Business Associations Law School Ooutline -- Loyola

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Business Associations Law School Ooutline -- Loyola Powered By Docstoc
					                                 Biz Ass Outline – Fall 2007, Pratt

I. STARTING A BUSINESS
   A. Economics of the firm
       The Firm’s Players
          Service Provider – the expert (person w/ the business idea) or professional manager (in large
            publicly traded company).
          Capital Provider – provides money to the biz (2 types):
             Equity Participant: contributes money in exchange for a piece of the biz. In a corp. this is the
                 shareholder or stockholder, and in an LLC it’s the members. They wants a return on their
                 investment either by (1) getting dividends or (2) by selling their interest in the biz for more
                 than they bought it for.
             Lender: contributes money for a certain time to the biz at a specified interest rate w/ the
                 intention of getting the principal back plus interest payments while the loan is outstanding.
          Employees – suppliers of labor to the biz
          Suppliers of Materials to the Biz
          Customers – buy goods or services created by the biz
          Community – location where biz operates (ex: company town).
         * Note: there are inherent conflicts of interest between (1) service providers, (2) equity participants
         and (3) lenders.
       The Concept of Risk
          Types of Business Risks
             Firm-Specific Risks – risks that are particular to the type of biz being engaged in (ex: for a
                 biz that manufactures and sells umbrellas, a specific risk would be a drought).
             General Market Risks – general market conditions that affect return of businesses generally
                 (ex: predictions in the stock market that the default risk of loans is increasing which creates a
                 fear that credit to fund businesses will dry up).
             Controllable Risk – risks that biz can take steps to reduce as long as the service provider isn’t
                 lazy and he monitors and controls the risk (ex: risk of insects to vineyard wine biz).
             Uncontrollable Risk – risks that cannot be controlled (ex: with umbrella and vineyard
                 businesses, the weather is an uncontrollable risk). For this type of risk, a biz can buy
                 insurance to reduce the risk’s impact.
                 *Note: Corporate finance theory says that investors get compensated for taking on market
                 risk, but not for taking on firm-specific risk. Investors can protect themselves against firm-
                 specific risk by diversifying investments between several different types of firms.
          Relationship Between Risk & Reward
             Equity Investments are higher risk than Loans: If you want a greater return, you must expose
                 yourself to greater risk by contributing your investment to an ownership interest.
             Absolute Priority Rule: if a biz goes bankrupt, there is an order to which claims against the
                 biz get paid: (1) secured creditors (lenders that got collateral for the loan), (2) then general
                 unsecured creditors, (3) equity participants (first preferred stock, then common stock).
   B. Choice of Organizational Form
       Introduction
          All of the rules that apply to different organizational forms are only default rules and can be
            freely drafted around to meet the parties’ needs.
          Find the entity whose default rules best fit what the parties want and draft around any
            undesirable default rules. It costs the client money to draft around the default rules, so you must
            start off as close as possible.
          Think about the corporation and general partnership as opposite ends of the spectrum, with other
            forms in between.
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   Characteristics of Different Types of Business Models
    1. Corporation
        Limited Liability – corp is a legal entity separate from its shareholders. SH are not liable
          for the debts of the separate incorporated entity (except when a court ―pierces the corp veil‖).
          Limited liability is the MAIN reason that businesses are incorporated.
           The parties that lose economically end up being the corp’s creditors (either lenders or
               litigation claimants).
           Creditors of a corp determine their interest rate based upon the risk of default. Thus,
               typically, contract creditors are in a position to protect themselves from bearing the cost
               of limited liability through contract (either w/ a higher interest rate, charging more for
               their product, or asking for a personal guarantee from a director or SH). That is not true
               for an involuntary tort creditor.
           Even if a SH has to give a personal guarantee for a loan, limited liability is still better b/c
               the guarantee is limited to the amount of the loan (protected from litigation damages).
           A creditor could also ask for a security interest in the assets of the biz (like property,
               equipment, etc).
        Free Transferability of Interests – SH can freely transfer their interests in a corp. Because
          of limited liability, an investor is encouraged to invest his money in the corp w/o having to
          research the net worth of all the other investors to make sure he’s not the deepest pocket.
           In the context of public corps, free transferability of interests is very important for the
               workings of the free capital market b/c we want low transaction costs to encourage
               investment or exit if needed.
           In the context of small startup corps with a small number of owners, the parties often
               draft around the free transferability of interest default rule (ex: SH buy-sell agreements).
               For example, can have a right of first refusal (if any party wants to transfer their interest,
               they must first offer it either to the corp or to the other SH).
        Continuity of Life – the corp continues even if there’s a death or withdrawal of any SH or
          director b/c it’s an entity separate from its investors. This doctrine promotes stability.
        Centralized Management – The SH elect directors of the corp (called the board of
          directors). The board oversees the senior officers of the corp. The board & officers manage
          the corp.
           With a small corp, centralized management isn’t necessary, but it is essential with a big
               corp.
           In the day-to-day operation of the biz, the SH have zero say. The SH get to vote during
               ―fundamental corporate transactions.‖ This requires 2 steps: (1) centralized
               management makes a decision, (2) that decision goes to the SH for a vote. Ex: mergers,
               dissolution, sale of substantially all assets.
     General Partnership
        Unlimited Liability – GP’s a jointly and severally liable for obligations of partnership.
           Can alter this by K, for example by having a GP structure with most financing through
               non-recourse loans (if available).
        Transferability only w/ Consent of all Partners – the assignee of a general partnership
          interest does not become a substitute partner unless all of the partners consent.
        Dissolution upon Death or Withdrawal of a Partner
        Management by the Partners – under default rules, each partner has equal control over the
          biz regardless of how much money they invested.
     Limited Partnership
        Limited Liability – A limited partnership has at lease one GP and at least one LP. LP’s
          have limited liability. GP’s are jointly and severally liable for the obligations of the limited
          partnership.

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             In practice, the GP of a limited partnership is often an entity w/ limited liability (ex: a
                corp or LLC). That way, if a creditor tries to recover from the limited partnership, it
                would be limited to the assets of the GP entity and the capital contributed by the LPs
                (can’t go after LPs individually).
             Typically, LP’s are passive investors. However, a LP who participates in the control of
                the limited partnership might be liable for its debts (under RULPA, but not under ULPA).
         Restrictions on Transferability – the assignee of a limited partnership interest does not
            become a substitute partner unless all of the partners consent. However, partners can freely
            assign their profits interests (w/o consent).
         Continuity of Life – the states apply 2 model statutes.
             RULPA: the death or withdrawal of a GP results in dissolution of the Limited Partnership
                unless: (1) there is no other GP and all of the LPs agree to continue the limited
                partnership; or (2) there is another GP and the partnership agreement permits the
                remaining GP to carry on the partnership biz.
                 If biz loses its GP, that’s an act of dissolution and the only way that the biz can keep
                    going is if there’s a remaining GP or the LPs quickly name a new GP.
             ULPA: the death or withdrawal of a GP results in the dissolution of the limited
                partnership if (1) there is no other GP and a majority of LPs do not vote to continue to the
                limited partnership & replace the GP; or (2) there is another GP, but a majority of the
                partners vote to dissolve the partnership. Thus, the default is that the limited partnership
                continues if a GP remains.
                 The limited partnership agreement can also specify events that will result in the
                    dissolution of the limited partnership.
                 The death or withdrawal of a LP doesn’t result in the dissolution of the partnership.
         Centralized Management – the GPs manage the limited partnership.
             LPs are passive investors, but they may have the right to vote on certain matters (based
                upon the partnership agreement). The consent of all partners is also required for certain
                fundamental actions.
     Limited Liability Company
         Limited Liability
         All other Characteristics Vary by Contract
             Some states do create default rules but you can freely draft around them. Delaware LLC
                default rules are (1) members manage the LLC (no centralized management), (2) no free
                transferability of interests, (3) continuity of life.
             LLC’s are said to be the best of both worlds b/c they get favorable tax treatment while
                keeping limited liability. However, b/c LLCs are relatively new there isn’t a wide body
                of case law. Thus, there are many open-ended issues in the law (when there are
                variations in state law, it’s unclear how the conflicts rules apply. Also, there is some
                ambiguity as to the extent of the limited liability).
    *Note on Formality: The least formal biz type is the general partnership b/c it doesn’t require filing
    any documents (cheapest). Setting up an LLC, LP or corp requires filing docs with the secretary of
    state (costs $$$).
    *Note on Raising Capital: privately held corps can get a lot of capital for expansion when they go
    public (IPO – initial public offering). The only other publicly traded biz type is the master LP
    (MLP). If biz needs to raise a lot of capital, parties should think about these biz types. Also, only
    corps that can sell to the public are C corps.
   Taxation
     Partnership Taxation – also called pass-through model. The biz itself is disregarded and tax
        reporting for biz occurs on the level of the individual investors. The biz is not a separate tax-
        paying entity; all of the money from the biz is taxed at the individual level. Applies to
        partnerships, LLCs and S corps.
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   Publicly-traded Entities – MLPs are taxed like a C corp (i.e. if you have an unincorporated
      entity that’s publicly traded, it will be taxed like a C corp).
   ―Check the Box‖ Regulation – IRS rule that an unincorporated biz entity gets partnership
      (pass-through) treatment unless they check the box indicated that they want corporate tax
      treatment.
   S Corp – to be taxed as an S corp., the corp must (1) be eligible and (2) elect to be treated as
      an S corp (a corp is C unless it makes a valid S election).
       Eligibility Requirements: (1) no more than 100 SH, (2) SH cannot be nonresident aliens
          or entities, (3) cannot have more than one class of stock.
       Lawyering Notes: Deadline for making S election is only a few months after the
          technical date of formation under state law, and if at anytime the corp fails to meet any of
          the eligibility requirements, the S corp automatically reverts to a C corp (―inadvertent
          termination of the S election‖).
   Tax Rate on Partnership Income – Partnership’s income will be taxed at the rate of each
      individual partner. Ranges from 35% at highest tax bracket to 15%. Each partner is taxed on
      the partnership’s income regardless of whether that income is distributed to the partners.
       Common Practice: often, if the income is going to stay in the partnership, each partner
          pays the tax on his share and the partnership makes a ―distribution‖ to each partner in the
          amount of tax paid. The partner isn’t taxed on the distribution b/c that money has already
          been taxed.
   One-Time Taxation - unlike with C corps, a partnership’s income is taxed once the year it’s
      earned (on the partner level). It’s not taxed when it’s distributed (either as a dividend or as a
      sale of stock).
   Income Losses – the partnership’s loss is allocated to the partners so that each partner reports
      a fraction of the total loss on their tax return. That loss can offset the partner’s other income,
      reducing the partner’s overall liability.
       IRS Exception: various provisions in the IRC may limit a partner’s ability to deduct biz
          losses against their other income. For ex, if the biz borrows a lot of money non-recourse
          or if partner is a passive investor, he may have to wait to deduct until IRC requirements
          are satisfied (Congress set up these hurdles so that rich people couldn’t abuse the pass-
          through system with ―funny-money‖ deductions in order to create big biz losses).
 Corporate Taxation – C corp is a tax-paying entity separate from its SH. Each year, the corp
  taxpayer must compute its income for the year and must pay tax on that income to the IRS. The
  SH are not liable for the tax on the corp’s annual income/losses.
   Double Taxation – C corp income is taxed twice: once at the entity level and then again at the
      SH level (either when the SH gets a distribution or when he sells his shares).
   Taxation of Dividends – In 2003, Congress passed a law saying dividends would be taxed at
      the lower capital gains tax rate of 15%. That rule expires in 2010.
   C Corp Tax Reducing Strategies – (1) Aggressive Tax Planning: there are a number of ways
      in the tax code a C corp can reduce the entity-level tax (some are lawful & some aren’t), (2)
      Certain SH are Tax-Exempt: institutional investors such as charities, tax-exempt investment
      plans, foreign taxpayers whose income is subject to bilateral tax treaties, (3) Interest
      Deductions: corps can deduct the interest paid to lenders (but the bondholder has to include
      the interest as individual income at the normal tax rate).
   Income Losses – Corp loss is called ―net operating loss‖ (NOL), and it sits in the corp’s
      system for that year. It provides no benefit to the indiv SH for that year and has no effect on
      their taxes at all for that year. The year a corp generates an NOL, no tax is owed.
       Carrying the NOL: If the corp has a NOL for a specific tax year, it can ―carry back‖ the
          NOL for 2 years (to get a tax refund), and it can ―carry forward‖ the NOL for 20 years (to
          be used as a tax deduction for that year).

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B. Setting up the Corporation
    Ethical Considerations
        Who is the Client?: if there are multiple people who want to form a corp together, there are
           inherent conflicts of interest between them. Client could be any party and also the corp entity.
           Lawyers are prohibited from continuing to rep more than one client when there are conflicts of
           interest unless clients give informed consent. Attny should say that it isn’t her role to resolve
           conflicts; she will draft what they want but each should have their own attny (ideal situation).
        What is Corp’s Role in Society?: see below
    State of Incorporation
        Internal Affairs Doctrine: (1) rights of SH (right to vote, distribution of property, right to bring
           suit etc), (2) corp governance and (3) obligations of management, are determined under the law
           of incorporation.
            All internal corp affairs are governed by the state law of the state of incorporation while state
                law of any other jurisdiction can control external affairs (ex: tort law of state where biz
                committed a tort).
        Delaware vs. Home State: Del is the favored state for incorporating large corps b/c it is thought
           to have a set of rules governing internal affairs that is favorable to management.
            Race to the Bottom: idea that states compete for incorporation b/c of corporate taxation and
                Del has won b/c of its laws favoring management of SH (which is bad for SH).
            Race to the Top: idea that competition is good between states b/c it will result in the best
                laws. If the managers do a bad job, the SH will sell their shares and the corporation will fail.
            Small Biz: don’t incorporate in Del if a small biz b/c you’ll have to pay franchise taxes both
                in Del and in state of operation.
    Required Information in Incorporating Documents
       1. Name of Corporation: must give an indication that it’s an incorporated business that’s not
           deceptively similar to another name being used in the state
       2. Name and Addy of Registered Agent and Registered Office: required to facilitate the service of
           process if corp is sued. Office must be in state of incorp and can be agent’s office.
       3. Nature of the Biz: use boilerplate language for purpose: ―to engage in lawful activities authorized
           under state law.‖ However, if nature of biz is one that’s regulated either by state or fed law, must
           state the purpose in such a way that adheres to all relevant regulations (ex: child day care).
            Ultra Bires (“beyond the power”): this doctrine used to be used to stop corps from doing
                things that were beyond their stated corp powers. This doctrine isn’t used much anymore b/c
                under the law a corp has all of the powers of a natural person. Also, corps can’t invoke the
                doctrine offensively anymore (to get out of contracts).
       4. Stock Authorized to be Issued: must specify (1) the number of authorized shares (of all classes of
           stock) and (2) the par value of the stock.
       5. Incorporator(s): name(s) and mailing addy(s)
       *Note: under both Del and Cal, if any of these things are missing, the incorporation is faulty.
       *Note: provisions that are the same as the state’s default rules should still be included in the
       certificate so that the reader understands the basic rights & duties of the corp operators.
    Optional Information in Incorporating Documents
       1. Initial Board of Directors: if the initial board members are specified, the incorporator loses all
           power as soon as the corp comes into being. Otherwise, the incorporator continues in his role
           until there’s a mtg where the incorporator chooses the initial directors (―initial incorp mtg‖). If
           directors don’t want their names public, don’t include them in the certificate and then name them
           at the mtg. Can have papers prepared in lieu of the mtg (actual mtg isn’t required).
            If the directors’ names aren’t included in the certificate, the incorporator must adopt the
                corp’s by-laws and conduct the corp’s biz until the directors are named.
            The initial incorp mtg can be unanimous written consent of all the incorporators

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                All of the incorporator’s docs must go into the corp minute book.
                Initial directors will serve until the next regular/annual mtg of the SH
           2. Right to Amend Bylaws: default rule is that only SH have the right to amend the by-laws, but
               can draft around rule in the certificate. It’s common to give the board the power to amend the
               bylaws too.
                If there’s a conflict btwn the certificate and the by-laws, the certificate controls (b/c it’s
                   harder to amend).
           3. Limitation of Director/Officer Liability: can put in a provision eliminating or limiting the
               personal liability of a director to the corp or its SH for monetary damages for breach of duty of
               care (can still get an injunction). Including this clause reduces the corp’s cost of director and
               officer liability insurance.
           4. Indemnification Clause: this provides director & officer protection of indemnification by the
               corp, so they’d be willing to serve.
          Amending the Incorporating Documents- 2 step process:
           1. Board must propose the amendment, and
           2. SH must vote to approve the amendment (typically a majority of shares authorized to vote).
          Filing the Incorporating Documents
            Incorporator: can be anyone (doesn’t need to be a lawyer).
            Filings: In Del, the ―certificate of incorporation‖ must be filed with the secretary of state. In Cal,
               the ―articles of incorporation‖ must be filed with the state (same thing, different names).
               1. Certificate must be signed by incorporator, and
               2. Original Documents must be filed along with applicable taxes and fees, and
               3. The documents must be stamped with the date and the time of the filing, which is when the
                   corp comes into existence (unless a future date is specified, up to 90 days from stamp date).
          Liability for Preincorporation Contracts
            General Rule: the promoter is liable for preincorporation contracts entered into on behalf of the
               corporation to be formed.
            Ex Ante Exceptions (planning stages)
               1. Promoter can sign K with ―[name of corp to be formed] [in formation or a corp to be formed]
                   by [name of promoter], promoter.‖
               2. K can specifically provide for a novation (the legal substitution of one party for another)
                   when corp comes into existence.
               3. Promoter can wait to enter into the K until the corp is actually formed.
               4. Promoter can take an assignable option on the K and assign the option to the corp after it’s
                   formed.
               *Note: Technical novation is the best option of the 4, and the first option is the worst.
            Ex Post (litigation arguments)
               1. Minority View: courts sometimes look to the intentions of the parties, based on all of the
                   facts and circumstances to determine whether a promoter is liable.

II. CORPORATIONS AS LEGAL ENTITIES
    A. Introduction
        Corporation & the Constitution
           Corporations have the same constitutional rights as individuals. If a law restricts a corp’s right to
             free (noncommercial) speech, the court will apply strict scrutiny: (1) compelling state interest
             must justify the restriction and (2) the restriction serves its function w/o being overly or under-
             inclusive (First Nat’l Bank v. Bellotti).
           Arguments against free corporate speech



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            Drownout Theory – corp speech can drown out the speech of individuals b/c it’s so
               powerful (counter: maybe so, but must show empirical evidence like market or social science
               research to the court).
            Other Peoples’ Money Theory – SH money is being spent for speech that not all of the SH
               may agree with (counter: SH already have corporate governance rights under state law).
      *Note: Under the case law, it seems easier to enact a restriction on corp speech in the tax code than
      it is to write a state law that is a flat out prohibition on corp speech.
B. Corporation & Society
    Berle-Dodd Debate
       Berle’s view: corporations exist solely to maximize shareholder profits w/o regard to societal
           needs (this is the dominant, law & economics view of corp law).
       Dodd’s view: part of the corporation’s role is to directly benefit society.
    ALI Principles: ―A corp should have as its objective the conduct of business activities w/ a view to
      enhancing corp profit and SH gain.‖
       ALI says that a corp may devote a reasonable amount of resources to public welfare,
           humanitarian, educational, and philanthropic purposes.
    Constituency Statutes: certain states have laws that require corps to take into account the needs of
      other constituencies under certain circumstances (ex: protection of employees, creditors, customers,
      etc). These statutes say that directors may take into account the interests of constituencies other than
      the SH when making corp decisions.
      *Note: Del and Cal have NOT adopted constituency statutes b/c they can create inherent conflicts of
      interest for the directors and make it more likely the directors will get sued.
    Role of Counsel: In rendering advice, a lawyer may refer not only to the law, but to other
      considerations such as moral, economic, social and political factors that may be relevant to the
      client’s situation. Lawyers can advise about social considerations as long as they give good
      technical corporate advice.
C. Corporate Charitable Giving & Social Responsibility
    State Corp Law: in both Del and Cal, corporate charitable giving is permitted even w/o a showing of
      benefit to the SH. This rule comes from a combo of state statutes and case law application.
    Federal Tax Law: IRS rules encourage charitable giving on the corporate level b/c corps get a
      deduction for the charitable contribution and the SH don’t have to pay any tax on the money used to
      make the contribution (whereas if the indiv SH made the donation, the money would be taxed as a
      dividend before it went to the charity).
    Substantive Test for Legality of a Charitable Contribution (2 elements):
       Amount of Contribution is Reasonable: element is satisfied if the gift is w/in the deduction limit
           allowed under the tax rules (right now it’s 10% of annual income).
       Purpose of Contribution is Reasonable: balances benefits of those in need against the loss to the
           SH. If the gift creates a net benefit to society under this balancing, it will be reasonable. Suspect
           types of gifts are those made to pet charities of corporate management or gifts that benefit rich
           people instead of poor people.
      *Note: if the SH sue the directors under a breach of fiduciary duty claim for the donation, the court
      will only get to the substantive test if the SH can rebut the presumption that the directors used a good
      process. Otherwise, if a proper process was used to decide to make the donation, the Business J-
      ment Rule applies and the directors win.




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III. LIMITED LIABILITY
     A. Introduction
         Limited Liability: corp’s creditors can only look to the assets of the corp to satisfy their claims. The
           creditors may not proceed personally against SH for claims that can’t be paid by the corp entity.
            Limited liability doesn’t mean zero liability. The SH can lose whatever money they put into the
               corp in exchange for their stock, but they can’t lose more than their investment.
            Limited liability is the general rule, but there are exceptions.
           *Note: A corp can abrogate LL in the certificate of incorp, but nobody does.
           *Note: LL can be adjusted by state statute (ex: in NY SH are liable for unpaid wages), or it can be
           trumped by federal laws (ex: CERCLA says that SH in control of the corp can be held personally
           liable for environmental violations of the corp/minority of case law says that capacity for control by
           the SH is enuf to impose liability).
         Rationales for Limited Liability: (a) Creditor Protection thru Contract (Creditors can contract to
           lower the risk of limited liability by (1) asking for collateral, (2) asking for a personal guarantee, (3)
           charging a higher interest rate); (b) LL promotes capital formation of businesses (the only capital
           committed to the biz is at risk, so people are more willing to invest); (c) LL reduces monitoring
           costs of management & other SH (w/o LL, SH would have to closely watch their investment to
           make sure management isn’t screwing up & to ensure that they’re not the deepest pocket); (d) LL
           facilitates diversification of investment; (e) LL allows for orderly trading of investments (w/o
           LL the price of stock would be related to the net worth of each SH); (f) LL facilitates the taking of
           business risks (LL lowers overall risk to SH).
     B. Piercing the Corporate Veil
         Introduction: Veil Piercing is the main exception to LL that allows creditors to go after the personal
           assets of an owner when the corp has no money. It’s a very messy area of the law b/c it’s state CL.
           The particular test used to pierce will vary by state, but there are 4 theories/factors that are common.
         Piercing Theories/Tests
           1. Instrumentality/alter ego/ agency – most common articulation of the veil piercing test. It’s
               basically when the owner (nominal or equitable) and corp are not really separate—they’re one in
               the same.
                Factors: (1) Disregard of corporate formalities, (2) Inadequate capitalization, (3)
                   Intermingling of funds, (4) overlap of ownership (btwn officers, directors & employees), (5)
                   shared office/living space, (6) whether dealings are arms-length, (7) whether the corp is an
                   indep profit-center, (8) intermingling of property.
                Look for domination or control of the corp by the party to whom the creditor wants to pierce
                   and whether the corp seemed to exist as a separate entity.
                Control = actual, factual control, not percentage ownership (stock ownership alone not enuf).
           2. Undercapitalization – in the 9th circuit undercap, if extreme, can be grounds to pierce on its own
               (Carlton), but it’s relevant in all jurisdictions b/c a biz being undercap is highly relevant in the
               test above.
                Undercap = assets insufficient to cover expected liabilities. Undercap is determined at the
                   inception of the biz.
                Liabilities = all known and foreseeable (ex: paychecks for employees and tort suits).
                If a biz isn’t undercapitalized at the outset, you don’t have a good veil piercing claim.
                Buying minimum liability insurance required under state law isn’t undercapitalization.
           3. Failure to Observe Corp Formalities – doesn’t rise to the level of a separate test, but it’s a fact
               that’s always relevant in veil piercing cases.
           4. Fraud/misrepresentation – most relevant in contract creditor cases. In a tort case, only need to
               prove injury and loss but in a K creditor case must also show some type of fraud or misrep.
           *Note: can pierce to both nominal owner of a corp (i.e. actual SH) and equitable owner (Freeman).
           *Note: veil piercing is an equitable doctrine where court weighs the totality of the circumstances.

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          When Veil Piercing Applies: piercing is a possibility in 2 contexts: (1) Corp is closely held by a few
           SH or (2) Corp is large w/ many SH but is owned or operated by another company (parent/sub).
          Contract Case Test: (1) owner (nominal or equitable) of the corp has exercised such control that the
           corp has become the instrument/alter ego/agent of the owner, (2) such control has been used to
           commit a fraud (requires intent) or other wrong (intent not necessary, maybe recklessness or gross
           neg enough), and (3) the fraud or wrong results in an unjust loss or injury to the plaintiff.
          Tort Case: (1) owner (nominal or equitable) of the corp has exercised such control that the corp has
           become the instrument/alter ego/agent of the owner and (2) Plaintiff is injured by the corp (prove
           elements of tort claim).
          Parent-Sub and Affiliated Corp Case: must show that the parent (or sister/cousin corp) exercised
           actual factual control over the day-to-day business of the subsidiary. Provide as many facts as
           possible to show actual control.
            Factors: (1) parent & sub have common directors or officers, (2) P & S have common biz
               departments, (3) P & S file consolidated financial statements & tax returns, (4) P finances S, (5)
               P caused the incorporation of S, (6) S operates w/ grossly inadequate capital (undercap), (7) P
               pays the salaries and other expenses of S, (8) S receives no biz except that given to it by P, (9) P
               uses S’s property as its own, (10) daily operations of the 2 corps are not kept separate, (11) S
               doesn’t observe basic corp formalities.
           *Note: common structure of parent corp creating a cash management system for all of its subs to
           manage all of the investments isn’t a factor indicating domination and control as long as careful
           records are kept by the parent (i.e. accurate record-keeping to prevent commingling of assets).
           *Note: Test in Del is (1) P & S operated as a single economic unit; and (2) an overall element of
           injustice or unfairness is present. This is still the instrumentality (domination & control) test.
          Piercing other LL Companies: we don’t know whether piercing law that applies to corps would
           apply to piercing an LLC to the members. There’s no case law yet.
          Alternatives to Piercing: If there’s a large corp w/ many SH and no parent/sub (i.e. piercing won’t
           work), creditor can try to use equitable subordination, fraudulent conveyance or the legal capital
           rules to get their money.

IV. CORPORATE SECURITIES
    A. Introduction
        Elements of a Corporate Security
           Security = every type of financial instrument you can think of.
           Factors to Determine the Type of Security: (1) Entitlement to Income from the Biz (SH has no
             right to income from the biz while some loans require periodic interest payments); (2) Rights to
             Assets in Liquidation (First paid are the secured creditors, then come unsecured creditors, then
             preferred SH, last are common SH); (3) Right to Participation in Corp Governance (SH vote to
             elect directors & on some fundamental corp transactions while debt holders generally don’t get
             to vote unless the biz is insolvent); (4) Duration of the Investment (stock is considered a
             permanent investment b/c there’s no right to get money back from the corp while a debt
             investment is for a fixed term).
           Derivative Instrument: financial interest that trades like, or by reference to another financial
             interest (ex: interest rate is determined by the value of the stock).
        Determining the Capital Structure
           Capital Structure = the various attributes on money invested in the business.
           Forming the Capital Structure: only the initial corp structure must be specified in the articles (i.e.
             number of classes of stock, number of shares authorized, initial par value of stock), but nothing
             about debt must be in articles. Board has freedom to authorize the debt.
        Leverage


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        Leverage = the effect of using debt in the capital structure. More leverage magnifies the
         financial situation of the corp (i.e. if biz is profitable, the more debt in the capital structure the
         more the SH make, but if the biz is not profitable, the more debt the less the SH make).
        Effect of Leverage: (1) if the biz is making a higher percentage return on all capital invested than
         the percentage interest rate, the more leveraged the corp, the higher the return on equity; (2) if
         the corp is making a percentage return that’s lower than the interest rate, the corp that’s
         leveraged will have a lower return on equity; (3) if percentage return equals the interest rate, the
         return on equity will equal the interest rate no matter how leveraged the corp is.

           Example: $100,000 investment
           Debt to Equity Ratio 3:1
           $75,000 debt, $25,000 equity (same size biz w/ less equity invested)
           10% interest rate on debt

           Return on Investment (%)        10 %                   12 %            6%
           Return on Investment ($)        $10,000                $12,000         $6,000
           Interest Payment                $7,500                 $7,500          $7,500
           Return on Equity ($)            $2,500                  $4,500         ($1,500)  $ 98,500 capital left
           Return on Equity (%)            10 %                    18 %           (6 %)


       SH-Creditor Conflict: SH want management to go after risky investments or lots of leverage b/c
          the worst that could happen would be that the SH lose their investment, but creditors don’t want
          corp managers to engage in risky projects b/c that could jeopardize their money (either interest or
          principal loaned) and creditors get the same interest payment no matter what.
          *Note: in reality, leverage will be limited b/c as a project gets riskier the interest rate charged by
          a creditor will go up proportionately to the risk of default. Also, creditors can reduce risk
          through contract by limiting what management can do (―negative covenants‖).
B. Debt
    Types of Debt
       Bank Financing: typically a term loan (bank enters into credit agreement w/ a specific debtor.
          It’s a private K btwn the bank and the borrower). Two types:
           Fixed Dollar Amount Loan
           Revolving Credit Line: like a credit care w/ a fluctuating balance.
       Bonds: long-term debt of a corp issuer (usually over 20 years). Generally, bonds are secured
          with collateral (like property).
       Debentures: long-term debt but tends to have a slightly shorter maturity than bonds (10-20 years);
          typically they’re not secured (i.e. only backed by general credit of the debtor).
       Notes: unusually shorter-term obligations. Generally they’re traded & held by large financial
          institutions.
    Interest on Debt: interest is compensation for the use of the lender’s money (also called a ―coupon‖).
      Interest payments have 2 elements:
       Time-Value of Money – it’s the amount of interest that compensates lender for the fact that it
          doesn’t have it’s money to invest while the principal is outstanding (―risk-less rate of return‖).
       Compensation for Risk of Non-Payment – amount of interest that compensates lender for the risk
          of default (depends on borrower’s credit rating).
       Rate of Interest Payment – in simplest case interest is paid once a year. At opposite extreme, can
          arrange for interest to accrue on the debt w/o payment until maturity of the loan (called a zero-
          coupon bond). Payment of interest is deferred until the bond matures.
           Tax law & finance call unstated interest ―original issue discount.‖ (OID) (ex: if one bond is
               sold for $1000 and when bond matures $1200 will be paid. The $200 is the OID). Corp
               debtor can deduct the OID interest from its taxes as it accrues financially, even before it’s
               actually paid.
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    Contractual Nature of Debt: the nature of debt is contractual. Corp law isn’t set up to protect
     debtors b/c it assumes that these creditors can set up the debt K to protect themselves.
      Bank Loan: debt K is called a credit agreement.
      Bonds or Debentures: debt K is called an indenture.
      Notes: debt K is called the debt note agreement.
      Underwriter: helps create the debt instruments by negotiating the debt K and buys them all and
          then turns around and sells them to the public investors. A bank may get involved and act as the
          indenture trustee.
           The underwriter must figure out during negotiation what will sell to the public. If the
              underwriter gets it wrong, the bonds won’t sell for the desired price. Once the bond is out on
              the market, its value will depend on what’s happening with the interest rates.
      Terms to be Negotiated
           Interest: what the rate is, how it’s calculated and how often it’s paid out (ex: Amortizing
              Loan provides for a fixed payment where part of payment is interest and part is principle.
              Floating Interest Rate makes interest rate contingent upon something else, like LIBOR
              (London Interbank Offering Rate)).
           Repayment of Principal: Sinking Fund Provision requires that the corp set aside a certain
              amount of money each year into a fund to make sure that it has enuf money to pay the
              ballooned principle payment when the loan matures. Redemption is when a corp issuer buys
              back its own securities. Mandatory Redemption is when at regularly scheduled intervals
              the corp pays off a certain percentage of its outstanding bonds (works like a sinking fund).
           Right to Convert: Convertible Bond gives the owner the right to convert the debt
              instrument into stock depending upon some formula in the K as long as the bond is
              outstanding. Providing this feature is a way to lower the interest rate on the bond.
           Priority: issuer can contract to be lower in the priority line in the event of
              liquidation/dissolution in exchange for a higher interest rate (―junk bond‖), or issuer can
              contract to be higher in the priority line in exchange for charging a lower interest rate.
           Events of default & rights upon default: default is whatever the debt K defines as the corp
              not making good on its obligations (ex: not making interest payment by a specific date).
              Debt K can specify that an uncured default triggers control rights of the creditor (ex: voting
              rights).
           Negative Covenants: contractual restrictions on the conduct of the corp issuer (ex:
              prohibition on the issuance of additional debt that is senior to the debt subject to the K).
              Can’t have too many neg covenants b/c can’t restrict corp too much from financing itself.
           Role in Corp Governance: can contract for bondholders to have voting rights, but not
              typical unless there’s a default.
           Information: under fed securities law public companies must making periodic filings of info
              w/ the SEC. Bondholders may want to contract to receive additional info that corp doesn’t
              have to disclose.
C. Equity
    Statutory Authorization to Issue Stock: Del law allows corps to issue stock in various classes and
     series as long as it’s specified in the certificate (number of shares authorized, type of shares
     authorized, par value). Board cannot issue more stock than what’s been authorized in the certificate
     unless the certificate is amended.
    Common vs. Preferred Stock: If there’s only one class of stock, it’s common voting stock by default
     (each share gets one vote and all shares would vote together at the annual mtgs). However,
     certificate can specify 2 classes of stock. Preferred stock is preferred as to dividends and as to
     liquidating distribution (preferred gets paid in full before common gets anything). Preferred SH are
     very close to subordinated debt holders (junk bond holders) in the priory ladder.


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       Cumulative Preferred Shares: not entitled to get a dividend until directors decide to pay a
           dividend, but when board does declare a dividend, these SH are first in line. They’re paid an
           amount equal to the cumulative value of all annual dividends that haven’t yet been paid (ex: 5%
           cumulative preferred are entitled to 5% of par value per share per year from the date the shares
           are issued before common SH get anything).
       Preference Shares (aka ―blank check preferred‖): such stock is called ―blank check‖ b/c the
           certificate doesn’t specify the terms of that class of stock; it just delegates the decision-making
           authority to the board to fill in those terms.
       Common Shares: always entitled to the residual amount (whatever amount is left after paying all
           of the other claims). Amount paid to these SH isn’t related to the par value of the stock.
    Redemption: when a corp buys back its own securities. Whenever certificate creates preferred stock
      that has a dividend preference, must also limit redemptions. Otherwise redemptions can be used as
      an end-run around the priority requirement b/c a pro-rata redemption is the economic equivalent of a
      pro rata dividend. If a corp redeems some of the common shares instead of issuing a dividend, each
      common SH has the same percentage ownership, the same cash in hand, and the same value of their
      stock and the preferred SH never get their dividend.
D. Other Types of Securities
    Calls: the holder of a call option has the right to buy a security at a specified price for a specified
      period of time. The price at which the security will be bought if the option is exercised is called the
      exercise price or strike price. If the stock is currently trading at a price that’s higher than the strike
      price, the call option is in the money. If stock is trading at a price that’s lower than the strike price,
      the call option is out of the money. Even out of the money call options have value b/c the trading
      price could exceed the strike price during the period of the option (value depends upon the volatility
      of the trading price where the more volatile the higher the value).
       Another factor that sets the value of an option is the current interest rate. The higher the interest
           rate, the higher the value.
       The Black Shoals Option Pricing Theory is the most popular formula for valuing an option.
       Options can be issued by any one (either by underlying corp or by third party).
       There are negative tax consequences for issuing an option that’s in the money when it’s issued.
    Warrants: like a call option except that a warrant can only be issued by the underlying corp and
      expires after a longer period of time (e.g. 5 years). Warrants are issued as an ―equity sweetener‖ in
      debt offerings in order to lower the interest rate of the bonds.
    Puts: holder of a put option has the right to sell a security at a specified price for a specified period
      of time (inverse of call option). If the stock is currently trading lower than the strike price, the put
      option is in the money. If the stock is trading higher than the strike price, the put is out of the money.
    Interest Rate Swap: this is one way of hedging (entering into a financial transaction that manages
      risk based upon a particular factor). Corp A borrows X amount from the bank with a floating
      interest rate. Corp A knows it can pay a max of 10% interest, but is afraid that the floating interest
      rate could go above 10%. Corp A enters into a contract with Corp B where Corp A agrees to pay
      Corp B 10% of X and Corp B agrees to pay Corp A whatever the current interest rate of X is.
E. Shareholder-Creditor Conflict
    Equitable Subordination: It’s an equitable doctrine that arises in the context of a bankruptcy
      proceeding. Court will step in to protect a creditor when a SH/insider who’s also a creditor used his
      inside info to abuse his position as the biz is going under. Bankruptcy court rearranges the priority
      ladder by taking the SH-creditor’s claim out of the creditor group and putting it in the equity group.
       Test: SH/Insider-Creditor committed a wrongdoing or abuse of insider position to the detriment
           of the creditor plaintiff. If the court finds the test is met, it will treat the SH/Insider’s claim as an
           equity claim.
       Ex: SH-creditor tries to convert his unsecured loans to the corp into secured loans once he finds
           out biz is going bankrupt (Fett Roofing).

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          Bondholders in Leveraged Buyouts: in a leveraged buyout, SH vote to allow another company to use
           lots of debt (by borrowing lots of money) to finance the acquisition of their corp. SH make lots of
           money in LBO. But when corps merge, the debt of the company merges with the debt of the
           acquired corp and the corp’s bondholders lose the value of their bonds (b/c the credit rating of the
           corp goes down). Courts will not protect bondholders here b/c they can contract for LBO protection
           if they want it (i.e. not having LBO protection is a realistic risk of the bond business).

V. ACCOUNTING AND FINANCIAL STATEMENTS
   A. Introduction
       GAAP (generally accepted accounting principles): standards set by the accounting profession that
         tell you how to present a company’s financial statement. It’s a common language that all large
         companies use. Even with GAAP, accounting has a lot of gray areas. There’s a generally tendency
         to present the financial info conservatively (err on the side of under-reporting income).
       Use of Financial Statements: the accounting choices a company makes has to be used for both
         financial reporting and tax, so it’s not always beneficial to report higher earnings.
       Statement of Cash Flows: shows cash in & cash out of the biz (only shows the cash transactions).
       Accrual Method: used in companies that have inventory. Instead of keeping track of cash flow, it
         shows the company’s legal right to receive payment and obligation to make payment.
       Balance Sheet: it’s the snapshot of the assets, liabilities & equity of a biz as of a particular date.
       Income Statement: business’ income for one year.
   B. The Balance Sheet
       Mathematical Fact: ASSETS = LIABILITIES + EQUITY (if the balance sheet doesn’t balance,
         there’s a mistake in it).
       Asset Accounts: assets = cash assets + operating assets
          Cash Assets: Cash + Accounts Receivable + Inventory + Prepaid Expenses
               Accounts Receivable – outstanding money owed that biz expects to get back in near future
                 (often offset by some percentage to account for some amount that will never be paid).
               Inventory – goods available for sale by the biz multiplied by how much each piece is worth.
          Operating Assets: Land + Bldgs + Equip + Intangible Assets – Accumulated Depreciation
               Historic Cost – operating assets are listed at the historic cost not the current valuation, but
                 you can list the current value of these assets in a footnote on the balance sheet.
               Intangible Assets – patents, good will etc purchased by the biz (intangible assets created by
                 biz itself isn’t reflected on the balance sheet).
               Accumulated Depreciation – total depreciation taken on all depreciable assets for all prior
                 and current years.
                  Depreciable assets = assets whose value declines over time (ex: vehicle used for biz,
                     machinery, office equipment, not land or buildings)
                  Straight Line Depreciation Method = cost of asset divided by the number of years biz can
                     use the asset before it dies. Deduct that amount each year as the depreciation.
                  Accelerated Depreciation Method = allows a larger deduction in the first few years an
                     asset is purchased and a lower deduction in later years. Figure out the straight line
                     deduction and multiply it by a percentage (ex: double declining method would be to take
                     the straight line deduction and double it for the first year. 150% declining method
                     multiplies the straight line deduction by 1.5 for the first year).
       Liabilities: Total Liabilities = current liabilities + future/long-term liabilities
          Current Liabilities: accounts payable + notes payable + accrued expenses payable + other
               Accounts Payable – current amounts the biz has to pay out to third parties (mirror image of
                 accounts receivable).
               Notes Payable – total balance due on outstanding notes
               Accrued Expenses Payable – expenses due to be paid that haven’t yet been paid.
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       Long-Term Liabilities: long-term notes payable.
    Equity: Pain-in Capital + Retained Earnings
       Paid-in Capital: total consideration paid for the stock (total number of outstanding shares
          multiplied by the price paid per share).
           Paid-in Capital = stated capital (par value times number of outstanding shares) + capital
              surplus (consideration paid for the stock in excess of the stated capital).
       Retained Earnings: earned surplus
C. The Income Statement (income for one year)
    Net Income = Net Sales – Operating Expenses – Interest Expense (on loans) – Income Taxes
    Operating Expenses = Cost of Goods Sold + Depreciation (that year) + Selling & Admin Expense
      (like salaries) + R&D
    Cost of Goods Sold: allocates a dollar cost to the goods that have been sold out of the inventory.
       Opening Inventory (closing inventory from previous year’s balance sheet) + Purchases During
          the Year = Goods Available for Sale
       Goods Available for Sale – Closing Inventory (either under FIFO or LIFO) = Cost of Goods
          Sold
           FIFO (first-in-first-out): Looks like a pipeline. Assume first items bought for inventory are
              first items sold out of inventory.
           LIFO (last-in-first-out): Looks like a well. Assume last items bought for inventory are first
              items sold out of inventory.
           Inflation: generally inflation causes the price of inventory to increase over time. Therefore,
              closing inventory is lower under LIFO, cost of goods sold is higher under LIFO, & profit
              from sales is lower under LIFO.
           Effect of Method Used: LIFO will result in less tax paid, but FIFO will make investors
              attracted to your biz. Majority of biz use FIFO for this reason.
       Gross Receipts from Sales – Cost of Goods Sold = Operating Profit from Sales
D. Analyzing the Balance Sheet & Income Statement
    Profitability of the Biz
       Profits per dollar of net sales = operating profit/income divided by net sales
           Use this formula to see if percentage of profits per net sales has increased or decreased. If
              increased, could be that operating expenses decreased.
       Return on Equity = net income (current year) divided by SH total equity (from previous year’s
          balance sheet)
           Use this formula to see if the SH are earning a better return w/ this biz than they would in the
              stock market.
    Liquidity of the Biz (ability of the biz to pay its debts as they come due)
       Working Capital = current assets – current liabilities
           This should be a fat dollar amount b/c current assets includes accounts receivable (some of
              which won’t be repaid) and inventory (which isn’t cash).
       Current Ratio = current assets divided by current liabilities
           If this ratio is less than 1 the biz can’t pay its debts as they come due.
       Quick Ratio = (current assets – inventory – prepaid expenses) divided by current liabilities
           This ratio just looks at whether the biz has enough cash and cash coming (accounts
              receivable) to pay its current debts. Assumes biz can’t sell any inventory (so it’s more
              conservative than the current ratio). Also called acid test ratio.




                                                   14
VI. VALUATION
    A. Valuation Methods
        Salvage Value: method assumes that there’s no future income earning ability for the asset.
           If buying an apple tree, salvage value is the value of the fire wood, not for any fruits the tree
              might bear.
           This method undervalues the asset b/c it doesn’t take future earning capability into account.
        One Year’s Earnings: this method fails to take future earning potential into account.
        Accumulated Gross Revenue: looks at what gross revenue the asset is currently generating and
          multiplies that value times the number of years the asset will last.
           Problems: (1) doesn’t take into account the cost of earning that income (better to look at net
              revenue), (2) fails to take into account the time value of money.
        Time-Value of Money: $5 today is worth more than $5 one year from now. This is b/c of inflation
          and the fact that the money you have today can be used for investing while the money you won’t get
          until later cannot.
           FV = PV (1 + r)n
           PV = FV divided by (1 + r)n
               FV is Future Value. PV is Present Value. r is the interest rate. n is the rate of compounding.
        Market Price: only a good valuation method if there’s active trading of the asset biz being valued (i.e.
          lots of trading of similar businesses). It’s an indicator of what people are willing to pay for the biz at
          a particular point in time, not what the biz is actually worth.
        Book Value: add up the historic cost of all of the biz assets (i.e. how much the biz is worth on the
          books). This method sets the floor of the value of the biz (a rough benchmark). Usually people use
          book value to supplement the other valuation methods.
        Capitalization of Earnings: one of the more popular valuation methods (along w/ discounted cash
          flow). Look at net income and determine whether that amount is representative of what income the
          biz will earn going forward. Can use this income and make relevant adjustments up or down going
          into the future (then calculate PV). Also, figure out an appropriate return on the biz and calculate
          PV. Add these up to get the present valuation of the biz.
           Value of Biz = Earnings divided by Capitalization Rate
           Earnings: start w/ income statement and adjust up or down to come up w/ an annual earnings
              number that you’d be comfortable with extrapolating into the future.
           Capitalization Rate: totally a facts & circumstances based number. Can look to normal cap rates
              in a certain industry (comparables). Buyer wants a higher cap rate, seller wants a lower one.
        Discounted Cash Flow: (1) compute yearly cash flow of biz for next X years, (2) calculate the PV
          for each year, and (3) add all those values up + salvage value to find the current value of the biz.

VII. LEGAL CAPITAL RULES & CREDITOR PROTECTIONS
   A. Legal Capital
       Introduction
          Legal Capital Rules: restrict the ability of the directors to make dividend distributions. These
             rules used to do a much better job of protecting creditors than they do today.
          Result of an Unlawful Distribution: directors are personally liable to repay the unlawful
             distribution (dividend or redemption) back into the corp.
       Capital Accounts and Par Value
          Par Value: the minimum consideration that can be received for the stock.
              Under Del law, the certificate may state zero par value, but if the board fails to designate how
                 much of the consideration for that stock goes into stated capital and how much into surplus,
                 100% of the consideration will go into the stated capital account. That’s why it’s more
                 popular to state penny par ($0.01) or some other low par value.

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       Lawfully Issued Stock: must be (1) duly authorized (according to state law & certificate of
          incorp), (2) validly issued (out of authorized shares), and (3) nonassessable (consideration for
          stock is valid and promised payment has been made in full).
           Acceptable Consideration: In Del, the board has the last word on the valuation for in-kind
               consideration for stock unless there’s a showing of fraud (e.g. board will value the land etc to
               make sure that the amount of stock distributed in exchange is fair). Consideration can be
               cash, personal or real property, leases, intangible property, exchanging past services for stock.
           Assessability: In Del, a SH can make a down payment to cover the par value of the stock and
               issue a promissory note for the rest (method is used to attract key employees). However, if
               the assets of the corp are insufficient to pay creditors, the SH can be forced to pay the
               balance on the principle on the promissory note (that’s why this stock is ―assessable‖).
       The Capital Accounts
          Stated Capital – P*N (par value times number of outstanding shares)
          Capital Surplus (paid-in capital) – total consideration received for stock minus stated capital
          Earned Surplus (retained earnings) – total earnings of biz less all dividends paid
B. Restrictions on Dividends
    Legal Capital Restrictions
       Delaware: Dividends or redemptions may be paid out of any surplus (capital surplus + earned
          surplus), but not out of stated capital. Under this test, par value is relevant.
       California: Dividends or redemptions may be paid out of retained earnings (earned surplus), but
          not out of capital surplus. Under this test par value is irrelevant.
    Other Restrictions
       Insolvency Test: under the Model Business Corp Act, a distribution cannot be made if it renders
          the corp insolvent, either (1) balance sheet insolvent (liabilities exceed assets) or (2) biz cannot
          pay its debts as they come due.
    Nimble Dividend Statutes
       Delaware: If the corp doesn’t have enuf surplus, the board can still make a distribution if the corp
          is currently earning income. It may distribute that income. Income means net profits for the
          fiscal year in which the dividend is declared and/or net profits from the preceding year. This rule
          also applies if a dividend is declared in an amount in excess of surplus. If corp made profits in
          current year and preceding year, you add the profits together. Otherwise, just use the profits
          from one year (don’t include any loss).
       California: if the corp doesn’t have enuf retained earnings, the board can still pay a dividend if (1)
          total assets equal at least 1.25 times total liabilities after the distribution and (2) either (a) corp’s
          average earnings from past 2 years (b4 interest & taxes) have at least equaled the average interest
          expense and current assets at least equal current liabilities after the distribution OR (b) current
          assets are at least 1.25 times current liabilities.
    Director Liability for Unlawful Distributions
       In both Cal and Del, directors are held personally liable to repay illegal distributions to the corp.
       Under Del law, creditors cannot generally recover from the SH who received the illegal
          distribution. However, if the directors are held personally liable (jointly & severally), the
          directors can recover from the SH if the SH knew the distribution was illegal.
C. Fraudulent Conveyance
    Typical Facts: there’s a bankruptcy proceeding or insolvency or failed biz in state court and there
      was a transfer of property for less than equivalent value. If the court determines that the conveyance
      was fraudulent, the transfer is voided and the funds go back into corp solution from which creditors’
      claims can be paid.
    Test: Actual intent to defraud OR constructive fraud.
       Constructive Fraud: (1) transfer of property, (2) without receiving equivalent value and (3) either
          (a) the debtor’s assets remaining after the transfer were unreasonably small in relation to the

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               business as a whole (total liabilities to total assets) or (b) the debtor intended to, believed, or
               should have believed that the debtor would incur debts beyond the debtor’s ability to pay as they
               became due (current liabilities to current assets).

VIII. CORP MANAGEMENT & CONTROL
   A. Officers
       Introduction
          Close Corps: officers tend to also be SH and directors. Don’t have the problem of separation of
             ownership and control.
          Large/Public Corps: officers are appointed by the board and are separate from the passive SH
             investors. Here there’s a separation of ownership and control.
          Officer Duties: corp law leaves their role very open (doesn’t specify their duties). Role of
             officers will typically be reflected in the bylaws and maybe in the certificate. They run the corp
             from day to day.
       Agency Principles
          Agency: an agency relationship confers on the agent the power to create rights in the principal’s
             favor and to subject the principal to liability to third parties.
          Officers as Corp Agents: the corp is the principal (acting thru the board) and the officers are the
             agents.
          Sources of Agency Authority
             1. Actual Authority (express or implied)
                  Express Actual = explicit grant of authority by the principal to the agent.
                     look to bylaws first and then to corp minute books to see if board adopted resolutions that
                         specifically granted authority to a particular officer to carry out a certain act.
                  Implied Actual = course of conduct between principal and agent establishes that the agent
                     had authority to act on behalf of the principal.
                     look for a history of officer doing the act in question. Look at minute books to determine
                         course of conduct and course of dealing between the officer and the corp.
                 *Note: the higher up in the chain of command the purported agent is, the more likely it is that
                 there was actual authority.
                 *Note: In actual authority, what third party believed is irrelevant.
             2. Apparent Authority: third party reasonably believed, based upon his relationship w/ the
                 principal that the purported agent had the power to act on behalf of the principal.
                  It’s an objectively reasonable standard.
             3. Inherent Authority: if the agent is acting w/in the scope of his typical authority, there is a
                 penumbra of agency that binds the principal (murkiest, catch-all standard).
                  Look at title of officer and whether the transaction was in the ordinary course of business.
                  Don’t argue this type of authority unless you don’t have either actual or apparent.
             4. Ratification or Estoppel
                 Ratification = principal explicitly ratifies the transaction the agent entered into w/ the third
                     party (principal basically says it will assume the obligation to the third party).
                 Estoppel = principal learns that purported agent entered into a transaction w/ a third party and
                     does nothing. Principal is estopped from arguing lack of agency.
             *Note: If there’s an agency case where the purported agent was the ―President‖, the case will
             come down to whether the transaction was done in the ordinary course of business. If yes, then
             the Prez has actual authority. This is typically a Q of fact unless the contract is so extraordinary
             that the court can decide it as a Q of law b/c reasonable people cannot differ (ex: ee K vs.
             pension K vs. lifetime K).



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B. Directors
    Introduction
       Director Duties: the board manages the ―biz & affairs‖ of the corp.
           Responsible for initiating fundamental corp changes (amending certificate, approving
               mergers or dissolutions or sale of substantially all assets of corp). Can also typically amend
               the bylaws.
           Choose & oversee the officers.
           Decide when to declare & pay dividends (or redemptions).
           Decide how to allocate shares that are authorized by the articles.
           Make decisions about corp policy and major financing decisions (ex: bond offerings).
    Procedural Rules for Board Meetings
       Statutory Rule: quorum of directors must be present at the meeting (either physically or
          electronically) in order for the board to take action.
       Exception: Proposal can pass w/o a board mtg if there’s unanimous assent among the directors.
       Quorum: minimum number of directors who must be present to take action at a meeting. Default
          rule is that quorum is a majority of the directors. Certificate can designate a different quorum,
          but it cannot be less than 1/3 of the directors.
    Committees
       Statutory Rule: A committee properly constituted by the board has the full decision-making
          authority of the entire board of directors (i.e. committee can make decisions on board’s behalf).
           Properly constituted = designation of committee has to be approved by a majority of the
               entire board of directors.
       Exception: Certain decisions are so important that they can’t be made by committees: amending
          the certificate, adopting a merger agreement, selling/dissolving the biz, amending bylaws.
       Compensation Committee: decides the salaries and other compensation of corp’s officers.
          Committee must be (1) independent (outside directors only—those that aren’t also officers) and
          (2) experts or seek the advice of experts.
       Audit Committee: exercises oversight to make sure there’s no financial funny-business. At least
          one member of the committee must be a financial or accounting expert.
       Nominating Committee: selects the nominees for board positions then distributes its
          recommendations to the SH so they can vote by proxy.
    Director Election
       How it Works: nominating committee selects the nominees for the board positions and
          distributes the info to the SH (corp pays for this). Then the directors get elected at the annual SH
          meeting where the SH are allowed to vote by proxy (in advance of the mtg).
           Director election is thought to be SH most important right, but b/c they are choosing from
               nominees selected by the board it’s really not much of a choice. It’s difficult and expensive
               for SH to nominate an alternate board.
       Staggered Board: board can be divided into one, two, or three terms. This way the directors will
          hold office for more than one year with different directors up for election each year. Otherwise,
          all of the directors will be up for election each year.
           Staggered board provision can either be in the certificate (harder to change) or in the bylaws.
           Provides for continuity of the board
           Makes it harder for a hostile acquirer who’s bought a majority of the voting stock to take
               over the board
       Class-Designated Board: board can be set up so that a certain number of directors are elected by
          the holders of a certain class of stock and other directors are elected by the other class.
       Straight Voting: the bare majority of voting shares elect the directors. This is the default rule in
          Delaware.
           Under straight voting, minority SH have no representation on the board (even if they’re 49%).

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                In Delaware, can still opt in to cumulative voting, but must put it in the certificate.
            Cumulative Voting: Uses a formula to determine the number of shares needed to elect the
               desired number of directors. This is the default rule in California.
                NS = (ND * TS) / (TD + 1) + some fraction (or 1)
                    NS = shares needed to elect desired directors, ND = desired directors, TS = total shares
                        authorized to vote, TD = total number of directors to be elected.
                In California, only listed corps may opt out of cumulative voting (listed = corps whose shares
                   are listed on the NYSE, American SE or NASDAQ).
                Some say cumulative voting creates tension on the board b/c of minority representation.
          Director Removal
            Delaware Rule: any or all directors may be removed by a majority of all shares entitled to vote,
               with or without cause.
            Exceptions: (1) ―Classified‖ directors can only be removed for cause and (2) if there’s
               cumulative voting in effect, removal w/o cause must include the minority shares.
          Filling Director Vacancies
            Board Vacancy: occurs either (1) when a director is removed prior to the end of their full term or
               (2) the number of directors on the board is increased at a time other than the time of the annual
               election of directors.
            Delaware Rule for Filling a Vacancy: unless otherwise noted in certificate or bylaws, vacancies
               are filled by the remaining directors in office (not the SH). There is no quorum requirement (i.e.
               even only director left can fill all vacancies).
                Class-Designated Board: only remaining directors of the class of the removed director can
                   elect the replacement.
                Resignation: if a director resigns effective upon a future date, she may join in the decision
                   about her replacement.

IX. SHAREHOLDERS & CORPORATE GOVERNANCE
    A. SH Right of Inspection
        Intro: Generally, SH have a right to the kind of information that they would need to exercise their
          own rights (i.e. their rights to vote on fundamental corp decisions, amendments to certificate and
          election of directors). The scope of this right varies from state to state.
        Delaware: Inspections are available to SH ―of record‖.
        Other States: some states have threshold requirements (must own a threshold amount of stock to
          exercise right of inspection).
        Test: A proper (i.e. of record/threshold) SH may only inspect corp records for a ―proper purpose‖.
           Proper Purpose = ―investment purpose‖ (info that relates to making the corp more profitable).
          If the court determines that the SH wants to inspect in order to injure the corp, his right will be
          denied.
          SH must have a proper purpose, but that doesn’t have to be the SH’s only or main purpose for the
          inspection.
           Sliding Scale: if SH just wants a SH list, the threshold is lower than if the SH wants financial or
          proprietary info like trade secrets.
           In Del, if SH wants only the SH list, the burden of proof is on the corp to show that the SH’s
               purpose is improper. But if the SH is seeking other info, the burden is on the SH to prove that he
               has a proper purpose.
           Test if SH wants SH list: if SH wants list to communicate w/ other SH about issues that relate to
               investment, that’s proper. But, communications about social policy are improper.




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   B. SH Power to Initiate Action
       SH Meetings
           Calling a Meeting: there’s always an annual mtg of SH, and the formula for determining the date
            is usually in the bylaws. Most state statutes say that special SH mtgs can be called under certain
            circumstances. Del says that a special SH mtg can be called by the board or by other persons
            authorized in the certificate or bylaws.
           Notice: there must be written notice given that there’s going to be a SH mtg.
           Quorum: a quorum of voting shares must be present to take action at a SH mtg. Present means
            either in person or by proxy. Del default sets quorum as the majority of voting stock, and it cannot
            be less than 1/3 of voting stock.
           Action by Written Consent: Del rule is that if the number of shares required to pass an action if
            all voting shares were present at a mtg give their written consent to the action, it passes w/o a mtg.
       Actions that SH Can Initiate
           Vote on resolutions to endorse certain people for officer positions (SH speech)
           Vote to amend certificate (after director initiation) or bylaws
           Vote on the removal of directors (SH proxies to remove directors are only valid if the directors
              have an opportunity to defend themselves before the SH vote).
   C. Board Responses to SH Initiatives
       General Rule: Since the most important SH power is voting to elect directors, the board CANNOT
          act to restrict the SH’s powers to vote to elect directors in any way absent some very compelling
          justification (like maybe a single powerful SH with a coercive tender offer).
      *Note: It doesn’t matter if board thinks it’s acting in best interest of corp (paternalistic). If it restricts
      the SH voting power, it breaches the duty of loyalty to the SH.

X. FEDERAL PROXY RULES
   A. Introduction
       What are the FPR: they are federal SEC rules that govern the procedure w/ which the corp must
         communicate w/ the SH & SH must communicate w/ each other (b/c most SH vote by proxy).
          FPR are not supposed to alter the substantive state-law rights of the SH, just the procedural rules
             that govern communication to SH.
          B/c most SH do not attend the SH mtgs, can only get a quorum by soliciting proxies.
          Proxy: SH gives someone else the authority to vote her shares for her on the day of the mtg.
       Corps Subject to the FPR: any corp that is a reporting company (corp whose stock is traded on a
         national securities exchange or corp w/ at least 500 SH & $10 in assets)
       To What Communications the FPR Apply: to both proxy solicitations by management & SH.
   B. The Federal Proxy Rules
       General FPR: It is unlawful to solicit any proxy or consent authorization in respect to any security
         of a reporting company w/o doing everything the fed proxy rules require. (page 60)
       Solicitation = (1) any request for a proxy, or (2) any request to execute or not to execute, or to
         revoke, a proxy, or (3) furnishing of a form of proxy or other communication to the security holders
         under circumstances reasonably calculated to result in the procurement, withholding or revocation
         of a proxy.
          The third method of solicitation is the broadest and can encompass almost anything (ex: ad in the
             newspaper accusing corp’s officers of mismanagement where ad is placed by group supporting
             someone who is gonna wage a proxy contest – LILCO v. Barbash).
       Exemptions to FPR: the following have been excluded from the definition of solicitation: (1) SH
         announces in the media how she plans to vote, (2) person soliciting doesn’t seek the power to act as
         proxy or request a form of revocation, abstention, consent or authorization, or (3) solicitation is of 10
         SH or less.


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          Rules for Solicitations: if there is no exemption that applies to the solicitation, it must adhere to the
           following rules in order to be lawful:
            Disclosure: Proxy statement has to contain the info specified in schedule 14A (ex: info about
               person soliciting proxy, nominees for directors, compensation of management, etc).
            Technical Requirements: Proxy statement must adhere to all technical requirements (ex: copies
               of proxy statement must be filed with SEC at least 10 days before the material is sent to SH).
            False/Misleading Statements: No false or misleading statements about any material fact are
               allowed in the proxy statement, including omitting any material fact. Fact is material if there is a
               substantial likelihood that a reasonable SH would consider it important in deciding how to vote.
            Proxy Contests: during proxy contests for election/removal of directors, corp can reject SH
               proposal that relates to election/removal of directors. This means that anyone who wants to offer
               alternative nominees has to mount a full-scale proxy contest at their own cost. They must also
               satisfy all SEC disclosure and filing requirements.
            SH Proposals: typically relates to either (1) corp governance or (2) public policy (activist SH).
                Rule: corp must include the eligible SH proposal in its proxy statement and form of proxy.
                Eligibility Requirements: (1) SH must be a record or beneficial owner of at least 1% or
                   $2000 of the securities entitled to vote; (2) SH must have held the securities for at least one
                   year and hold them thru the date of the SH mtg.
                Procedural Requirements: (1) SH or his rep must personally attend the mtg to present the
                   proposal; (2) proposal must be submitted at least 120 days before the corp’s proxy statement
                   is released; (3) proponent can only submit one proposal each year; (4) proposal plus
                   supporting statement can’t be more than 500 words.
                   *Note: management can include a statement in opposition to the SH proposal.
                Excluding SH Proposal: if corp wants to exclude the SH proposal, it must file a copy of the
                   proposal with the SEC along with an explanation of why it wants to omit it from the proxy
                   materials. There are only 13 statutory exclusions that a corp can use. If the SEC agrees w/
                   the corp, it will issue a ―no-action letter.‖ Most Important Exclusions:
                   1) Proposal is not a proper subject for action by SH under the laws of the state of incorp
                   2) Proposal relates to operations which account for less than 5 % of corp’s total assets and
                        less than 5 % of net earnings and gross sales and is not otherwise significantly related to
                        the corp’s biz.
                   3) Proposal concerns a matter pertaining to the ordinary biz operations of the corp.
                   4) Proposal would require corp to break the law
                   5) Proposal violates the proxy rules
                Challenging Exclusion of SH Proposal: SH have a private right of action to challenge the
                   corp’s omission of the proposal.
               *Note: even if a SH proposal is not approved by the SH, it can still be an effective public
               relations tool (especially if it highlights corp’s policy in the media).

XI. DIRECTOR DUTIES
    A. Introduction
        Director Fiduciary Duties: corp law protects SH from mismanagement by directors caused by either
          laziness (duty of care) or selfishness (duty of loyalty/good faith).
           Courts differ on whether there are only 2 duties (care & loyalty) or 3 duties (care, loyalty, good
              faith). Some say that good faith is subsumed w/in the duty of loyalty.
        Elements of Fiduciary Duty Case: Director is liable if (1) director had a duty to the plaintiffs, (2)
          director breached that duty, and (3) breach was the proximate cause of plaintiff’s loss.
        Who has the Duties: all directors of a corp have fiduciary duty of care to the SH. There’s no such
          thing as a director in name only (or a dummy director) – Francis v. United Jersey Bank.


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     Who the Duties Run To: generally, director fiduciary duties run to the SH. The two exceptions are
      (1) if the corp is on the brink of insolvency, then the duties run to the creditors; (2) nature of biz is
      such that the corp handles large amounts of money as a fiduciary for its clients, then duties run to
      clients/creditors of the corp.
       Insolvency: when a company is on the brink of insolvency the duties of the directors (care, good
          faith, loyalty) that normally run to the SH shift to the creditors (Credit-Leonase Case).
    SH Derivative Suit: when SH sue directors on behalf of the corp for breach of fiduciary duties.
      Procedurally, to bring suit SH must first either (1) make a pre-suit demand to the directors to sue on
      behalf of the corp or (2) SH must plead that if they had made that demand it would have been futile.
    Remedy for Breach: if a director breaches any of his fiduciary duties, he can be held personally liable.
       Exception: if corp has a 102(b)(7) provision in the certificate, directors cannot be held liable for
          damages for breach of the duty of care. However, they can still be liable for damages for the
          breach of loyalty or good faith, and SH can still get an injunction for breach of care.
B. Business Judgment Rule
    Intro: the BJR is applied to director fiduciary duty cases to protect against the danger of hindsight.
    Rule: the court applies a presumption that the board of directors acted consistently with their duties:
      (1) Plaintiff must demonstrate that the process/procedure the board used to make its decision was
      bad; (2) (a) if P fails to rebut the presumption, the board wins. The court will never look to the
      substance of the decision, but (b) if P shows that the process used was bad, the burden shifts to the
      board to prove that their decision was inherently fair.
       Factors for Process/Procedure: whether board deliberated, whether board looked at all of the
          facts they needed to be well-informed
C. Duty of Care
    Rule: Duty of care requires that a director generally monitor the corp’s affairs and policies. This
      includes a duty to act (i.e. director can be held liable for failing to make important corp decisions or
      for failing to adequately monitor what’s going on). Duties arises w/ both ACTS & OMISSIONS.
       Level of Care: Care that an ordinary prudent director would use under the circumstances.
       Fixing a Problem: once a director finds out that something is wrong, he has an affirmative duty
          to try to fix the problem (just resigning won’t absolve him of liability).
    Application of BJR to Duty of Care Cases: SH can rebut the BJR presumption by showing that the
      board was grossly negligent in the procedure they used to make their decision. If SH are successful
      and burden shifts to directors to show inherent fairness of the decision, board will probably lose.
       Factors Showing Gross Negligence: no informed basis for making decision (i.e. no study done to
          determine share price for merger agreement); board doesn’t have sufficient time to make
          informed decision & doesn’t ask for extension; board votes on agreement w/o actually reading it
          (Smith v. Van Gorkom).
       Officer Reports: directors are fully protected in relying in good faith on reports made by officers
       Effect of SH Vote: board cannot delegate its decision-making authority to the SH (i.e. just b/c
          SH vote in favor of a decision doesn’t mean directors won’t be liable for breach of duty of care).
       Proving Inherent Fairness: once P rebuts presumption and D loses protection of the BJR, D must
          prove that the decision was intrinsically fair: (1) fair dealing and (2) fair price.
           Fair Dealing: how transaction was timed, initiated, structured, negotiated, and disclosed.
           Fair Price: whether price of the biz was fair (ct can use any well-respected method of
               valuation to value the biz).
          *Note: once the directors lose the BJR presumption, they’re going to lose b/c it’s nearly
          impossible to show fair dealing when the court has already determined that the process was bad.
    Hostile Bidder Situations: there is an enhanced duty of care if the board adopts defensive measures
      to fend off a hostile bidder: (1) board must conduct a good faith, reasonable investigation (of the
      threat posed by the offer), and (2) BJR only applies if the measures taken are reasonable in relation
      to the threat posed.
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       Threat Posed by Hostile Bidder: either (1) inadequate price or (2) total breakup of the company.
       Example of Defensive Measures: Poison Pill – board issues bonds to SH for sale of their shares
          (worth $50) that turn into bonds (worth $70) if the hostile bidder takes control. Board will take
          away the poison pill if it finds a white knight to make a good offer.
       When Change is Inevitable: when breakup or change of control of the corp is inevitable (ex:
          hostile bidder says it will match any price of another bidder), then the duty of the board changes
          from defenders of the in-tact corp to auctioneers charged with getting the best price for the stock.
    Effect of 102(b)(7) Provision in Certificate: in order to lower premiums on director/officer liability
      insurance, it’s common for corp’s to put a 102(b)(7) provision in the certificate. This provision
      prevents plaintiff from getting damages from directors/officers who breach the duty of care.
       To Get Damages: If there’s a 102(b)(7) provision, plaintiff will have to characterize the lawsuit
          as a breach of loyalty claim if she wants damages. Omission can be both care & loyalty breach.
D. Duty of Loyalty
    Rule: duty of loyalty is breached when (1) directors intentionally act w/ a purpose that goes against
      the best interests of the corp; or (2) directors consciously violate the law; or (3) directors fail to act in
      the face of a known duty to act that demonstrates a conscious disregard for that duty.
       Loyalty Cases: (a) Directors act to restrict the SH vote (Blasius); (b) Directors fail to adequately
          monitor (Stone v. Ritter); (c) Interested Director Transactions; (d) Corp Opportunity.
    Duty of Good Faith: some courts view this duty as separate, while others view it as subsumed w/in
      the duty of loyalty (ex: director breaches duty of good faith when failing to adequately monitor corp
      activity (Caremark claim) which breaches duty of loyalty to SH).
    Director Oversight Liability: when there are no red flags: (1) directors utterly failed to implement
      any reporting or information system or controls; or (2) having implemented such a system or
      controls, consciously failed to monitor or oversee its operations thus disabling themselves from
      being informed of risks or problems requiring their attention (Caremark standard).
       When there are Red Flags: directors have a heightened duty to monitor the source of the red flag.
       If the board properly oversees (either under Caremark or w/ heightened duty), the court will not
          second guess the board’s decisions (BJR – proper process was used).
    Interested Director Transactions: breach of loyalty has to do with director self-dealing occurring
      when the director is on both sides of the transaction. The law here is very statutory.
       Delaware: No contract/transaction btwn a corp and one or more of its directors/officers…shall be
          void solely for this reason, if (1) the material facts as to the interested transaction are known to
          the board or committee and they in good faith authorize the contract/transaction by a majority
          vote of the disinterested directors or (2) the material facts as to the interested transaction are
          disclosed to the voting SH and the transaction is approved in good faith by a vote of the SH or (3)
          the transaction is fair to the corp as of the time it is authorized.
           Strict compliance with the statute may not bar the court from looking at the substantive
              fairness of the interested transaction. It doesn’t even shift the burden to the plaintiffs on the
              fairness issue (Fliegler v. Lawrence).
           Supercompliance with statute (by either disinterested director vote or disinterested SH vote)
              invokes BJR and judicial review is limited to issues of gift or waste (Marciano v. Nakash).
           3 Approaches if there’s Supercompliance: (1) test for fairness & directors have burden of
              proof, or (2) test for fairness and SH have burden, or (3) directors get BJR protection.
           Directors will argue third approach (with second as fall-back). SH will argue first approach.
       California: No transaction btwn a corp and its directors…is void if (1) the material facts as to the
          transaction and as to such director’s interest are fully disclosed or known to the SH and such
          contract/transaction is approved by the SH in good faith, with the shares own by the interested
          director not being entitled to vote, or (2) the material facts as to the transaction and as to such
          director’s interest are filly disclosed or known to the board or committee and the
          board/committee authorized the contract/transaction in good faith by a vote sufficient w/o

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              counting the vote of the interested director and the contract/transaction is just and reasonable as
              to the corp at the time it’s authorized or (3) if transaction isn’t approved under (1) or (2), the
              person asserting the validity of the transaction must prove that it was just and reasonable to the
              corp at the time it was authorized.
               It’s unclear whether a court may look to the substantive fairness of the interested transaction
                  if the statue has been technically complied with (i.e. if either disinterested directors or
                  disinterested SH vote). General consensus is that technical compliance is enough.
               3 Approaches: (1) test for fairness & directors have burden of proof, or (2) test for fairness
                  and SH have burden, or (3) directors get BJR protection.
               Directors will argue third approach (with second as fall-back). SH will argue first approach.
          Corporate Opportunity: breach of loyalty has to do with a third party offering the corp an
           opportunity that the director takes for himself. Law here is combo of CL and statute
            Test: (1) the biz opportunity was a corporate opportunity (CL) and (2) director/officer breached
              his duty of loyalty by taking the corporate opportunity (statutory).
            Corporate Opportunity: 3 tests:
              1. Interest or Expectancy Test: A corp opportunity is a biz opportunity in which the corp has
                  an interest or expectancy or which is essential to the corp. One of more common tests.
                   Interest – director takes an opportunity that the corp may be interested in (ex: corp’s
                       headquarters are cramped and director gets offered a great piece of real estate nearby).
                       However, cts generally need some indication that the corp was interested in the specific
                       type of opportunity (ex: something in corp minutes about wanting to buy more land).
                   Expectancy – further along than interest. Corp is actively negotiating the deal and in the
                       11th hour the director comes in and takes the opportunity for himself.
              2. Line of Business Test: broader than interest or expectancy test. Biz opportunity is somehow
                  related to the corp’s type of business. Takes into account corp’s realistic, future needs.
              3. Fairness Test: minority test b/c it’s the hardest to apply. Looks to whether what the corp
                  fiduciary did was fair to the corporation.
              *Note: Del applies either the first or second test. Most jurisdictions apply either of the first 2
              tests or some combo of the 3.
              *Note: passive investments aren’t considered corp opportunities
            Breach of Duty: Director breaches duty of loyalty if the opportunity was not fully disclosed to
              the corp and/or the corp didn’t make an informed decision to reject the opportunity first.
              *Note: Del statute gives corp the power to renounce the protections of the biz opp doctrine in
              either the certificate or the bylaws, or corp can specify what types of opps aren’t allowed.
            Defenses (vary by jurisd): (1) if opp was presented to the director is his individual capacity; (2)
              corp is incapable of taking the opp (ex: corp is insolvent); (3) disinterested board or disinterested
              SH vote to reject opportunity after full disclosure.
            Remedies: standard remedy is the imposition of a constructive trust. All income generated by
              the corp opportunity flows from the director (as trustee) to the corp (as beneficiary).

XII. INSIDER TRADING
   A. Introduction
       Insider Trading Law: it’s principally federal securities law (promulgated by the SEC). Some states
         do have their own version of insider trading laws that involve fraud or deceit (narrower than 10b-5).
       California Insider Trading Law: It’s unlawful for anybody with access to material nonpublic info to
         purchase or sell any security of the issuer at a time when he knows material info that would
         significantly affect the market price.
          Remedies: damages for investors who bought/sold securities from the defendant and treble
             damages plus attorney’s fees for the issuer.


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       Jurisdiction: applies to purchase/sale of securities in California, even if issuer is incorporated in
          another state.
    Delaware: no express insider trading law.
B. Rule 10b-5
    Intro: Rule 10b-5 comes from SEC pronouncement promulgated under fed securities act.
    Elements
      1. Interstate Commerce: D used any means or instrumentality of interstate commerce, mails, or any
          facility of a national securities exchange (this element is usually not an issue).
      2. In Connection With the Purchase/Sale of a Security: deception was connected with the
          purchase/sale of a security (also not really an issue).
      3. Material Misinformation: D either affirmatively misrepresented a material fact, or failed to state
          a fact that made his statement misleading, or remained silent in the face of a fiduciary duty to
          disclose a material fact. This is the big element.
           Materiality: a fact is material if a reasonable investor would consider it as altering the total
              mix of information in deciding whether to buy or sell.
           Deception: there must be deception to violate 10b-5, substantially unfair isn’t enough.
      4. Scienter: D knew or was reckless in not knowing of the misrep and intended the P to rely on the
          misrep (negligence is not enough).
      5. Reliance: P relied on the misrep. Cts presume this element where there is a public trading of
          stock (―fraud on the market presumption.‖ D can rebut presumption by showing (1) misrep had
          no effect on the stock’s trading price or (2) P investor would have traded even absent the misrep.
      6. Causation: P suffered actual damages as a result.
C. Classic Insider Trading
    Intro: classic insider trading theory is used to satisfy third element of a 10b-5 claim.
    Rule: D is a corp insider who has a duty to the SH to abstain or disclose the material nonpublic info.
    Constructive Insider: outsiders retained to work for the corp, such as accountants, lawyers, and
      investment bankers (professionals), may become constructive insiders as a result of entering into a
      relationship of trust and confidence w/ the corp and receiving nonpublic info.
    Tippee Liability: tippee assumes the insider’s fiduciary duty to SH if (1) the insider breached his
      duty to the SH by disclosing the info to the tippee and (2) the tippee knew or should have known that
      there was a breach.
       Insider Breached Duty: first element is satisfied if insider benefited personally, directly or
          indirectly, from disclosing the info to the tippee
           Breaches Duty: insider gives info to tippee as a gift
           Doesn’t Breach Duty: insider tells tippee info so he can investigate the problem or third
              party eavesdrops on insider’s private conversation (so disclosure wasn’t intentional).
D. Outsider Misappropriation
    Intro: outsider misappropriation theory is used to satisfy third element of a 10b-5 claim.
    Rule: D’s a corp outsider who has a duty to source of material nonpublic info to abstain or disclose.
       ―A person violates 10b-5 when he misappropriates material nonpublic info in breach of a
          fiduciary duty or similar relationship of trust and confidence and uses that info in a securities
          transaction or passes it on to a tippee who trades on it.‖
       Duty to the Source of the Info: there must be a relationship of trust and confidence. Mere family
          relationship, by itself, won’t be enough to create a duty (Chestman). However, a family
          relationship w/ a history of repeated disclosure of biz secrets will create the duty (Reed).
           New Rule 10b5-2: a person receiving material nonpublic info under any of the following
              circumstances owes a duty of confidence, and thus can be liable under the misappropriation
              theory if she trades on the basis of such info: (1) recipient agreed to keep info secret; (2)
              people involved in communication have a history, pattern or practice of sharing secrets; (3)
              communicator of info was a spouse, parent, child or sibling, unless recipient can show that
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                 there as no reasonable expectation of confidentiality (undoes Chestman). This is an SEC
                 announcement. It isn’t law unless a court determines it’s a valid SEC promulgation.
      Tippee Liability: tippee assumes the misappropriator’s duty to the source of the info if (1) the
        misappropriator has breached his duty to the source of the info by disclosing the info to the tippee
        and (2) the tippee knew or should have known there has been a breach of the duty.
E.   Statute of Limitations: 10b-5 action must be brought w/in 3 years after the challenged violation and 1
     year after the discovery of the facts constituting the violation.
F.   Remedies
      Who Can Sue: both SEC and private parties may bring civil actions and the justice dept may bring a
        criminal action.
      Remedies: rescission (unwind transaction), disgorgement damages, out-of-pocket damages, civil
        penalties (but no punitives), criminal penalties (including fines and prison), censure (SEC prevents D
        from working in the securities industry).
G.   Rule 14e-3
      Rule: during the course of a tender offer, anyone (other than the bidder) who has material nonpublic
        info about the tender offer is prohibited from trading if he knows or has reason to know that the info
        was obtained from the bidder or the target.
         There’s no duty req’mt. If D knew conf’y info related to tender offer and traded, he’s guilty.
H.   Section 16(b)
      Intro: this is a mechanical rule that serves as a trap for the uninformed.
      Rule: Officers, directors, and ―10% SH‖ must disgorge to the corp any profits they make by
        purchasing and selling the corp’s stock during a 6-month period.
      When the Rule Applies: applies to the stock of a ―reporting corp‖
      How the Rule Works: look to see if there’s a profit from matching any purchase by the insider with
        any sale by the same insider w/in a 6-month period. The purchase doesn’t have to precede the sale.
        If there’s any profit, the insider must return it to the corp.
     *Note: this rule can also apply along with 10b-5 if the trades occurred w/in a 6-month period.




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