities is
       b. Reasonable restrictions on director discretion are
          not against public policy and are not precluded by

                        statute. The key factor is the minimal harm to other
                    c. However, exercising this type of control in a corp.
                        (close corp.) can lead to the piercing of the corp.
                    d. In Delaware, you must file as a close corp. This
                        puts outside parties (e.g. creditors) on notice that the
                        directors’ powers can be limited.
             5. Matter of Auer v. Dressel p. 426
                    a. Facts: Agreement to hold a special meeting when
                        55% of the shareholders call the meeting. The
                        meeting called concerns a subject that the
                        shareholders have no authority over.
                    b. Rule: Corp. management must call a special
                        stockholders’ meeting when the necessary number
                        of voting shares back such a request and no purpose
                        for the meeting is improper.
                    c. The Board should not be allowed to deny a meeting
                        where the shareholders want to bring something to
                        the directors’ attention. Otherwise, how would the
                        directors be held accountable?
b. Shareholder Voting and Agreements
       i. MBCA § 7.28
      ii. Shareholders have limited power and cannot take power away
          from the directors (McQuade rule)
             1. Over time this rule has slowly become more lenient.
             2. Ways for a minority shareholder to gain a say:
                    a. Pooling Agreement
                    b. Cumulative Voting
     iii. Voting Methods for Shareholders
             1. Straight Voting

       a. One vote per share
       b. Majority shareholders always win
2. Cumulative Voting (CV)
       a. Shareholders can cumulate their votes and distribute
           them any way they want.
       b. In cumulative voting, a minority shareholder could
           elect at least one director to the board. This gives
           them a voice on the board.
       c. CV is an opt-in clause.
       d. Notice of CV must be provided before an election.
3. Ringling Bros case p. 444
       a. Rule: A group of shareholders may lawfully
           contract with each other to vote in such a ways as
           they determine.
4. Voting Trust
       a. Definition: It's the transfer of "legal" rights of the
           shares to a 3rd party. The trustee can vote the
       b. A pooling agreement is different. In a pooling
           agreement you still own and can vote your shares.
       c. Brown v. McLanahan
               i. Rule: Under a corp. voting trust agreement,
                      "a trustee may not exercise powers granted
                      in a way that is detrimental to the cestuis
                      que trustent (i.e. actual owner of the voting
                      shares); nor may one who is trustee for
                      different classes favor one class at the
                      expense of another."
5. Stock Restrictions (Ling and Co. v. Trinity Saving and
   Loan Ass'n.)

                      a. Rule: A corp. may impose restrictions upon the
                          transfer of its stock as long as those restrictions do
                          not constitute unreasonable restraints.
     iv. MBCA §§ 7.30, 7.31, 7.32
c. Deadlocks
      i. In General
               1. With advanced planning this won’t occur.
               2. Shareholders: If 50/50 split there is a problem because
                  there is no majority. Cumulative voting solves this
               3. Directors: When the board has an even number of directors
                  a deadlock could occur. The problem is heightened with
                  supermajority standards.
      ii. Deadlocks don’t necessarily mean the company can’t continue
         doing business.
     iii. Deliberate Deadlock (Gearing v. Kelly p. 480)
               1. Facts: When P refused to attend a directors’ meeting, D
                  elected Hemphill, and the P faction objected.
               2. Rule: Where a shareholder-director deliberately causes a
                  lack of quorum required for a director’s meeting by
                  refusing to attend, equity will refuse to set aside a board
                  decision held at such a meeting for lack of quorum.
     iv. Dissolution of a Corporation (In Re Radom & Neidorf, Inc. p. 483)
               1. Facts: P and his sister D were the sole shareholders in a
                  music publishing corp. Due to a mutual dislike and
                  distrust, they were deadlocked as to the election of directors
                  and the declaration of dividends.
               2. Rule: Where corp. dissolution is authorized by statute in
                  the case of deadlock or other specified circumstances, the
                  existence of the specified circumstances does not mandate
                  the dissolution. The court will exercise its discretion,

         taking into account benefits to the shareholders as well as
         injury to the public.
      3. Other Solutions:
             a. You can put a provision in your by-laws for
                  dissolution in this situation.
             b. Buy-out Agreement: One will buy out the other as
                  an exit strategy.
                      i. Between 2 shareholders: e.g. when one dies.
                     ii. Between the shareholder and corp.: corp.
                          uses funds to purchase back SH’s shares.
                          The only problem is lack of funds.
v. MBCA-Chapter 14-Dissolution
      1. Voluntary Dissolution
             a. § 14.02—Dissolution by Board of Directors and
             b. Directors may propose dissolution for submission to
                  the shareholders.
      2. Administrative Dissolution (NOT ON THE SYLLABUS)
             a. § 14.20—Commenced by Secretary of State if
                  franchise taxes have not been paid, annual report
                  has not been filed, period of duration of corp.
                  expires, etc.
      3. Judicial Dissolution (generally applies to closely-held
             a. § 14.30(2) The Court may dissolve
                      i. Makes it very discretionary on the part of
                          the court.
                     ii. Not as available as a remedy as it is for
                     iii. Typical of the statutes adopted by most

                               b. Some states have narrower grounds for dissolution
                                  (NY must have 20% holdings)
                               c. Some states have broader grounds (CA—“persistent
                                  unfairness to the minority”)
      d. Remedies
             i. Buy-outs
             ii. Arbitration
            iii. Dissolution of company
            iv. Advanced Planning: Use odd number of directors on the board.
IX.   Public Offerings (Securities Act of 1933)
      a. Introduction
             i. 1933 Act regulates offers & sales of securities. 1934 Act regulates
                everything else.
             ii. Definition of a Security: The courts have defined this term
                broadly. A good rule of thumb for determining whether something
                is a security is to ask whether the investor expects to take part in
                the management of the business being invested in. If the investor
                is passive—i.e., is relying solely on the management of others—
                the investment most likely is a security. Thus, stocks, bonds,
                debentures, stock options, and stock warrants are considered
            iii. Securities Law is guided by statute. Section 5 of the 1933 Act is
                the main thrust.
      b. Purpose (1933 Act)
             i. To assure that investors have sufficient information on which to
                make an informed investment decision.
             ii. The Act accomplishes this goal by requiring most issuers to:
                    1. Register most new issues of securities with the SEC.
                    2. AND, provide prospectuses containing material
                        information regarding the securities to prospective

      iii. State Law: some states also consider the worthiness of the security
c.   Who is Regulated?
       i. The 1933 Act is targeted primarily at sales by:
              1.   Issuers: entities whose securities are to be sold
              2. Underwriters: entities who undertake to sell the issuer’s
              3. Dealers: people who sell or trade securities on a full or
                   part-time basis
d. Registration Requirement
       i. Most securities cannot be sold unless they are first registered with
          the SEC. The purpose of registration is to put on file all
          information that a reasonable investor would consider important in
          deciding whether to invest
              1. Example: a balance sheet and profit and loss statement,
                   facts affecting the security’s price or risk, remuneration of
                   directors, etc.
      ii. Prospectus
              1. The registration must include a copy of the “statutory
                   prospectus.” The prospectus summarizes the detailed
                   information required for registration and must be given to
                   purchasers of the security prior to or contemporaneously
                   with any sale.
e. You need the following to comply with the 1933 Act
       i. Registration Statement
      ii. Prospectus
f. Amount of Information Required
       i. Initial Public Offering (IPO): A lot of information is required for
      ii. Public Offering (PO): Not as much information is required as the
          IPO since there is already information on file.

g. Exemptions from the Registration Requirements: The Act is
   concerned only with sales by issuers, underwriters, or dealers. Other sales
   are “casual” sales and are not covered. The Act also has two other types
   of exemptions:
       i. Securities Exemptions (which exempt issuances of certain types of
              1. Section 3 of the 1933 Act specifically exempts certain
                    securities, such as those issued by banks, governments, or
                    charitable organizations. If a security qualifies for a
                    securities exemption, it will continue to be exempt no
                    matter how or when sold.
      ii. Transaction Exemptions (which exempt securities issued in certain
          types of transactions): While the availability of securities
          exemptions depends primarily on the nature of the issuer,
          transaction exemptions depend on the nature of the offer.
          Transaction exemptions are specific to the transaction in question,
          so if the securities are reissued they will have to be registered
          unless the reissuance itself qualifies for another exemption.
              1. Intrastate Offerings
                        a. Section 3(a)(11) of the 1933 Act provides a
                           transaction exemption for any security that is part of
                           an issuance offered and sold only to residents of a
                           single state, where the issuer of the security is also a
                           resident and doing business within that state.
                        b. Rule 147 deems a company to be doing business
                           within a state if it derives at least 80% of its
                           operating revenues within the state; has at least 80%
                           of its assets located within the state; and applies at
                           least 80% of the proceeds of the offering to
                           operations within the state. Purchasers cannot resell
                           the securities for at least 9 months.

2. Private Offerings: Regulation D
       a. The registration requirements apply only to public
          offerings; private offerings of securities are exempt
          under section 4(2).
       b. Whether an offering will be considered private
          depends on a number of factors, including:
              i. Sophistication of the investors and their
                  access to information
              ii. Diversity of the offeree group
             iii. Whether the offering has the appearance of a
                  public offering
             iv. The marketability of the securities
              v. The manner of the offering
                     1. Is there public advertising or private
       c. Rule 506 is the most significant exemption. An
          offering can be made under Rule 506 in any dollar
          amount, but:
              i. There can be no public advertising of the
              ii. AND, sales must be limited to accredited
                     1. Banks,
                     2. Investment companies,
                     3. Business with at least $5 million in
                     4. OR individual with at least $1
                         million in assets or annual income of
                         at least $200,000.

                               iii. AND, no more than 35 unaccredited
                                    investors who are sophisticated in business
                                    and financial matters.
              3. Small Offerings: Regulation A
                     a. Regulation A does not provide an exemption from
                            registration, but rather provides a “short form”
                            registration less costly to prepare than a full
                            registration statement.
                     b. This regulation can be used only if the securities
                            issued in the public offering do not exceed $5
                            million in the aggregate in any 12-month period.
h. Waiting Period
       i. Purpose: It gives investors some time to think it over. Also it
          allows the SEC to comment on the disclosure.
      ii. You can make oral and written offers based on the preliminary
          prospectus during the waiting period.
      iii. You cannot accept offers until the SEC approves your securities.
i. Civil Liabilities Under the 1933 Act
       i. Section 11 Liability
              1. Cause of Action: A plaintiff needs to show only two
                     a. A material misstatement of fact in a registration
                            statement signed by the defendant
                     b. AND, damages
              2. Plaintiffs can sue:
                     a. Everyone who signed the registration statement
                     b. Directors
                     c. Underwriters
                     d. Lawyers and every expert who made a statement in
                            the registration statement
              3. Material Fact

      a. A fact is considered to be material if there is a
         substantial likelihood that a reasonable person
         would consider it important in making an
         investment decision.
      b. See TSC Industries, Inc. v. Northway, Inc.
4. Privity NOT Required
      a. A plaintiff under section 11 does not have to show
         that the misrepresentation was actually directed to
         her, since the statute refers to “any person acquiring
         such security.”
5. Defenses
      a. Due Diligence
              i. If D can show due diligence--i.e. that after
                 reasonable investigation she had reasonable
                 grounds to believe that the statements in the
                 registration were true and that there were no
                 material omissions—she will not be liable.
      b. Knowledge
              i. If the plaintiff knew at the time she acquired
                 her security that there was an untruth or
                 omission in the registration statement, D has
                 a defense.
      c. Withdrawal
              i. It is a defense for directors or officers that
                 they had resigned or taken steps to resign
                 before the effective date of the registration
                 statement and that they had advised the SEC
                 in writing that they would not be responsible
                 for the registration statement.
              ii. Further, they may show that the registration
                 statement became effective without their

                              knowledge and, upon becoming aware of the
                              fact, they gave public notice that it had
                              become effective without their knowledge.
ii. Prospectuses and Communications: Section 12(a)(1) imposes
    liability upon any person who offers or sells a security in violation
    of the registration provisions, and section 12(a)(2) imposes liability
    upon any issuer or controlling shareholder that offers or sells a
    security by means of an untrue statement or omission of a material
    fact in a “prospectus.”
       1. Violation of Registration Requirements: Section 12(a)(1)
       2. Privity
               a. There is a privity requirement in section 12, in that
                    the plaintiff must have purchased the security from
                    the person who is allegedly liable. Only the first
                    purchaser of the security is entitled to use section 12
                    as a remedy.
       3. Defenses
               a. Plaintiff knows of Untruth or Omissions.
               b. Defendant did not and could not know the untruth.
iii. Safe Harbor for Forward Looking Statements
       1. There is a safe harbor provision relieving issuers, persons
           acting on behalf of issuers, and outside reviewers from
           liability arising from forward looking statements (i.e.,
           statements that set forth plans for the future or that project
           future economic performance).
       2. The safe harbor applies only in a private action for
           securities fraud based on untrue statement or omission of
           material fact.
       3. Two forms of protection are provided:

                           a. Defendants cannot be held liable unless P can show
                               that the statement was made with actual knowledge
                               of its falsity.
                           b. Even if P can show such knowledge, a defendant
                               cannot be held liable if the forward statement is
                               accompanied by a “meaningful” cautionary
                               statement identifying factors that could cause results
                               to differ materially from those in the statement.
                           c. NOTE: the safe harbor provision is not available
                               for statements made in connection with an initial
                               public offering.

X.   Proxy Regulations (Securities Exchange Act of 1934)
     a. Scope of Regulation
            i. Status Oriented
           ii. Periodic disclosure by corporations that have a certain status
               determined by
                   1. How the stocks are traded
                   2. Number of shareholders
                   3. Assets
           iii. 10(b)(5) regulations apply to all corporations
           iv. Proxy regulation only applies to shareholders
            v. Studebaker Corp. v. Gittlin
                   1. Rule: Any communication that seeks a shareholder’s
                       support in an action that is part of a continuous plan for the
                       solicitation of the shareholder’s right to vote is considered a
                       “p required to comply with the proxy solicitation rules.”
     b. Proxy Forms
            i. Registration

1. Integration of the 1933 and 1934 Acts: The provisions of
   the 1933 and 34 acts have been incorporated through an
   integrated disclosure program to permit issuers that have
   filed reports under the 34 Act for more than three years to
   incorporate by reference this information in its 1933 Act
   filing, thereby greatly simplifying the registration process.
2. Proxy: A grant of authority by the shareholder to transfer
   his/her voting rights to someone else. Mostly regulated by
   federal law, not much state law on proxy regulation.
3. Very expensive and confusing to comply with the 1934
4. Used to be focused on historical-fact oriented disclosure
   with no emphasis on predictions and speculation. NOW it
   permits projections and future predictions.
       a. Future predictions are what is important to investors
       b. SEC now requires disclosure of this information but
           provides “safe harbor” provisions so that liability
           will be reduced for incorrect predictions.
5. Prior to the 1934 Act
       a. Solicit proxies
       b. Disclose nothing
       c. Everything the Board wants will be approved.
6. Registration under the 1934 Act
       a. Three requirements
               i. Must disclose the nature of the vote to be
              ii. Non-Management solicitations must be
              iii. General fraud prohibition against false and
                  misleading statements.
       b. § 14 Requirements (p. 593-94)—Criminal Statute

       i. Unlawful for any “Person” = issuer,
          shareholder, any other person “to solicit or
          to permit the use of his name to solicit any
          proxy or consent or authorization in any
          security,” … “in contravention” of SEC
c. § 12 Registration Requirements
       i. Any security (including debt or equity)
      ii. “Affecting interstate commerce”
      iii. (G)(1)(A): now raised to $10 million in
          assets and class of equity held by 500
              1. Class: stocks can be aggregated to
                  meet this amount if they are
                  “substantially similar”
              2. “Of record”: the issuer only knows
                  how may shareholders of record
                  there are, doesn’t know about others
                  (thus “of record” is no necessarily
                  equal to the number of true
                  beneficial owners of the shares.)
      iv. (1)(b) 500 to 750, $10 million in assets
d. What you need:
       i. Proxy card
      ii. Disclosure statement
      iii. Info about yourself and the person you’re
          nominating (if applicable).
      iv. Statements of the company
e. HYPOS: Must these stocks be registered?

                              i. Company A—total assets of $10 million,
                                 450 shareholders—NO, not enough
                                 shareholders to meet the 500 requirement.
                             ii. Company B—total assets of $4.8 million,
                                 700 shareholders—NO, not enough assets.
                             iii. Company C--$4.8 million, 450
                                 shareholders—May its registration be
                                 terminated? YES, exemption if assets fall
                                 below $10 million, less than 500
                             iv. 300 shares of common, 400 shares preferred,
                                 $20 million in assets. NO, different classes
                                 of securities. The different classes cannot be
                                 aggregated to meet the 500 requirements.
                             v. 400 voting common, 400 non-voting
                                 common, same dividend rights. If they are
                                 considered to be “substantially similar”
                                 YES, they can be aggregated to meet the
                                 500 amounts if there is over $10 million in
      ii. In the Matter of Caterpiller, Inc.
              1. Facts: D failed, in annual and quarterly reports, to
                  adequately comply with the disclosure requirements of §
                  13(a) of the 1934 Act.
              2. Rule: Disclosure is required where a known trend,
                  demand, commitment, event, or uncertainty is likely to
                  occur, and, where such a determination cannot be made, an
                  objective evaluation must be made of the consequences of
                  such an occurrence on the assumption that it will occur.
c. Proxy Solicitation

 i. Typical proxy card and communication from broker to stockholder
    will say, “If we don’t hear from you, we will vote your shares as
    management recommends.” If out of the ordinary issues are being
    considered, this rule does not apply and the broker must wait to
    hear from the shareholder before voting.
ii. Annual Reports in General
        1. Must be submitted with proxy materials if a solicitation is
           by management and relates to an annual meeting where
           directors are to be elected.
        2. Annual reports are generally more readable and try to avoid
           legalistic and technical terminology.
        3. Most important section, “Management’s Discussion and
           Analysis of Financial Conditions and Results of
           Operations” or “MD & A” (Item 303)
               a. Provides financial condition report, projections of
                   financial data, goals and objectives for future
                   performance, etc. (see discussion above—shift from
                   fact to predictions) but still includes both historical
                   and prospective data.
               b. Safe harbor provisions allow future predictions to
                   be made: No liability if the statement were made
                   without actual knowledge that they were false or
                   misleading. Nonetheless, these requirements have
                   still created a culture of reluctance to make
                   predictions under Item 303.
               c. SEC has not been pleased with compliance with
                   Item 303, intentional are criminal.
iii. False or Misleading Statements in Connection with Proxy
    Solicitations (p. 615)
        1. § 14(a) “false or misleading with respect to any material
           fact or which omits to state any material fact necessary in

order to make the statements therein not false or misleading
or necessary to correct any statement in any earlier
communication with respect to the solicitation”
   a. Includes statements and omissions
   b. Includes facts and opinions that act as facts. (If you
       say something not believing it to be true.) An
       opinion can be a fact if it’s not what it purports to
   c. HYPO: “All directors who support the minority
       approved the merger.”
             i. False: No directors support the minority.
             ii. Misleading: True, but misleading because
                qualifications are lacking.
   d. Omission HYPO: CEO statement, “We will oppose
       the takeover offer if it’s not in the best interest of
       the shareholders.”
             i. He does not oppose, but it’s not in the best
                interests of the shareholders.
             ii. His reason for not opposing was because he
                got a large employment contract with the
                takeover company.
          iii. Non-disclosure of this information is a
   e. “Predictions as to specific future market values”
       may be considered misleading.
             i. But these are difficult to predict with total
                accuracy, market values of shares are always
                changing with the market, much easier to
                predict expected earnings, etc.

              ii. Reflects the importance the SEC gives to
                   this information (see MD & A disclosure
              iii. Cannot make predictions about market
                   values of shares BUT you can state future
                   issuers’ earnings.
       f. Proxy statements are 100+ pages long because of
           this—they are written with an eye toward and in
           anticipation of litigation.
2. Private Right of Action under § 14(a): J.I. Case Co. v.
       a. Rule: When a federal securities act has been
           violated, but no private action is specifically
           authorized or prohibited, a private civil action will
           lie and the court is free to fashion an appropriate
3. Implied Private Right of Action—Causation Defined:
   Mills v. Electric Auto-Light
       a. Common law causation for fraud—must be reliance
           to one’s detriment—but how can the reliance be
           established with respect to 10,000 shareholders—
           10,000 depositions?
       b. Court has adopted something less than this standard
           in the context of securities regulation.
       c. You don’t need to prove reliance anymore.
       d. Test for Causation: Where there has been a finding
           of materiality, a shareholder has made a sufficient
           showing of causal relationship between the
           violation (misleading statement) and the injury (ex.
           Merger) if, as here, he proves that the proxy
           solicitation itself, rather than the particular defect in

          the solicitation materials, was an essential link in
          the accomplishment of the transaction.
              i. This test avoids the impracticalities of
                   determining exactly how the votes were
              ii. This test answers the question of causation
                   open in Borak.
       e. Test for materiality of the misstatement or omission
          was whether “it MIGHT have been considered
          important by a reasonable shareholder who was in
          the process of deciding how to vote.”
4. Implied Private Right of Action—Materiality Defined:
   TSC Indus., Inc. v. Northway
       a. Need materiality to determine causation, because
          we can’t use reliance (see Mills).
       b. Rule: A fact omitted from a proxy solicitation is
          “material if there is a substantial likelihood that a
          reasonable shareholder would consider it important
          in deciding how to vote.
5. Non-Voting Causation under § 14(a): Virginia Bankshares,
   Inc. v. Sandberg
       a. Facts: After a freeze-out merger, in which the
          minority shareholders of (Bank) lost their interest, P
          and other minority shareholders sued for damages,
          alleging violation of § 14(a) and Rule 14a-9 and a
          breach of the fiduciary duties.
       b. Rule:
              i. An individual is permitted to prove a
                   specific statement of reason knowingly false
                   or materially misleading, even when the
                   statement is couched in conclusory terms.

                             ii. Causation of damages is compensable
                                 through a federal implied right of action
                                 cannot be demonstrated by minority
                                 shareholders whose votes are not required to
                                 authorize the transaction given rise to the
                    c. Proxy solicitation here wasn’t necessary to obtain
                        votes legally required to authorize the action.
                             i. Why do it?
                                     1. Puts shareholders on notice of major
                    d. If you can show that directors solicited proxies in
                        order to get minority shareholders to abandon their
                        appraisal rights, you have a cause of action.
d. Shareholder Proposals and Communications with Shareholders
      i. Most shareholder proposals are never actually adopted.
      ii. Rule 14a-8:
             1. A shareholder can include a proposal if they hold 1% of
                outstanding securities. One proposal per shareholder
             2. Corp. can exclude some proposals from the proxy
                    a. Why?
                             i. Too much information for shareholders to
                             ii. Too costly to print all that information.
             3. SEC can force the corp. to include some proposals.
     iii. Proxy Statements
             1. Can be in different forms.
             2. Usually the management will do it to elect board members.
                Easier when the shareholders are spread out.
             3. Shareholders can also do it.

            iv. Prohibitions: Things excludable from proxy statements
                    1. You can’t put personal grievances in proxy statements.
                    2. Things that deal with “ordinary business matters”
                    3. Management may try to exclude socially, political proxy
                        statements in by-laws.
                    4. Proposal related to director elections.
                            a. See Rauchman v. Mobil Corp. p. 655
XI.   Securities Fraud and Insider Trading
      a. Rule 10b-5 (from the 1934 Act): Under this rule, it is unlawful for any
         person, directly or indirectly, by the use of any means or instrumentality of
         interstate commerce or the mails, or of any facility of any national
         securities exchange to:
             i. Employ any device, scheme, or artifice to defraud;
             ii. Make any untrue statement of a material fact or omit to state a
                material fact necessary in order to make the statement made, in
                light of the circumstances under which they were made, not
            iii. OR engage in any act, practice, or course of business that operates
                or would operate as a fraud or a deceit upon any person, in
                connection with the purchase or sale of any security.
      b. A violation of 10b-5 can result in:
             i. A private suit for damages;
             ii. An SEC suit for injunctive relief;
            iii. OR criminal prosecution
      c. Elements of a10b-5 Cause of Action
             i. Intent to Deceive
             ii. Manipulation
                    1. affirmative act to deceive
                    2. silence in the face of a duty to disclose
                    3. a breach of fiduciary duty IS NOT enough
            iii. “Materiality” of the information

                1. reliance is presumed
                2. the info would have impacted a reasonable investor’s
                3. Can be a subjective test.
                        a. If you start trading on the information it can become
      iv. Duty
       v. Causation

d. Rationale for the Rule: You should only use inside information for the
   benefit of the corporation not for your own personal benefit.
e. Duty to Disclose & The Classic Insider: SEC v. Texas Gulf Sulphur p.
         i. Facts: D made a significantly large discovery of mineral deposits.
            While concealing the magnitude of the find, certain corp.
            employees purchased large amounts of D’s stock. A misleading
            press release was issued to suppress the effect of rumors of the
            large discovery. Some nonemployees bought D’s stock just prior
            to public release of the discovery based on their advance
            knowledge of the release.
       ii. Scenarios: C knows there are valuable minerals on B’s land. B is
            a subsidiary of C. C offers to buy B’s land. C has a fiduciary duty
            to B because of the subsidiary relationship. C could be liable for
            the first (fraudulent) press release.
      iii. Materiality: The info affected the investors’ decision to invest.
                1. When did it become material?
      iv. Rule: If a corp. employee has inside information, he/she must
            abstain from trading OR they must wait until the info is disclosed
            before trading.
       v. Rule: A corp. that issues public statements concerning a matter
            which could affect the corporation’s securities in the marketplace

          must fully and fairly state facts upon which investors can
          reasonably rely. Any departure from that standard subjects the
          corporations to liability for violation of Rule 10b-5.
f. There must be a Duty to Disclose for liability to attach: Chiarella v.
   US p. 850
       i. Facts: While employed as a printer, D saw information that one
          corp. was planning to attempt to secure control of another, and he
          used this info by going out and trading stock.
       ii. Rule: A purchaser of stock who has no duty to a prospective seller
          because he is neither an insider nor a fiduciary has no obligation to
          disclose material information he has acquired, and his failure to
          disclose such information does not, therefore, constitute a violation
          of 10b-5 of the 1934 Act.
g. Misappropriation Theory (2nd method to find a duty)
       i. Theory: To the extent you owe a duty to the information provider
          and use inside information to trade for your own personal benefit,
          you have misappropriated the information.
       ii. US v. O’Hagan p. 861
               1. Facts: D, an attorney, was indicted for trading securities in
                  Pillsbury based on confidential information he obtained by
                  virtue of his association with the corporation’s law firm.
               2. Rule:
                      a. When a person misappropriates confidential
                          information in violation of a fiduciary duty, and
                          trades on that information for his own personal
                          benefit, he is in violation of SEC §10(b) and Rule
                      b. The SEC did not exceed its rulemaking authority by
                          promulgating Rule 14e-3(a), which prohibits trading
                          on undisclosed information in a tender offer

                         situation, even where the person has no fiduciary
                         duty to disclose the information.
h. Tipper/Tippee Liability: Dirks v. SEC p. 873
       i. Rule:
             1. A tippee assumes a fiduciary duty to the shareholders of a
                  corp. not to trade on material nonpublic info only when the
                  insider (tipper) breached his fiduciary duty AND the tippee
                  knows or should know that there has been a breach.
             2. The tipper only breaches his/her fiduciary duty if they gain
                  a benefit from tipping the info.
i. Relationship of Trust & Confidence
       i. US v. Chestman p. 881
             1. Facts: After stockbroker D purchased shares of a corp.
                  when he acquired nonpublic inside info, he was indicted
                  and convicted of violating the 1934 Act.
             2. Rule: One who misappropriates material nonpublic info in
                  breach of a fiduciary duty or similar relationship of trust
                  and confidence and uses that info in a securities trade
                  violates Rule 10b-5.
             3. Misappropriation theory won’t work because D owes no
                  duty to the family (where the info originated).
             4. Why shouldn’t Ira (the father) be held liable?
             5. Did Keith (the tipper) breach a fiduciary duty or similar
                  relationship duty to his wife?
                     a. You need to prove a breach in order to get D
                     b. The Court says there is a difference between sharing
                         secrets and sharing of business secrets. To have a
                         duty there must be regular business communication.
                     c. Here, there is no such duty between the tipper and
                         his wife so D can’t be held liable.

             6. What if Susan (the wife of tipper) told the broker instead of
                 her Keith?
                     a. There would be a breach of duty.
                     b. Here, Susan promised her mother not to tell anyone.
                            Keith did not agree to a confidentiality agreement
                            with Susan.
j. How do you prove reliance?
      i. In Basic Inc. v. Levinson p. 906, the Court goes with the “fraud on
         the market” theory.
      ii. Who should bear the burden of proving reliance?
             1. It’s a rebuttable presumption of reliance.
     iii. Court will presume a reasonable investor relied on the info.
k. Rules Recap
      i. You have to trade on material, non-public info to be liable.
             1. It’s difficult to disprove if you trade on the info.
      ii. The trader must allow adequate time for the public to analyze and
         digest the info.
     iii. There must be reliance on the info.
             1. It’s a rebuttable presumption of reliance.
     iv. There must be a breach of fiduciary duty for liability.
l. How to Approach an exam question on inside trading: ASK
      i. Is the info material?
      ii. Is the info confidential or public knowledge?
     iii. How did the trader get the info?
             1. Classic Insider or Temporary Insider
             2. Misappropriation Theory: see p. 865
             3. Tipper & Tippee Liability
                     a. The tipper must gain a personal benefit from
                     b. Tippee must know or have reason to know the
                            tipper breached a fiduciary duty.

m. Hypos
      i. A wife overhears her husband (VP of corp.) talking about a tender
           offer. Wife trades on the info and makes a profit. Can she be held
              1. Traditional Insider: NO
              2. Misappropriation Theory: Need two things
                        a. Regular sharing of confidential business info
                             between H and W.
                        b. H had an expectation that W would keep the info
              3. Tipper/Tippee Theory: W could be liable. H arguably
                     received a benefit because their family income increased.
                     W probably should have known H breached a fiduciary
     ii. Former employee did research for a corp. (10 years earlier).
           Afterwards he followed the company and bought stock.
              1. No liability: the information is too old to be material.
     iii. Maid finds confidential info in the trashcan at the corp. She trades
           on it and makes a profit.
              1. Classic Insider: Could get her on this if she works directly
                     for the corporation. If she worked for a Maid Service
                     check the agreement between the corp. and the service.
     iv. Thief steals corp. info: NO DUTY; NO LIABILITY
n. New Regulations & Amendments (NOT ON THE EXAM)
      i. Regulation F-D
              1. Went into effect October 22, 2000
              2. Selective disclosure of info is prohibited.
     ii. New Amendments to 10b-5
              1. If you are aware of the info, you have relied on it.
              2. 10b-5(2): Relationship in which you share confidence is
                     enough to establish a duty.

XII.   The Takeover Movement
       a. Tender Offer: A buyer issues an advertisement to shareholders offering
          to buy their shares usually at a premium price.
              i. General Info
                     1. Most tender offers are designed to take over the board. It’s
                         easier than forcing a shakeup on the board.
                     2. In most situations, the buyer is not obligated to buy the
                         shares unless they get majority control.
                     3. The buyer accepts the stock either on a first come first
                         serve OR Pro-rata basis.
             ii. If there were no federal securities law (hypothetically) how would
                 you regulate buyers?
                     1. General Fraud Statutes
             iii. Defensive Tactics to Counter Tender Offers
                     1. To counter a tender offer management will sometimes have
                         an auction or sell the shares at a discount price to a “white
                         knight” (friendly buyer).
                             a. Problems:
                                     i. If the tender offer has a short time window
                                         (“Saturday Night Special”) finding a “white
                                         knight” could be difficult.
                                    ii. Management may be breaching their
                                         fiduciary duty.
                     2. Management could contract to sell off the corporation’s key
                         assets if the tender offer is consummated.
                     3. Counter Tender Offer
             iv. Methods to reduce the likelihood of the buyer gaining control of
                 the board: These plans force the buyer to negotiate directly with
                 the directors. The directors can repeal these provisions if they
                 approve the transaction.
                     1. Shark Repellent”: see p. 991

              2. Staggered director terms
              3. Cumulative voting
              4. Require supermajority voting (2/3 approval)
              5. Fair price provisions
                      a. In the 2nd step the buyer must pay the shareholders a
                          fair price for their shares.
              6. “Golden Parachute” contracts for top management
              7. “Poison Pills” (Shareholder Preferred Rights Plans)
                      a. The rights plans are triggered after a tender offer
                          usually when the buyer acquires a certain % of
                          shares. The aggressor can’t participate in any of the
                          “poison pill” benefits.
                      b. Flip Over Provision: Shareholders can purchase
                          shares of the new corp. at a discounted price.
                      c. Flip In Provision: Allows people in the target corp.
                          to purchase discounted shares. It’s triggered when a
                          buyer acquires a certain % of stock.
b. The Williams Act
       i. Introduction: Congress amended the 1934 Act and added the
          Williams Act in 1968.
       ii. Duties under the Act:
              1. Mandatory Disclosures
              2. No false or misleading info used in tender offers. See sect
              3. Minimum time window
                      a. Offers must be held open for at least 20 days.
              4. Board must issue a statement about the offer within 10
              5. Unlawful to pass confidential info.
c. Leveraged Buyouts: In this situation most of the purchase price is
   financed through loans and junk bonds.

       i. Purpose: The seller hopes the company’s assets will repay the
          loans by generating income.
d. Responses by State Legislatures
       i. Rule: The Williams Act, the federal law regulating tender offers,
          does not specifically preempt state law. Therefore, preemption
          will occur only if the laws contain inconsistent provisions such that
          mutual compliance is impossible, or if the state law violates the
          intention behind the federal law. See CTS Corp. v. Dynamics
          Corp. of America p. 1010
e. Judicial Review of Defensive Tactics
       i. Should the Board be active or passive during a takeover?
             1. A Board can’t remain totally inactive. The Board must
                 make recommendations to the shareholders.
             2. They should try and figure out if the price offered is a good
             3. They should gather information about the deal.
             4. They should make sure the shareholders get a fair price.
                     a. The Board can take other factors into account when
                           mounting a defensive attack:
                               i. General public’s interest
                              ii. Company employees
                              iii. Coercive factors
      ii. Analyzing the Board’s defensive action in hostile takeovers:
          Delaware Law
             1. Board needs to show that a legitimate threat to the
                 company’s interests exists.
                     a. Example: employee layoffs, forcing the
                           shareholders to sell or take inferior junk bonds, etc.
             2. The Board’s response must be reasonable related to the
                     a. Unocal Corp. v. Mesa Petroleum Co.

                b. Facts: Mesa, which already owned 13% of Unocal,
                    instituted a two-tier front-loaded tender offer for
                    another 37% of Unocal. The offer indicated that if
                    it were successful, Mesa would then bring about a
                    back-end cash-out merger in which the remaining
                    half of Unocal stock would be bought out for junk
                    bonds. Unocal’s board then offered to have Unocal
                    repurchase up to 49% of its shares in exchange for
                    debt that Unocal claimed to be worth $72 per share.
                    But this repurchase program would backfire if Mesa
                    was allowed to participate by reselling its shares to
                    Unocal for the $72 debt package because Unocal
                    would be subsidizing Mesa’s takeover by paying
                    $72 for shares that Mesa had just bought for $54.
                    Therefore, Unocal’s offer to repurchase its shares
                    specifically excluded Mesa.
                c. Holding: The Delaware Supreme Court upheld the
                    repurchase program and its exclusion of Mesa.
                    Unocal directors had the burden of showing
                    reasonable grounds to believe:
                        i. That Mesa’s takeover posed a danger to the
                           corporation’s welfare (not just to directors
                           and management)
                       ii. AND, that the repurchase program
                           undertaken as a defensive measure was
                           proportional to the threat posed.
iii. Poison Pill Plans: In general, courts have upheld the validity of
    poison pill plans. But a few plans have been struck down. A key
    element to the fate of a poison pill plan is likely to be the degree to
    which it discourages hostile takeovers: if the plan so economically
    burdens bidders that practically no bidder is likely to come

    forward, the court is much more likely to strike down the plan than
    if it has merely a minor impact on the whole takeover process.
       1. Moran v. Household Int’l p. 1034
               a. Question: Does the board have authority to create
                   poison pills?
                       i. The provisions are in effect before the
                            tender offer. So the aggressor has full
               b. The court allowed the poison pill provision to go
                       i. The aggressor could always buy 19% of the
                            stock (20% triggers the pill). Then they
                            could wage a proxy contest to gain control
                            and deactivate the pill.
                      ii. Problems: It’s not very practical since the
                            aggressor must disclose its intentions in the
                            statement. But it’s still legal.
               c. Rights plans are often passed without shareholder
                       i. The statute allows it.
                      ii. Blank check provision in the charter. It
                            gives the board the ability to issue any type
                            of stock.
       2. Poison pills will probably not be upheld if the triggering %
           is too low and/or the flip-in price is too low. See CTS
iv. “Level Playing Field” Rule: Revlon, Inc. v. MacAndrews & Forbes
    Holdings Inc. p. 1046
       1. Facts: Revlon had a poison pill provision. In response
           Pantry Pride (the aggressor) increased its bidding price if
           Revlon would waive the pill. Revlon also searched for and

                      found a white knight and entered into a lock-up agreement
                      to purchase two of Revlon’s divisions if another acquirer
                      got 40% of Revlon’s shares.
                   2. The Court ruled:
                          a. The first response (poison pill) was fine because the
                              price was too low.
                          b. The second response (lock-up) was inappropriate in
                              this situation.
                   3. New Rule: Once a sale or breakup of the company
                      becomes inevitable, the board must seek to obtain the
                      highest possible price for the shareholders and may not
                      consider the interests of other constituencies.
                   4. When is the duty triggered?
                          a. The duty is only triggered if the board starts a
                              bidding war (e.g. the selection of a white knight)
                              OR if they make a response to a hostile takeover.
                              See Time Warner case p. 1049-1050
                          b. In the Revlon case it was triggered when the board
                              went to the white knight and acknowledged the
                              company was for sale. At this point it became clear
                              that a sale would occur either way.
                   5. Once a Revlon duty is triggered can the board take into
                      account outside and long-term interests?
                          a. NO, unless these factors could reasonably affect the
                              best price.
                   6. To the extent the company is not for sale (no Revlon duty
                      triggering), the board has the freedom to do what they want
                      with offers.
XIII. Business Combinations
      a. 3 Ways to Acquire Another Corp.
             i. Purchase Stock

             1. Benefits:
                     a. Non-taxable transaction
                     b. No interface with the board or announcement
                     c. No transfer of liabilities or debts to acquirer
             2. The board of the acquieree must approve.
     ii. Buy Assets of the Other Corp.
             1. Benefits:
                     a. Just need board approval.
                     b. No shareholder approval needed
                     c. You only acquire the liabilities you choose
             2. Downside: Can’t liquidate the acquired corp. until all of its
                 creditors have been paid.
     iii. Merger: Once the merger takes place the surviving corp. assumes
         all assets, liabilities, and debt of the defunct corp.
b. Mergers
      i. Types of Mergers: See notes from 11/27/00 for diagrams
             1. Statutory
                     a. A simply merges into B.
             2. Triangular
                     a. C merges with B, B is A’s wholly owned
                     b. Approval from A’s shareholders is not required.
             3. Reverse Triangular
                     a. C is the survivor; B is absorbed by C
                     b. A will be the parent of the surviving corp. which is
                     c. A doesn’t want the debts and liabilities of C. But
                         for some reason A wants C to stay alive.
             4. Freeze Out
                     a. A sets up B as a wholly owned subsidiary. A owns
                         51% of C.

                      b. C merges with B, the minority shareholders are paid
                          and cashed out.
c. Protections Given to Shareholders During Mergers
       i. Duty of Care from directors
             1. Heightened duty during the merger
      ii. Controlling shareholders have a duty of care to the minority
     iii. Shareholder approval for mergers
             1. Past: unanimous shareholder approval of mergers
                      a. Rationale:
                              i. You believe that when you invest in a corp.
                                 that corp. will continue to exist.
                             ii. Hostility toward mergers.
             2. Present: Unanimity no longer required. Only a majority of
                 shareholder approval is required.
     iv. Moratorium on a Merger (DE law): If you (aggressor) acquire a
          controlling group of stock in a corp. you must wait for five years
          before commencing a merger unless 2/3 of the shareholders
          approve the transaction.
      v. Minority Rights (Appraisal Remedies)
             1. See below
d. Appraisal Rights
       i. Purpose: Shareholders who are dissatisfied with the terms of a
          merger, consolidation, or sale of assets other than in the normal
          course of business are permitted to compel the corp. to buy their
          shares at a fair value. However, this right usually does not extend
          to reductions of capital and other changes that only involve
          amendments to the articles of incorporation. The shareholders’
          right to dissent is founded upon the belief that it would be
          fundamentally unfair to force dissenters to remain owners of a
          fundamentally changed corp.

ii. How it works:
       1. First, the minority shareholder must object to the proposed
           merger and put it in writing.
       2. Second, the shareholder must make a demand for an
           appraised value of his/her shares.
       3. Third, the shareholder gets appraisal rights.
iii. PA Law: Farris v. Glen Alden Corp. p. 1088
       1. Facts: D and List Corp. entered into a reorganization agreement
           under which D was to acquire List’s assets. P, a stockholder in
           D, sued to enjoin performance of this agreement on the ground
           that the notice to the shareholders of the proposed agreement did
           not conform to the statutory requirements for a proposed merger.
           D defended the action on the basis that the form of the
           transaction was a sale of assets rather than a merger so the
           merger statute was inapplicable.
       2. Holding: The Court said the transaction was a de facto
           merger. A transaction is a de facto merger, and the
           minority shareholders get appraisal rights, if the agreement
           will so change the corp. character that to refuse to allow the
           shareholder to dissent will, in effect, force him to give up
           his shares in one corp. and accept shares in an entirely
           different corp.
       3. Problems with suing on a fiduciary duty breach instead of a
           de facto merger
               a. Tougher burden of proof
       4. DE and most other states do not follow the de facto merger
iv. Duties under Freeze Out Mergers: Coggins v. New England
    Patriots (handout)
       1. Under what test do you apply a freeze-out merger?
               a. Business Purpose Test
               b. OR, Intrinsic Fairness Test

                             c. OR, Both (The court follows this)
XIV. Social Responsibility


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