Business Associations Fall 2010 Fendler Outline by JoshuaCollums

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                                          B USINESS A SSOCIATIONS
                                         Fall 2010/Prof. Fendler/Joshua R. Collums
                              Business Associations (7th Ed.) by Klein, Ramseyer & Bainbridge

C H A PTER O N E : A G EN CY
I.       W ho is an Agent?
         A.        Restatement (Third) of Agency § 1.01 Agency Defined
                   Agency is the fiduciary relationship that arises when one person (a “principal”) manifest’s assent to another
                   person (an “agent”) that the agent shall act on the principal’s behalf and subject to the principal’s control, and
                   the agent manifests assent or otherwise consents so to act.
         B.        Restatement (Third) of Agency § 1.02 Parties’ Labeling and Popular Usage Not
                   Controlling
                   An agency relationship arises only when the elements stated in § 1.01 are present. W hether a relationship is
                   characterized as agency in an agreement between parties or in the context or industry or popular usage is not
                   controlling.
         C.        Restatement (Third) of Agency § 1.03 Manifestation
                   A person manifests assent or intention through written or spoken words or other conduct.
         D.        Gorton v. Doty (Idaho 1937)
                   1.         Issue. W as the coach, Garst, the agent of appellant while and in driving her car from Soda
                              Springs to Paris, and in returning to the point where the accident occurred?
                   2.         Broadly speaking, “agency” indicates the relation which exists where one person acts for
                              another. It has these three principal forms:
                              a.         The relation of the principal and agent.
                              b.         The relation of master and servant; and
                              c.         The relation of employer or proprietor and independent contract.
                   3.         Agency. The relationship which results from the manifestation of consent by one person to
                              another that the other shall act on his behalf and subject to his control, and consent by the
                              other so to act.
                              a.         Manifestation of consent by P that A will act:
                                         (1)       On P’s behalf
                                         (2)       Subject to P’s Control
                              b.         A’s consent so to act.
                   4.         This court has not held that the relationship of principal and agent must necessarily involve
                              some matter of business, but only that where one undertakes to transact some business or
                              manage some affair for another by authority and on account of the latter, the relationship
                              of principal and agent arises.
                   5.         Appellant could have driven car herself. Instead, she designated the driver (Garst) and, in
                              doing so, made it a condition precedent that the person she designated should drive her
                              car.
                              a.         Appellant consented that Garst should act for her and in her behalf, in driving her
                                         car to and from the game from her act in volunteering the use of her car upon the
                                         express condition that he should drive it.
                              b.         Garst consented to so act for the appellant by driving the car.
                   6.         It is not essential to the existence of authority that there be a contract between principal
                              and agent or that the agent promise to act as such, nor is it essential to the relationship or
                              principal and agent that they, or either, receive compensation.
                              a.         There must be an agreement but it does not necessarily have to rise to the level of
                                         a legal contract.
                   7.         The fact of ownership alone, regardless of the presence or absence of the owner in the car
                              at the time of the accident, establishes a prima facie case against the owner for the reason




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                             that the presumption arises that the driver is the agent of the owner. 1
                     8.      Dissenting Opinion.
                             a.         An agent is one who acts for another by authority from him, one who undertakes
                                        to transact business or manage some affair for another by authority and on
                                        account of the latter. Agency means more than mere passive permission. It
                                        involves a request, instruction or command.
         E.          A. Gay Jenson Farms Co. v. Cargill, Inc. (Minn. 1981) (Lender Liability)
                     1.      Plaintiffs Argument. Plaintiffs alleged that Cargill was jointly liable for W arren’s indebtedness
                             as it had acted as principal for the grain elevator.
                     2.      Issue. W hether Cargill, by its course of dealing with W arren, became liable as principal on
                             contracts made by W arren with plaintiffs.
                     3.      Rule. Agency is the fiduciary relationship that results from the manifestation of consent by
                             one person to another that the other shall act on his behalf and subject to his control, and
                             consent by the other so to act.
                             a.         In order to create an agency, there must be an agreement, but not necessarily a
                                        contract between the parties.
                                        (1)       An agreement may result in the creation of an agency relationship
                                                  although the parties did not call it an agency and did not intend the legal
                                                  consequences of the relation to follow.
                             b.         The existence of the agency may be proved by circumstantial evidence which
                                        shows a course of dealing between the two parties.
                                        (1)       W hen an agency relationship is to be proven by circumstantial evidence,
                                                  the principal must be shown to have consented to the agency since one
                                                  cannot be the agent of another except by consent of the latter.
                     4.      Creditor/Debtor. A creditor who assumes control of his debtor’s business may become
                             liable as principal for the acts of the debtor in connection with the business. 2
                             a.         Security holder’s mere veto power v. Becoming a principal. 3
                     5.      Buyer/Supplier v. Principal/Agent
                             a.         One who contracts to acquire property from a third person and convey it to
                                        another is the agent of the other only if it is agreed that he is to act primarily for
                                        the benefit of the other and not for himself.
                                        (1)       Factors indicating that one is a supplier, rather than an agent, are 4:
                                                  (a)       That he is to receive a fixed price for the property irrespective
                                                            of price paid to him. This is the most important.
                                                  (b)       That he acts in his own name and receives title to the property
                                                            which he thereafter is to transfer.



         1
              W illi v. Schaefer Hitchcock Co. (Idaho 1933).

        2
          A creditor who assumed control of his debtor’s business for the mutual benefit of himself and his debtor
may become a principal, with liability for the acts and transactions of the debtor in connection with the business.
Restatement (Second) of Agency § 14 O.

        3
             “A security holder who merely exercises a veto power over the business acts of his debtor by
preventing purchases or sales above specified amounts does not thereby become a principal. However, if he takes
over the management of the debtor’s business either in person or through an agent, and directs what contracts may or
may not be made, he becomes a principal, liable as a principal for the obligations incurred thereafter in the normal
course of business by the debtor who has now become his general agent. The point at which the creditor becomes a
principal is that at which he assumes de facto control over the conduct of his debtor, whatever the terms of the formal
contract with his debtor may be. Id., cmt. a.

         4
              Id., § 14 K, cmt. a.

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                                             (c)         That he has an independent business in buying and selling
                                                         similar property.
II.   Liability of Principal to Third Parties in Contracts
      A.        The Agent’s Authority
                1.        2 Broad Classifications of Power 5
                          a.        Actual (Real) – arises from the manifestation of consent from the principal to the
                                    agent (not to a third person) that the agent should act for the principal.
                                    (1)       Express Authority – actual authority contained within the “four corners”
                                              of the agency agreement between the principal and the agent, i.e.,
                                              authority expressly granted by the principal to the agent.
                                    (2)       Implied Authority – An agent’s authority includes not only the authority
                                              expressly granted by the principal to the agent, but also any authority
                                              implied by the agent from the words or conduct between the principal
                                              and the agent.
                          b.        Apparent (Ostensible) – a principal will be bound by his agent’s unauthorized acts
                                    if the principal has manifested to a third party, through words or conduct, that the
                                    agent has authority, and the third party reasonably believes on this manifestation.
                                    (1)       An agent cannot create apparent authority by his own manifestations.
                                              The manifestations must be from the principal to the third party.
                                              (Conduct and silence can be a manifestation from the principal).
                                              (a)        Exception. If the principal gives the agent express authority to
                                                         tell third parties that he has authority.
                2.        Mill Street Church of Christ v. Hogan (Ky. 1990) (Implied Authority)
                          a.        Implied v. Apparent Authority. Implied authority is actual authority circumstantially
                                    proven which the principal actually intended the agent to possess and includes
                                    such powers as are practically necessary to carry out the duties actually delegated.
                                    Apparent authority on the other hand is not actual authority but is the authority
                                    the agent is held out by the principal as possessing. It is a matter of appearance on
                                    which third parties come to rely.
                                    (1)       Implied Authority Rule. In examining whether implied authority exists, it
                                              is important to focus upon the agent’s understanding of his authority. It
                                              must be determined whether the agent reasonably believes because of
                                              present or past conduct of the principal that the principal wishes him to
                                              act in a certain way or to have certain authority.
                                              (a)        Nature of task/job. The nature of the task or job may be
                                                         another factor to consider. Implied authority may be necessary
                                                         to implement the express authority.
                                              (b)        Prior similar practices. The existence of prior similar practices is
                                                         one of the most important factors. Specific conduct by the
                                                         principal in the past permitting the agent to exercise similar
                                                         powers is crucial.
                          b.        Burden/Standard of Proof. The person alleging agency and resulting authority has
                                    the burden of proving that it exists. Agency cannot be proven by a mere
                                    statement, but it can be established by circumstantial evidence including the acts
                                    and conduct of the parties such as the continuous course of conduct of the parties
                                    covering a number of successive transactions.
                          c.        Subagent. One agent appoints someone else who will also be an agent of the
                                    principal.
                                    (1)       W hen a principal engages an agent to perform a task, the principal has in
                                              effect delegated the task to the agent. If the agent, acting with authority,
                                              in turn delegates part of all of that task to an agent of its own, then the


      5
          The power to bind is equal. The principal is equally bound whether based on actual or apparent authority.

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                                                   second agent becomes a subagent of the original principal.
                  3.       Power of Position. Sometimes the principal’s sole manifestation to the third party may be to
                           put an agent in a particular role. In light of local custom and standard business practices,
                           that role may by itself cause a third party to believe reasonably that the agent has certain
                           authority.
                  4.       Highland Capital Management, LP v. Schneider (2d Cir. 2010).
                           a.          An agent must have authority, whether apparent, actual or implied, to bind his
                                       principal.
                           b.          Actual Authority
                                       (1)         Under New York law, an agent has actual authority if the principal has
                                                   granted the agent the power to enter into contracts on the principal’s
                                                   behalf, subject to whatever limitations the principal places on this power,
                                                   either explicitly or implicitly. 6
                           c.          Apparent Authority
                                       (1)         W here an agent lacks actual authority, he may nonetheless bind his
                                                   principal to a contract if the principal has created the appearance of
                                                   authority, leading the other contracting party to reasonably believe that
                                                   actual authority exists.
                                       (2)         Apparent authority exists when a principal, either intentionally or by
                                                   lack of ordinary care, induces a third party to believe that an individual
                                                   has been authorized to act on its behalf.
                                       (3)         Essential to the creation of apparent authority are words or conduct of
                                                   the principal, communicated to a third party, that give rise to the
                                                   appearance and belief that the agent possesses authority to enter into a
                                                   transaction.
                                       (4)         However, the mere creation of an agency does not automatically invest
                                                   the agent with ‘apparent authority’ to bind the principal without
                                                   limitation. A party cannot claim that an agent acted with apparent
                                                   authority when it knew, or should have known that the agent was
                                                   exceeding the scope of its authority.
                  5.       W atteau v. Fenwick (Q.B. 1892) (Inherent Agency Power).
                           a.          Once it is established that the defendant was the real principal, the ordinary
                                       doctrine as to principal and agent applies that the principle is liable for all the acts
                                       of the agent which are within the authority usually confided to an agent of that
                                       character, notwithstanding limitation.
                                       (1)         It is said that it is only so where there has been a holding out of
                                                   authority–which cannot be said of a case where the person supplying the
                                                   goods knew nothing of the existence of a principal. But I do not think
                                                   so. Otherwise, in every case of undisclosed principal, or at least in every
                                                   case where the fact of there being a principal was undisclosed, the secret
                                                   limitation of authority would prevail and defeat the action of the person
                                                   dealing with the agent and then discovering that he was an agent and
                                                   had a principal.
                  6.       Inherent Agency Power. In some situations, an agent has neither actual nor apparent
                           authority, and estoppel does not apply. Yet the agent’s position creates the potential for
                           mischief with third parties. To deal with such situations (and others as well), the R.2d and
                           some courts use the doctrine of inherent agency power. The doctrine imposes enterprise
                           liability; that is, it places the loss on the enterprise that stands to benefit from the agency


         6
            Actual authority is created by direct manifestations from the principal to the agent, and the extent of
the agent’s actual authority is interpreted in light of all circumstances attending those manifestations, including the
customs of business, the subject matter, any formal agreement between the parties, and the facts of which both parties
are aware.

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               relationship.
     7.        Restatement (Second) of Agency § 8A. Inherent Agency Power.
               Inherent agency power is a term used in the restatement of this subject to indicate the power of an
               agent which is not derived from authority, apparent authority or estoppel, but solely from the agency
               relation and exists for the protection of persons harmed by or dealing with a servant or other agent.
     8.        Restatement (Second) of Agency § 194 states that an undisclosed principal is liable for acts
               of an agent “done on his account, if usual or necessary in such transactions, although
               forbidden by the principal.”
     9.        Under the Restatement (Second) of Agency § 195, “An undisclosed principal who entrusts
               an agent with the management of his business is subject to liability to third persons with
               whom the agent enters into transactions usual in such business and on the principal’s
               account, although contrary to the directions of the principal.”
     10.       The Restatement (Third) of Agency rejected the concept of inherent agency power in
               favor of a rule directly targeted at cases like W atteau:
               a.         Restatement (Third) of Agency § 2.06. Liability of Undisclosed
                          Principal.
                          (1) An undisclosed principal is subject to liability to a third party who is justifiably induced
                          to make a detrimental change in position by an agent acting on the principal’s behalf and
                          without actual authority if the principal, having notice of the agent’s conduct and that it
                          might induce others to change their positions, did not take reasonable steps to notify them of
                          the facts.
                          (2) An undisclosed principal may not rely on instructions given an agent that qualify or
                          reduce the agent’s authority to less than the authority a third party would reasonably believe
                          the agent to have under the same circumstances if the principal had been disclosed.
B.   Ratification
     1.        Ratification. Occurs when a principal affirms a previously unauthorized act. Ratification
               validates the original unauthorized act and produces the same legal consequences as if the
               original act had been authorized.
               a.         Ratification can take place in the following ways:
                          (1)        Expressly
                          (2)        Implied > Accept benefits
                          (3)        Implied > Silence/Inaction
                          (4)        Lawsuit to enforce the contract
               b.         Ratification is an “all or nothing” principle.
     2.        Restatement (Third) of Agency § 4.01. Ratification Defined.
               (1) Ratification is the affirmance of a prior act done by another, whereby the act is given effect as if
               done by an agent acting with actual authority.
               (2) A person ratifies an act by
                          (a) manifesting assent that the act shall affect the person's legal relations, or
                          (b) conduct that justifies a reasonable assumption that the person so consents.
               (3) Ratification does not occur unless
                          (a) the act is ratifiable as stated in § 4.03,
                          (b) the person ratifying has capacity as stated in § 4.04,
                          (c) the ratification is timely as stated in § 4.05, and
                          (d) the ratification encompasses the act in its entirety as stated in § 4.07.
     3.        Botticello v. Stefanovicz (Conn. 1979).
               a.         Agency is defined as “the fiduciary relationship which results from manifestation
                          of consent by one person to another that the other shall act on his behalf and
                          subject to his control, and consent by the other so to act....” Restatement
                          (Second) of Agency § 1.
                          (1)        Three elements required to show the existence of an agency
                                     relationship:
                                     (a)         a manifestation by the principal that the agent will act for him;
                                     (b)         acceptance by the agent of the undertaking; and

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                                  (c)        an understanding between the parties that the principal will be
                                             in control of the undertaking.
              b.        The existence of an agency relationship is a question of fact.
                        (1)       Marriage =/= Agency. Marital status cannot in and of itself prove the
                                  agency relationship. The fact that one spouse tends more to business
                                  matters than the other does not, absent other evidence of agreement or
                                  authorization, constitute delegation of power as to an agent.
              c.        Ratification is defined as “the affirmance by a person of a prior act which did not
                        bind him but which was done or professedly done on his account. Restatement
                        (Second) § 82.
                        (1)       Ratification requires “acceptance of the results of the act with an intent
                                  to ratify, and with full knowledge of all the material circumstances.”
                        (2)       Before the receipt of benefits may constitute ratification, the other
                                  requisites for ratification must first be present. Thus, if the original
                                  transaction was not purported to be done on account of the principal,
                                  the fact that the principal receives its proceeds does not make him a
                                  party to it. Restatement (Second) of Agency § 98, comment f.
                                  (a)        W alter at no time purported to be acting on his wife’s behalf, as
                                             is essential to effective subsequent ratification, and Mary is not
                                             bound by the terms of the agreement, and specific performance
                                             cannot be ordered as to her.
     4.       Ratification is a means by which the principal can say, “my agent didn’t have the right to
              enter into this contract, but I’m glad she did so. Accordingly, I’ll affirm the transaction
              and agree to be bound by the contract.”
C.   Estoppel
     1.       Hoddeson v. Koos Bros. (N.J. 1957).
              a.      The liability of a principal to third parties for the acts of an agent may be shown
                      by proof disclosing:
                      (1)       express or real authority which been definitely granted.
                      (2)       implied authority, that is, to do all that is proper, customarily incidental
                                and reasonably appropriate to the exercise of the authority granted; and
                      (3)       apparent authority, such as where the principal by words, conduct, or
                                other indicative manifestations has “held out” the person to be his agent.
                                (a)        General rule that the apparency and appearance of authority
                                           must be shown to have been created by the manifestations of
                                           the alleged principal, and not alone and solely by proof of those
                                           of the supposed agent.
                                (b)        Assuredly the law cannot permit apparent authority to be
                                           established by the mere proof that a mountebank in fact
                                           exercised it.
              b.      Broadly stated, the duty of the proprietor also encircles the exercise of reasonable
                      care and vigilance to protect the customer from loss occasioned by the deceptions
                      of an apparent salesman.
                      (1)       The rule that those who bargain without inquiry with an apparent agent
                                do so at the risk and peril of an absence of the agent’s authority has a
                                patently impracticable application to the customers who patronize our
                                modern department stores.
                      (2)       Our concept of modern law is that where a proprietor of a place of
                                business by his dereliction of duty enables one who is not his agent
                                conspicuously to act as such and ostensibly to transact the proprietor’s
                                business with a patron in the establishment, the appearances being of
                                such a character as to lead a person of ordinary prudence and circumspection to
                                believe that the impostor was in truth the proprietor’s agent, in such
                                circumstances the law will not permit the proprietor defensively to avail

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                                                   himself of the impostor’s lack of authority and thus escape liability for
                                                   the consequential loss thereby sustained by the customer.
                  2.       Restatement (Third) of Agency § 2.05. Estoppel to Deny Existence of Agency
                           Relationship.
                           A person who has not made a manifestation that an actor has authority as an agent and who is not
                           otherwise liable as a party to a transaction purportedly done by the actor on that person's account is
                           subject to liability to a third party who justifiably is induced to make a detrimental change in position
                           because the transaction is believed to be on the person's account, if
                                      (1) the person intentionally or carelessly caused such belief, or
                                      (2) having notice of such belief and that it might induce others to change their positions, the
                                      person did not take reasonable steps to notify them of the facts.
         D.       Agent’s Liability on the Contract
                  1.       Restatement (Third) of Agency § 6.01. Agent for Disclosed Principal.
                           W hen an agent acting with actual or apparent authority makes a contract on behalf of a disclosed
                           principal,
                                      (1) the principal and the third party are parties to the contract; and
                                      (2) the agent is not a party to the contract unless the agent and third party agree otherwise.
                  2.       Restatement (Third) of Agency § 6.02. Agent for Unidentified Principal.
                           W hen an agent acting with actual or apparent authority makes a contract on behalf of an unidentified
                           principal,
                                      (1) the principal and the third party are parties to the contract; and
                                      (2) the agent is a party to the contract unless the agent and the third party agree otherwise.
                  3.       Restatement (Third) of Agency § 6.03. Agent for Undisclosed Principal.
                           W hen an agent acting with actual authority makes a contract on behalf of an undisclosed principal,
                                      (1) unless excluded by the contract, the principal is a party to the contract;
                                      (2) the agent and the third party are parties to the contract; and
                                      (3) the principal, if a party to the contract, and the third party have the same rights,
                                      liabilities, and defenses against each other as if the principal made the contract personally,
                                      subject to §§ 6.05–6.09.
                  4.       Restatement (Third) of Agency § 6.10. Agent’s Implied W arranty of Authority.
                           A person who purports to make a contract, representation, or conveyance to or with a third party on
                           behalf of another person, lacking power to bind that person, gives an implied warranty of authority to
                           the third party and is subject to liability to the third party for damages for loss caused by breach of that
                           warranty, including loss of the benefit expected from performance by the principal, unless
                                      (1) the principal or purported principal ratifies the act as stated in § 4.01; or
                                      (2) the person who purports to make the contract, representation, or conveyance gives notice
                                      to the third party that no warranty of authority is given; or
                                      (3) the third party knows that the person who purports to make the contract, representation,
                                      or conveyance acts without actual authority.
                  5.       W hen is an agent liable on a contract?7 It depends on the type of principal.
                           a.         Disclosed – Agent is not personally liable.
                                      (1)          Exceptions. (1) If the parties intend the agent to be personally liable on
                                                   the contract he will be personally liable. However, a parole evidence
                                                   rule issue may arise, therefore, it is best to expressly set out in the
                                                   contract the agent’s liability. (2) The agent had no authority to enter
                                                   into the contract and the principal did not ratify. This would be a
                                                   breach of the agent’s implied warranty of authority.




        7
          The rules on contract liability are default rules. They can be overridden by express or implied agreement
between the agent and third party.

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                             b.       Partially Disclosed (Unidentified) – Agent is personally liable 8
                             c.       Undisclosed – Agent is personally liable.
                    6.              Salmon A.S. v. Curran (Mass. App. 1992)
                             Atlantic
                             a.       If the other party [to a transaction] has notice that the agent is or may be acting
                                      for a principal but has no notice of the principal’s identity, the principal for
                                      whom the agent is acting is a partially disclosed principal. Restatement (Second)
                                      of Agency § 4(2).
                             b.       Unless otherwise agreed, a person purporting to make a contract with another for
                                      a partially disclosed principal is a party to the contract.
                             c.       It is the duty of the agent, if he would avoid personal liability on a contract
                                      entered into by him on behalf of his principal, to disclose not only that he is
                                      acting in a representative capacity, but also the identity of his principal.
                                      (1)        It was not the plaintiffs’ duty to seek out the identity of the defendant’s
                                                 principal; it was the defendant’s obligation fully to reveal it.
                                                 (a)       “The duty rests upon the agent, if he would avoid personal
                                                           liability, to disclose his agency, and not upon others to discover
                                                           it. It is not, therefore, enough that the other party has the
                                                           means of ascertaining the name of the principal; the agent must
                                                           either bring to him actual knowledge or, what is the same
                                                           thing, that which to a reasonable man is equivalent to
                                                           knowledge or the agent will be bound. There is no hardship to
                                                           the agent in this, as he always has it in his power to relieve
                                                           himself from personal liability by fully disclosing his principal
                                                           and contracting only in the latter’s name. If he does not do
                                                           this, it may well be presumed that he intended to make himself
                                                           personally responsible.
                             d.       Administratively Dissolved. If the corporation has been administratively dissolved it
                                      is because it has failed to pay its franchise taxes.
                                      (1)        Those who act on behalf of an administratively dissolved corporation are
                                                 personally liable.
                                      (2)        Paying fees to reinstate will not backdate any actions.
                    7.       Arkansas. In Arkansas there is a great deal of emphasis on how the contract is signed, i.e.,
                             whether the contract is signed in a representative capacity or in a personal capacity.
                             a.       Examples:
                                      1.         By: John Doe
                                                 Agent (or President, Manager, etc.)

                                        2.      By: John Doe
                                                John Doe, Agent

                                        3.      By: John Doe

                                      John Doe is personally liable under #39 but is not personally liable
                                      under #1 & #2.
                    8.       General Agent/Special Agent.
                             a.       General Agent. If a principal authorizes an agent “to conduct a series of
                                      transactions involving a continuity of service,” the law calls the agent a general


        8
          The rationale is one of expectations. W ithout knowing the identity of the principal, the third party is
presumably relying on the trustworthiness, creditworthiness, and bona fides of the agent.

          9
              Arkansas courts would invoke the parole evidence rule and exclude external testimony about the parties’
intent.

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                                      agent.
                           b.         Special Agent. If a principal authorizes the agent only to conduct a single
                                      transaction, or to conduct a series of transactions that do not involve “continuity
                                      of service,” then the law calls the agent a special agent.
III.   Liability of Principal to Third Parties in Tort
       A.        Servant Versus Independent Contractor
                 1.        Restatement (Second) of Agency § 1. Agency; Principal; Agent.
                           (1) Agency is the fiduciary relation which results from the manifestation of consent by one person to
                           another that the other shall act on his behalf and subject to his control, and consent by the other so to
                           act.
                           (2) The one for whom action is to be taken is the principal.
                           (3) The one who is to act is the agent.
                 2.        Restatement (Second) of Agency § 2. Master; Servant; Independent
                           Contractor.
                           (1) A master is a principal who employs an agent to perform service in his affairs and who controls or
                           has the right to control the physical conduct of the other in the performance of the service.
                           (2) A servant is an agent employed by a master to perform service in his affairs whose physical conduct
                           in the performance of the service is controlled or is subject to the right to control by the master.
                           (3) An independent contractor is a person who contracts with another to do something for him but who
                           is not controlled by the other nor subject to the other’s right to control with respect to his physical
                           conduct in the performance of the undertaking. He may or may not be an agent.
                 3.        Restatement (Second) of Agency § 219. W hen Master is Liable for Torts of His
                           Servants.
                           (1) A master is subject to liability for the torts of his servants
                           committed while acting in the scope of their employment.
                           (2) A master is not subject to liability for the torts of his servants acting outside the scope of their
                           employment, unless:
                                      (a) The master intended the conduct or the consequences, or
                                      (b) The master was negligent or reckless, or
                                      (c) The conduct violated a non-delegable duty of the master, or
                                      (d) The servant purported to act or to speak on behalf of the principal and there was reliance
                                      upon apparent authority, or he was aided in accomplishing the tort by the existence of the
                                      agency relation.
                 4.        Restatement (Second) of Agency § 220. Definition of Servant.
                           (1) A servant is a person employed to perform services in the affairs of another and who with respect to
                           the physical conduct in the performance of the services is subject to the other’s control or right to
                           control.
                           (2) In determining whether one acting for another is a servant or an independent contractor, the
                           following matters of fact, among others, are considered:
                                      (a) the extent of control which, by the agreement, the master may exercise over the details of
                                      the work;
                                      (b) whether or not the one employed is engaged in a distinct occupation or business;
                                      (c) the kind of occupation, with reference to whether, in the locality, the work is usually
                                      done under the direction of the employer or by a specialist without supervision;
                                      (d) the skill required in the particular occupation;
                                      (e) whether the employer or the workman supplies the instrumentalities, tools, and the place
                                      of work for the person doing the work;
                                      (f) the length of time for which the person is employed;
                                      (g) the method of payment, whether by the time or by the job;
                                      (h) whether or not the work is part of the regular business of the employer;
                                      (i) whether or not the parties believe they are creating the relation of master and servant;
                                      and
                                      (j) whether the principal is or is not in business.



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                                                                                                     JR C /Fall 2010/Fendler/B usiness A ssoc .

                  5.        Restatement (Third) of Agency § 2.04. Respondeat Superior.
                            An employer is subject to liability for torts committed by employees while acting within the scope of
                            their employment.
                                       Comment (a). Terminology and cross-references. This Restatement does not use the
                                       terminology of “master” and “servant.” Section 7.07(3) defines “employee” for purposes
                                       of this doctrine. Section 7.07(2) states the circumstances under which an employee has acted
                                       within the scope of employment. Section 7.08 states the circumstances under which a
                                       principal is subject to vicarious liability for a tort committed by an agent, whether or not an
                                       employee, when actions taken with apparent authority constituted the tort or enabled the
                                       agent to conceal its commission.
                  6.        Restatement (Third) of Agency § 7.01. Agent’s Liability to Third Party.
                            An agent is subject to liability to a third party harmed by the agent's tortious conduct. Unless an
                            applicable statute provides otherwise, an actor remains subject to liability although the actor acts as an
                            agent or an employee, with actual or apparent authority, or within the scope of employment.
                  7.        Respondeat Superior. A venerable doctrine which imposes strict, vicarious liability on a
                            principal when: 10
                            a.         An agent’s tort has caused physical injury to a person or property
                            b.         The tortfeasor agent meet the criteria to be considered a “servant” (or under the
                                       R.3d, “employee”) of the principal, and
                            c.         The tortious conduct occurred within the servant/employee’s “scope of
                                       employment.”
                  8.        Rationales. The doctrine of respondeat superior rests on three rationales: enterprise
                            liability, risk avoidance, and risk spreading.
                            a.         Enterprise Liability. Links risk and benefits and hold accountable for risk-creating
                                       activities the enterprise that stands to benefit from those activities.
                            b.         Risk Spreading. The master can: (i) anticipate the risk inherent in its enterprise;
                                       (ii) spread the risk through insurance; (iii) take into account the cost of insurance
                                       in setting the price for its goods or services; and (iv) thereby spread the risk
                                       among those who benefit from the goods or services.
                            c.         Risk Avoidance. Creates a strong incentive for the employer/master to use its
                                       position of control to achieve “risk avoidance.”
                  9.        Under the doctrine of respondeat superior, “master” (employer) is liable for the torts of its
                            servants (employees).
                            a.         A master-servant relationship exists where the servant has agreed:
                                       (1)        to work on behalf of the master and
                                       (2)        be subject to the master’s control or right to control the “physical
                                                  conduct” of the servant (that is, the manner in which the job is
                                                  performed, as opposed to the result alone).
                  10.       Scope of Employment
                            a.         Even if the tortfeasor is en employee, vicarious liability results only if the tort
                                       occurred within the scope of employment.
                  11.       Independent Contractors Are of Two Types: Agent and Non-Agent.
                            a.         Agent-Type. One who has agreed to act on behalf on another, the principal, but
                                       not subject to the principal’s control over how the result is accomplished (that is,
                                       over the “physical conduct” of the task).
                            b.         Non-Agent. One who operates independently and simply enters into arm’s length
                                       transactions with others.
                  12.       Humble Oil & Refining Co. v. Martin (Tex. 1949). (Master/Servant Relationship [Liable])
                            a.         Even if the contract between Humble and Schneider were the only evidence on


          10
             The injured party may also assert claims of direct responsibility against the principal. In any event, the
tortfeasor agent will be directly liable. Being an agent does not immunize a person from tort liability. A tortfeasor is
personally liable, regardless of whether the tort was committed on the instruction from or to the benefit of a principal.

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                                                                         JR C /Fall 2010/Fendler/B usiness A ssoc .

               the question, the instrument as a whole indicates a master-servant relationship
               quite as much as, if not more than, it suggests an arrangement between
               independent contractors.
               (1)        For example, paragraph 1 includes a provision requiring Schneider “to
                          make reports and perform other duties in connection with the operation of said
                          station that may be required of him from time to time by Company.
      b.       Obviously, the main object of the enterprise was the retail marketing of Humble’s
               products with title remaining in Humble until delivery to the consumer. This
               was done under a strict system of financial control and supervision by Humble,
               with little or no business discretion reposed in Schneider except as to hiring,
               discharge, payment and supervision of a few station employees of a more or less
               laborer status.
      c.       This case differs from The Texas Company v. W heat. That case clearly showed a
               “dealer” type of relationship in which the lessee in charge of the filling station
               purchased from his landlord, The Texas Company, and sold as his own, and was
               free to sell at his own price and on his own credit terms, the company products
               purchased, as well as the products of other oil companies. The contracts contained
               no provision requiring the lessee to perform any duty The Texas Company might
               see fit to impose upon him, nor did the company pay any part of the lessee’s
               operating expenses, nor control the working hours of the station.
13.   Hoover v. Sun Oil Company (Del. 1965). (No Master/Servant Relationship [Not Liable])
      a.       W hile Petersen (Sun’s representative) did offer advice to Barone on all phases of
               his operation, it was usually done on request and Barone was under no obligation
               to follow the advice. Barone’s contacts and dealings with Sun were many and
               their relationship intricate, but he made no written reports to Sun and he alone
               assumed the overall risk of profit or loss in his business operation. Baron
               independently determined his own hours of operation and the identity, pay sale
               and working conditions of his employees, and it was his name that was posted as
               proprietor.
      b.       The legal relationships arising from the distribution systems of major oil-
               producing companies are in certain respects unique. As stated in an annotation
               collecting many of the cases dealing with this relationship:
               (1)        “This distribution system has grown up primarily as the result of
                          economic factors and with little relationship to traditional legal concepts
                          in the field of master and servant, so that it is perhaps not surprising that
                          attempts by the court to discuss the relationship in the standard terms
                          have led to some difficulties and confusion.”
      c.       In some situations traditional definitions of principal and agent and of employer
               and independent contractor may be difficult to apply to service station operators,
               but the undisputed facts of the case at bar make it clear that Barone was an
               independent contractor.
      d.       Test. The test be applied is that of whether the oil company has retained the right
               to control the details of the day-to-day operation of the service station; control or
               influence over results alone being views as insufficient.
14.   Murphy v. Holiday Inns, Inc. (Va. 1975). (Franchise Relationship)
      a.       W hen an agreement, considered as a whole, establishes an agency relationship,
               the parties cannot effectively disclaim it by formal “consent.” The relationship of
               the parties does not depend upon what the parties themselves call it, but rather in
               law what it actually is.
      b.       In determining whether a contract establishes an agency relationship, the critical
               test is the nature and extent of the control agreed upon.
      c.       The plaintiff pointed to several provision and rules of the agreement which he




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                                                                                                    JR C /Fall 2010/Fendler/B usiness A ssoc .

                                       claimed satisfied the control test to establish the principal-agent relationship. 11
                            d.         Franchising. Franchising is a system for the selective distribution of goods and/or
                                       services under a brand name through outlets owned by independent businessmen,
                                       called “franchisees.” Although the franchisor supplies the franchisee with know-
                                       how and brand identification on a continuing basis, the franchisee enjoys the right
                                       to profit and runs the risk of loss. The franchisor controls the distribution of his
                                       goods and/or services through a contract which regulates the activities of the
                                       franchisee, in order to achieve standardization.
                                       (1)        The fact that an agreement is a franchise contract does not insulate the
                                                  contracting parties from an agency relationship. If a franchise contract so
                                                  regulates the activities of the franchisee as to vest the franchisor with
                                                  control within the definition of agency, the agency relationship arises
                                                  even though the parties expressly deny it.
                            e.         Having carefully considered all of the regulatory provisions in the agreement, we
                                       are of the opinion that they gave defendant no “control or right to control the
                                       methods or details of doing the work, and, therefore, agree with the trial court
                                       that no principal-agent or master-servant relationship was created.
                                       (1)        The purpose of the provisions was to achieve system-wide uniformity of
                                                  commercial service, and optimum public good will, all for the benefit of
                                                  both contracting parties.
                  15.       Restatement § 1 indicates, as stated by the Holiday Inns court, that control is an essential
                            element of the definition of agency relationship, whether one is dealing with a servant or
                            an independent contractor. A key distinction between the servant and independent
                            contractor types of agents, however, is the differing natures and degrees of control
                            exercised by the principal. See Restatement § 220.
                  16.       Restatement (Third) of Agency § 1.02. Parties’ Labeling and Popular Usage
                            Not Controlling.
                            An agency relationship arises only when the elements stated in § 1.01 are present. W hether a
                            relationship is characterized as agency in an agreement between parties or in the context of industry or
                            popular usage is not controlling.
                  17.       Vandemark v. McDonald’s Corp. (N.H. 2006).
                            a.         The weight of authority construes franchiser liability narrowly, finding that absent
                                       a showing of control over security measures employed by the franchisee, the
                                       franchiser cannot be vicariously liable for the security breach.
                                       (1)        W endy Hong W u v. Dunkin’ Donuts, Inc. (E.D.N.Y. 2000).
                                                  (a)        The court specifically examined whether Dunkin’ Donuts had
                                                             control over the alleged “instrumentality” that cause the harm.
                            b.         “The evidence demonstrates that although the defendant maintained authority to
                                       insure the uniformity and standardization of products and services offered by the
                                       [franchise] restaurant, such authority did not extend to control of security
                                       operations. Thus, there was no genuine issue of material fact as to whether the


         11
              That licensee construct its motel according to plans, specifications, feasibility studies, and locations
approved by licensor; That licensee employ the trade name, signs, and other symbols of the ‘system’ designated by
licensor; That licensee pay a continuing fee for use of the license and a fee for national advertising of the ‘system’;
That licensee solicit applications for credit cards for the benefit of other licensees; That licensee protect and promote
the trade name and not engage in any competitive motel business or associate itself with any trade association designed
to establish standards for motels; That licensee not raise funds by sale of corporate stock or dispose of a controlling
interest in its motel without licensor's approval; That training for licensee's manager, housekeeper, and restaurant
manager be provided by licensor at licensee's expense; That licensee not employ a person contemporaneously engaged
in a competitive motel or hotel business; and That licensee conduct its business under the ‘system’, observe the rules
of operation, make quarterly reports to licensor concerning operations, and submit to periodic inspections of facilities
and procedures conducted by licensor's representatives.

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                                                                                                 JR C /Fall 2010/Fendler/B usiness A ssoc .

                                     defendant exercised control over the relevant security policies at the [franchisee’s]
                                     restaurant through adopting the QSC Play Book.”
         B.       Tort Liability and Apparent Agency
                  1.       Miller v. McDonald’s Corp. (Ore. App. 1997).
                           a.        Actual Agency. The kind of actual agency relationship that would make defendant
                                     vicariously liable for 3K’s negligence requires that defendant have the right to
                                     control the method by which 3K performed its obligations under the
                                     Agreement. 12
                                     (1)         A number of courts have applied the right to control test to a franchise
                                                 relationship.
                                                 (a)         “If in practical effect, the franchise agreement goes beyond the
                                                             stage of setting standards, and allocates to the franchisor the
                                                             right to exercise control over the daily operations of the
                                                             franchise, an agency relationship exists.”
                                     (2)         W e believe that a jury could find that defendant retained sufficient
                                                 control over 3K’s daily operations that an actual agency relationship
                                                 existed. The Agreement did not simply set standards that 3K had to
                                                 meet. Rather, it required 3K to use the precise methods that defendant
                                                 established. Defendant enforced the use of those methods by regularly
                                                 sending inspectors and by its retained power to cancel the Agreement.
                           b.        Apparent Agency 13
                                     (1)         Restatement (Second) of Agency § 267.
                                                 (a)         “One who represents that another is his servant or other agent
                                                             and thereby causes a third person justifiably to rely upon the
                                                             care or skill of such apparent agent is subject to liability to the
                                                             third person for harm caused by the lack of care or skill of the
                                                             one appearing to be a servant or other agent as if her were
                                                             such.”
                                     (2)         W e have not applied § 267 to a franchisor/franchisee situation, but
                                                 courts in a number of other jurisdictions have done so in ways that we
                                                 find instructive. In most case the courts have found that there was a jury
                                                 issue of apparent agency. The crucial issues are whether the putative
                                                 principal held the third party out as an agent and whether the plaintiff
                                                 relied on that holding out.
                  2.       Restatement (Third) of Agency § 7.08. Agent Acts W ith Apparent Authority.
                           A principal is subject to vicarious liability for a tort committed by an agent in dealing or
                           communicating with a third party on or purportedly on behalf of the principal when actions taken by
                           the agent with apparent authority constitute the tort or enable the agent to conceal its commission.
         C.       Scope of Employment
                  1.       Restatement (Second) of Agency § 228. General Statement.
                           (1) Conduct of a servant is within the scope of employment if, but only if:
                                     (a) it is of the kind he is employed to perform;
                                     (b) it occurs substantially within the authorized time and space limits;
                                     (c) it is actuated, at least in part, by a purpose to serve the master, and
                                     (d) if force is intentionally used by the servant against another, the use of force is not



         12
           Under the right to control test it does not matter whether the putative principal actually exercises control;
what is important is that it has the right to do so.

          13
             Apparent agency is a distinct concept from apparent authority. Apparent agency creates an agency
relationship that does not otherwise exist, while apparent authority expands the authority of an actual agent. In this
case, the precise issue is whether 3K was defendant’s apparent agent, not whether 3K had apparent authority.

                                                            -13-
                                                                                                     JR C /Fall 2010/Fendler/B usiness A ssoc .

                                       unexpectable by the master.
                           (2) Conduct of a servant is not within the scope of employment if it is different in kind from that
                           authorized, far beyond the authorized time or space limits, or too little actuated by a purpose to serve
                           the master.
                  2.       Restatement (Second) of Agency § 229. Kind of Conduct W ithin Scope of
                           Employment.
                           (1) To be within the scope of the employment, conduct must be of the same general nature as that
                           authorized, or incidental to the conduct authorized.
                           (2) In determining whether or not the conduct, although not authorized, is nevertheless so similar to
                           or incidental to the conduct authorized as to be within the scope of employment, the following matters
                           of fact are to be considered:
                                       (a) whether or not the act is one commonly done by such servants;
                                       (b) the time, place and purpose of the act;
                                       (c) the previous relations between the master and the servant;
                                       (d) the extent to which the business of the master is apportioned between different servants;
                                       (e) whether or not the act is outside the enterprise of the master or, if within the enterprise,
                                       has not been entrusted to any servant;
                                       (f) whether or not the master has reason to expect that such an act will be done.
                                       (g) the similarity in quality of the act done to the act authorized;
                                       (h) whether or not the instrumentality by which the harm is done has been furnished by the
                                       master to the servant;
                                       (i) the extent of departure from the normal method of accomplishing an authorized result;
                                       and
                                       (j) whether or not the act is seriously criminal.
                  3.       Restatement (Third) of Agency § 7.07. Employee Acting W ithin Scope of
                           Employment. 14
                           (1) An employer is subject to vicarious liability for a tort committed by its employee acting within the
                           scope of employment.
                           (2) An employee acts within the scope of employment when performing work assigned by the employer
                           or engaging in a course of conduct subject to the employer's control. An employee's act is not within
                           the scope of employment when it occurs within an independent course of conduct not intended by the
                           employee to serve any purpose of the employer.
                           (3) For purposes of this section,
                                       (a) an employee is an agent whose principal controls or has the right to control the manner
                                       and means of the agent's performance of work, and
                                       (b) the fact that work is performed gratuitously does not relieve a principal of liability.
                  4.       Unauthorized Conduct. Unauthorized conduct can be within the scope of employment.
                           a.          Restatement (Second) of Agency § 230. Forbidden Acts.
                                       An act, although forbidden, or done in a forbidden manner, may be within the scope of
                                       employment.
                  5.       Travel. Comment 3 to R.3d § 7.07 explains that “In general, travel required to perform
                           work, such a travel from an employer’s office to a job site or from one job site to another,
                           is within the scope an employee’s employment, while traveling to and from work is not.”
                  6.       Frolic and Detour. Agency law has a pair of labels to distinguish small-scale deviations from
                           substantial ones.
                           a.          Detour. The employee remains within the scope of employment (and
                                       consequently respondeat superior still applies).
                           b.          Frolic. A substantial deviation puts the employee outside the scope of


          14
              The R.3d is less formulaic. Note that R.3d has revised the R.2d’s third condition–substituting “an
independent course of conduct not intended by the employee to serve any purpose of the employer” for “actuated, at
least in part, by a purpose to serve the master.” The R.3d also rejects the R.2d’s condition–“substantially within the
authorized time and space limits”–as antiquated.

                                                              -14-
                                                                          JR C /Fall 2010/Fendler/B usiness A ssoc .

               employment.
7.   Ira S. Bushey & Sons, Inc. v. United States (2d Cir. 1968).
     a.        The Government relies on Restatement of Agency 2d § 228(1) which says that
               “conduct of a servant is within the scope of employment if, but only if: (c) it is
               actuated, at least in part, by a purpose to serve the master.”
               (1)        In Nelson v. American-W est African Line (2d Cir. 1936), Judge Learned
                          Hand concluded that a drunken boatswain who routed the plaintiff out
                          of his bunk with a blow, saying “Get up, you big son of a bitch, and
                          turn to,” and the continued to fight, might have thought he was acting
                          in the interest of the ship.
               (2)        It would be going too far to find such a purpose here; while Lane’s
                          return to the Tamaroa was to serve his employer, no one has suggested
                          how he could have though turning the wheels to be, even if–which is
                          by no means clear–he was unaware of the consequences.
     b.        Motive Test No Longer Viable. In light of the highly artificial way in which the
               motive test has been applied, the district judge believed himself obliged to test the
               doctrine’s continuing vitality by referring to the larger purposes respondeat
               superior is supposed to serve.
               (1)        A policy analysis, however, is not sufficient to justify this proposed
                          expansion of vicarious liability.
                          (a)        W hatever may have been the case in the past, a doctrine that
                                     would create such drastically different consequences for the
                                     actions of the drunken boatswain in Nelson and those the
                                     drunken seaman here reflects a wholly unrealistic attitude
                                     towards the risks characteristically attendant upon the operation
                                     of a ship.
                          (b)        Not Negligence Standard of Foreseeability. Put another way,
                                     Lane’s conduct was not so “unforeseeable” as to make it unfair
                                     to charge the Government with responsibility. W e agree with
                                     a leading treatise that “what is reasonably foreseeable in this
                                     context (of respondeat superior) is quite a different thing from
                                     the foreseeably unreasonable risk of harm that spells negligence.
     c.        Test. The proper test here bears far more resemblance to that which limits
               liability for workmen’s compensation than to the test for negligence. The
               employer should be held to expect risks, to the public also, which arise out of and in the
               course of his employment of labor.
     d.        Factors of Importance to J. Friendly:
               (1)        Foreseeability – W ell known that sailors on shore leave drink like
                          Irishmen.
               (2)        Economics – Judge Friendly says that the trial court’s economic analysis
                          may be valid but it is unknown what effect allocation would have.
               (3)        Justice – Justice requires this. The employer ought not to get a benefit
                          and be able to simultaneously disclaim the risk.
               (4)        Proximity – Geographically, seems to be a concern of Judge Friendly
               (5)        Risks associated with enterprise v. Risk attendant on the activities of the
                          community in general
               (6)        Because of the employment, unusual circumstances are encountered,
                          e.g., the job is inherently stressful.
8.   Clover v. Snowbird Ski Resort (Utah 1991). (Frolic & Detour)
     a.        Ski resort restaurant chef/supervisor, while skiing between resort restaurant
               locations, severely injured another skier after ignoring warning signs and
               launching off a jump. The trial court granted summary judgment to the resort on
               the theory that the employee was not acting within the scope of his employment.
     b.        The Supreme Court concluded that summary judgment should not have been

                                     -15-
                                                                              JR C /Fall 2010/Fendler/B usiness A ssoc .

                 granted in favor of the ski resort and remanded for trial.
                 (1)        The court rejected an alternative argument by the plaintiff, based on
                            Bushey, that the employer’s liability should depend “not on whether the
                            employer’s conduct is motivated by serving the employer’s interest, but
                            on whether the employee’s conduct is foreseeable.” The Utah court
                            noted simply that this is not the test under Utah case law.
9.    The district court’s analysis in Bushey amounted to virtually a rule of strict liability for the
      torts of an employee as long as any connection in time and space could be made between
      the conduct and the employment.
      a.         Judge Friendly affirmed the district court’s result but rejected its rationale, noting
                 that it was not at all clear that the proposed rule would lead to a more efficient
                 allocation of resources.
10.   Manning v. Grimsley (1st Cir. 1981).
      a.         In Massachusetts where a plaintiff seeks to recover damages from an employer for
                 injuries resulting from an employee’s assault, what must be shown is that the
                 employee’s assault was in response to the plaintiff’s conduct which was presently
                 interfering with the employee’s ability to perform his duties successfully. This interference
                 may be in the form of an affirmative attempt to prevent an employee from
                 carrying out his assignments.
                 (1)        Miller’s holding that a critical comment by a customer to an employee
                            did not in the circumstances constitute conduct interfering with the
                            employee’s performance of his work is obviously distinguishable from
                            the case at bar. Miller v. Federated Department Stores, Inc. (Mass. 1973).
                            (a)        Constant heckling by fans at a baseball park would be, within
                                       the meaning of Miller, conduct.
      b.         This test relates to the motivation of the employee to serve his or her employer.
11.   Restatement (Second) of Agency § 231. Criminal or Tortious Acts.
      An act may be within the scope of employment although consciously criminal or tortious.
12.   Serious Crimes or Torts. Under the traditional view, the master is not liable for the serious
      crime or tort of the servant. An irrebuttable presumption was created that the servant was
      not motivated by a purpose to serve the master.
      a.         The R.2d modifies this (See § 228(d)(1)): “if force is intentionally used by the
                 servant against another, the use of force is not expectable by the master.”
13.   Liability of Torts of Independent Contractor. In general, a principal is not vicariously liable for
      physical harm caused by the torts of a nonemployee agent (in R.2d terms, an
      “independent contract agent”).
      a.         Exceptions: (1) inherently dangerous activity (requires special skill to prevent grave
                 injury); (2) ultrahazardous activity (harm cannot be averted no matter how
                 careful); (3) nondelegable duties (special relationship, e.g., common carriers,
                 innkeepers/contractual relationships, e.g., landlord-tenant/statutory); and (4) cases
                 that impose liability with no general rationale (e.g., store security guards and false
                 imprisonment, store ratified when it did not fire guard, and there is an obligation
                 to protect customers from unwarranted attack).
14.   Torts Not Involving Physical Harm. If an agent’s misconduct consists solely of words and the
      third party suffers harm only to its emotions, reputation, or pocketbook, the agency
      analysis resembles the approach used for contractual matters. The key rules are those of
      actual authority, apparent authority, and inherent agency power. Except for the borderline
      areas of malicious prosecution and intentional interference with business relations,
      respondeat superior is largely irrelevant.
      a.         Defamation. Not whether the principal authorized the agent to defame but rather
                 to make the statement (Ex. Credit bureaus reporting incorrect credit
                 information.)




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                                                                                                    JR C /Fall 2010/Fendler/B usiness A ssoc .

IV.   Fiduciary Obligation of Agents.
      A.       Duties During Agency
               1.       Restatement (Third) of Agency § 8.01. General Fiduciary Principle.
                        An agent has a fiduciary duty to act loyally for the principal’s benefit in all matters connected with the
                        agency relationship.
               2.       Restatement (Third) of Agency § 8.02. Material Benefit Arising Out of
                        Position.
                        An agent has a duty not to acquire a material benefit from a third party in connection with
                        transactions conducted or other actions taken on behalf of the principal or otherwise through the agent’s
                        use of the agent’s position.
               3.       Restatement (Third) of Agency § 8.03. Acting as or on Behalf of an Adverse
                        Party.
                        An agent has a duty not to deal with the principal as or on behalf of an adverse party in a transaction
                        connected with the agency relationship.
               4.       Restatement (Third) of Agency § 8.04. Competition.
                        Throughout the duration of an agency relationship, an agent has a duty to refrain from competing
                        with the principal and from taking action on behalf of or otherwise assisting the principal's competitors.
                        During that time, an agent may take action, not otherwise wrongful, to prepare for competition
                        following termination of the agency relationship.
               5.       Restatement (Third) of Agency § 8.05. Use of Principal’s Property; Use of
                        Confidential Information.
                        An agent has a duty
                                   (1) not to use property of the principal for the agent's own purposes or those of a third party;
                                   and
                                   (2) not to use or communicate confidential information of the principal for the agent's own
                                   purposes or those of a third party.
               6.       Restatement (Third) of Agency § 8.06. Principal’s Consent.
                        (1) Conduct by an agent that would otherwise constitute a breach of duty as stated in §§ 8.01,
                        8.02, 8.03, 8.04, and 8.05 does not constitute a breach of duty if the principal consents to the
                        conduct, provided that
                                   (a) in obtaining the principal's consent, the agent
                                               (i) acts in good faith,
                                               (ii) discloses all material facts that the agent knows, has reason to know, or
                                               should know would reasonably affect the principal's judgment unless the principal
                                               has manifested that such facts are already known by the principal or that the
                                               principal does not wish to know them, and
                                               (iii) otherwise deals fairly with the principal; and
                                   (b) the principal's consent concerns either a specific act or transaction, or acts or transactions
                                   of a specified type that could reasonably be expected to occur in the ordinary course of the
                                   agency relationship.
                        (2) An agent who acts for more than one principal in a transaction between or among them has a duty
                                   (a) to deal in good faith with each principal,
                                   (b) to disclose to each principal
                                               (i) the fact that the agent acts for the other principal or principals, and
                                               (ii) all other facts that the agent knows, has reason to know, or should know
                                               would reasonably affect the principal's judgment unless the principal has
                                               manifested that such facts are already known by the principal or that the principal
                                               does not wish to know them, and
                                   (c) otherwise to deal fairly with each principal.
               7.       Restatement (Third) of Agency § 8.07. Duty Created by Contract.
                        An agent has a duty to act in accordance with the express and implied terms of any contract between
                        the agent and the principal.




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8.    Restatement (Third) of Agency § 8.08. Duties of Care, Competence, and
      Diligence.
      Subject to any agreement with the principal, an agent has a duty to the principal to act with the care,
      competence, and diligence normally exercised by agents in similar circumstances. Special skills or
      knowledge possessed by an agent are circumstances to be taken into account in determining whether the
      agent acted with due care and diligence. If an agent claims to possess special skills or knowledge, the
      agent has a duty to the principal to act with the care, competence, and diligence normally exercised by
      agents with such skills or knowledge.
9.    Restatement (Third) of Agency § 8.09. Duty to Act Only W ithin Scope of
      Actual Authority and to Comply W ith Principal’s Lawful Instructions.
      (1) An agent has a duty to take action only within the scope of the agent's actual authority.
      (2) An agent has a duty to comply with all lawful instructions received from the principal and persons
      designated by the principal concerning the agent's actions on behalf of the principal.
10.   Restatement (Third) of Agency § 8.10. Duty of Good Conduct.
      An agent has a duty, within the scope of the agency relationship, to act reasonably and to refrain from
      conduct that is likely to damage the principal's enterprise.
11.   Restatement (Third) of Agency § 8.11. Duty to Provide Information.
      An agent has a duty to use reasonable effort to provide the principal with facts that the agent knows,
      has reason to know, or should know when
                 (1) subject to any manifestation by the principal, the agent knows or has reason to know
                 that the principal would wish to have the facts or the facts are material to the agent's duties
                 to the principal; and
                 (2) the facts can be provided to the principal without violating a superior duty owed by the
                 agent to another person.
12.   Duty of Loyalty. All agents owe a fiduciary duty of loyalty. Agency is emphatically not an
      arm’s-length relationship.
      a.         Unapproved Benefits. An agent cannot make “secret profits” from the agency
                 relationship:
                 (1)        Forbids compensation from someone other than the principal in
                            connection with the agent’s duty (kickbacks, bribes, gratuities, etc.)
                 (2)        An agent may not become the other party to a transaction with the
                            principal, unless the agent discloses its role and the principal consent.
                 (3)        Not using the position to gain profits from someone with no connection
                            to the principal.
      b.         No Competition. Agent cannot compete with the principal or act on behalf of a
                 competitor.
      c.         Agent cannot use principal’s property for his own purposes or the purposes of
                 someone else.
      d.         Confidential Information. Agent cannot use or communicate the principal’s
                 confidential information for the agent’s own purposes or those of someone else.
13.   Reading v. Regem (K.B. 1948).
      a.         In my judgment, it is a principle of law that, if a servant takes advantage of his
                 service and violates his duty of honesty and good faith to make a profit for
                 himself, in the sense that the assets of which he has control, the facilities which he
                 enjoys, or the position which he occupies, are the real cause of his obtaining the
                 money as distinct from merely affording the opportunity for getting it, that is to
                 say, if they play the predominant part in his obtaining the money, then he is
                 accountable for it to his master.
                 (1)        It matters not that the master has not lost any profit nor suffered any
                            damage, nor does it matter that the master could not have done the act
                            himself. If the servant unjustly enriched himself by virtue of his service
                            without his master’s sanction, the law says that he ought not to be
                            allowed to keep the money, but it shall be taken from him and given to
                            his master, because he got it solely by reason of the position which he

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                                                                                      JR C /Fall 2010/Fendler/B usiness A ssoc .

                                   occupied as a servant of his master.
               b.      Distinguish from Service Giving Rise to Opportunity. This case is to be distinguished
                       from cases where the service merely gives the opportunity of making money. A
                       servant may, during his master’s time, in breach of his contract, do other things to
                       make money for himself, such as gambling, but he is entitled to keep that money
                       himself. The master has a claim for damages for breach of contract, but he has no
                       claim to the money.
     14.      General Automotive Manufacturing Co. v. Singer (W is. 1963).
              a.       Singer had broad powers of management and conducted the business activities of
                       Automotive. In this capacity he was Automotive’s agent and owed a fiduciary
                       duty to it. Under his fiduciary duty to Automotive, Singer was bound to the
                       exercise of the utmost good faith and loyalty so that he did not act adversely to
                       the interests of Automotive by serving or acquiring any private interest of his
                       own. He was also bound to act for the furtherance and advancement of the
                       interest of Automotive.
              b.       The title of the activity does not determine the question whether it was
                       competitive but an examination of the nature of the business must be made.
              c.       Rather than to resolve the conflict of interest between his side line business and
                       Automotive’s business in favor of serving and advancing his own personal
                       interests, Singer had the duty to exercise good faith by disclosing to Automotive
                       all the facts regarding this matter. Upon disclosure to Automotive it was in the
                       latter’s discretion to refuse to accept the orders from Husco or to fill them if possible or to
                       sub-job them to other concerns with the consent of Husco if necessary, and the profit, if
                       any, would belong to Automotive.
     15.      Other Duties
              a.       Agent to Principal: (1) duty of care; (2) duty of good conduct; (3) duty to act
                       within authority; (4) duty to obey instruction; (5) duty to indemnify principal for
                       agent’s misconduct; (6) duty to account; and (7) duty to provide information.
              b.       Principal to Agent: (1) duty to dear fairly and in good faith; (2) duty to pay; (3)
                       duty to indemnify.
B.   Duties During and After Termination of Agency: Herein of “Grabbing and Leaving”
     1.       Town & Country House & Home Service, Inc. v. Newberry (N.Y. 1958).
              a.       The only trade secret which could be involved in this business is plaintiff’s list of
                       customers.
                       (1)         Concerning that, even where a solicitor of business does not operate
                                   fraudulently under the banner of his former employer, he still may not
                                   solicit the latter’s customers who are not openly engaged in business in
                                   advertised locations or whose availability as patrons cannot readily be
                                   ascertained but whose trade and patronage have been secured by years of
                                   business effort and advertising, and the expenditure of time and money,
                                   constituting a part of the good will of a business which enterprise and
                                   foresight have built up.
C.   Attribution
     1.       Agency law provides that in some situations, information that an agent knows or has
              received is attributed to the principal–treated as if the principal knew or received the
              information.
              a.       Agent Has Actual/Apparent Authority to Receive Notice. The notice has the same
                       effect as if it had been made directly to the principal.
              b.       Business Entities. It will have a registered person, a person designated in the
                       records of the Secretary of State who is authorized to receive legal notices.
              c.       Agent’s Knowledge. If an agent has actual knowledge of a fact concerning a matter
                       within the agent’s actual authority, the agent’s knowledge is attributed to the
                       principal.
                       (1)         Exception. The agent’s knowledge is not imputed to the principal if the

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                                                    agent was acting adversely to the principal, and the third party knew or
                                                    had reason to know that the agent was acting adversely to the principal.
                                         (2)        Business Organizations. The law concerning attribution of knowledge is
                                                    important when the principal is an organization, like a corporation or
                                                    other business entity, that has multiple agents. If the requirements for
                                                    imputation are otherwise met, the knowledge of all of the agents is
                                                    imputed to the corporation.
C H A PTER T W O : P AR TN ER SH IPS
I.       W hat is a Partnership? And W ho Are the Partners?
         A.        Partners Compared W ith Employees
                   1.       Revised Uniform Partnership Act § 202. Formation of Partnership.
                            (a) Except as otherwise provided in subsection (b), the association of two or more persons to carry on
                            as co-owners a business for profit forms a partnership, whether or not the persons intend to form a
                            partnership.
                            (b) An association formed under a statute other than this [Act], a predecessor statute, or a comparable
                            statute of another jurisdiction is not a partnership under this [Act].
                            (c) In determining whether a partnership is formed, the following rules apply:
                                       (1) Joint tenancy, tenancy in common, tenancy by the entireties, joint property, common
                                       property, or part ownership does not by itself establish a partnership, even if the co-owners
                                       share profits made by the use of the property.
                                       (2) The sharing of gross returns does not by itself establish a partnership, even if the persons
                                       sharing them have a joint or common right or interest in property from which the returns are
                                       derived.
                                       (3) A person who receives a share of the profits of a business is presumed to be a partner in
                                       the business, unless the profits were received in payment:
                                                  (i) of a debt by installments or otherwise;
                                                  (ii) for services as an independent contractor or of wages or other compensation to
                                                  an employee;
                                                  (iii) of rent;
                                                  (iv) of an annuity or other retirement or health benefit to a beneficiary,
                                                  representative, or designee of a deceased or retired partner;
                                                  (v) of interest or other charge on a loan, even if the amount of payment varies
                                                  with the profits of the business, including a direct or indirect present or future
                                                  ownership of the collateral, or rights to income, proceeds, or increase in value
                                                  derived from the collateral; or
                                                  (vi) for the sale of the goodwill of a business or other property by installments or
                                                  otherwise.
                   2.       Fenwick v. Unemployment Compensation Commission (N.J. 1945).
                            a.         There are several elements that the courts have taken into consideration in
                                       determining the existence or nonexistence of the partnership relation:
                                       (1)        Intention of the parties.
                                                  (a)         The agreement between the parties is evidential although not
                                                              conclusive.
                                       (2)        Right to share in profits.
                                                  (a)         Sharing of profits will raise a presumption that a partnership
                                                              exists. See RUPA § 202(c)(3).
                                                  (b)         However, not every agreement that gives the right to share in
                                                              profits is, for all purposes, a partnership agreement.
                                       (3)        Obligation to share in losses.
                                       (4)        Ownership and control of the partnership property and business.
                                       (5)        Community of power in administration.
                                       (6)        Language in the agreement.
                                       (7)        Conduct of the parties toward third persons.
                                       (8)        Rights of the parties on dissolution.

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               b.        The Uniform Partnership Act defines a partnership as an association of “two of
                         more persons to carry on as co-owners a business for profit.”
                         (1)          The Act further provides that sharing of profits is prima facie evidence of
                                      partnership but “no such inference shall be drawn if such profits were
                                      received in payment ... as wages of an employee.”
     3.       Uniform Partnership Act § 18. Rules Determining Rights and Duties of
              Partners.
              The rights and duties of the partners in relation to the partnership shall be determined, subject to any
              agreement between them, by the following rules:
                         (a) Each partner shall be repaid his contributions, whether by way of capital or advances to
                         the partnership property and share equally in the profits and surplus remaining after all
                         liabilities, including those to partners, are satisfied; and must contribute towards the losses,
                         whether of capital or otherwise, sustained by the partnership according to his share in the
                         profits.
                         (b) The partnership must indemnify every partner in respect of payments made and personal
                         liabilities reasonably incurred by him in the ordinary and proper conduct of its business, or
                         for the preservation of its business or property.
                         (c) A partner, who in aid of the partnership makes any payment or advance beyond the
                         amount of capital which he agreed to contribute, shall be paid interest from the date of the
                         payment or advance.
                         (d) A partner shall receive interest on the capital contributed by him only from the date
                         when repayment should be made.
                         (e) All partners have equal rights in the management and conduct of the partnership
                         business.
                         (f) No partner is entitled to remuneration for acting in the partnership business, except that
                         a surviving partner is entitled to reasonable compensation for his services in winding up the
                         partnership affairs.
                         (g) No person can become a member of a partnership without the consent of all the partners.
                         (h) Any difference arising as to ordinary matters connected with the partnership business
                         may be decided by a majority of the partners; but no act in contravention of any agreement
                         between the partners may be done rightfully without the consent of all the partners.
     4.       Uniform Partnership Act § 31. Causes of Dissolution.
              Dissolution is caused:
              (1) W ithout violation of the agreement between the partners,
                         (a) By the termination of the definite term or particular undertaking specified in the
                         agreement,
                         (b) By the express will of any partner when no definite term or particular undertaking is
                         specified,
                         (c) By the express will of all the partners who have not assigned their interests or suffered
                         them to be charged for their separate debts, either before or after the termination of any
                         specified term or particular undertaking,
                         (d) By the expulsion of any partner from the business bona fide in accordance with such a
                         power conferred by the agreement between the partners;
              (2) In contravention of the agreement between the partners, where the circumstances do not permit a
              dissolution under any other provision of this section, by the express will of any partner at any time;
              (3) By any event which makes it unlawful for the business of the partnership to be carried on or for
              the members to carry it on in partnership;
              (4) By the death of any partner;
              (5) By the bankruptcy of any partner or the partnership;
              (6) By decree of court under section 32.
B.   Partners Compared W ith Lenders
     1.       Liability of Partners. The question of who is a partner is important because of the rule of
              partnership law that makes each partner potentially liable for all of the debts of the partnership.



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     2.       Martin v. Peyton (N.Y. 1927).
              a.        The plaintiff was a creditor of the firm Knauth, Nachod & Kuhne, and claimed
                        that the defendants, who had made investments in the firm, were partners and, as
                        such, liable for its debts.
              b.        There is no hint that the transaction is not a loan of securities with a provision for
                        compensation.
                        (1)        Until the securities were returned, the directing management of the firm
                                   was to be in the hands of John R. Hall, and his life to be insured for
                                   $1,000,000, and the polices were to be assigned as further collateral
                                   security to the trustees.
                                   (a)       These requirements are not unnatural. Hall was the one
                                             known and trusted by the defendants. W hat they required
                                             seems but ordinary caution. Nor does it imply an association
                                             in the business.
              c.        The trustees were to be kept advised as to the conduct of the business and
                        consulted as to important matters. They could inspect the firm books and were
                        entitled to any information they thought important. Finally, they could veto any
                        business decision they though highly speculative or injurious.
                        (1)        This was but a proper precaution to safeguard the loan. The trustees
                                   could not initiate any action as a partner could. They could not bind
                                   the firm by any action of their own.
              d.        Each member of the K.N. & K. firm was to assign to the trustees their interest in
                        the firm. No loan by the firm to any member was permitted and the amount
                        each may draw was fixed. No other distributions of profit were to be made.
                        There was no obligation that the firm continue business and it could be dissolved
                        at any time.
                        (1)        There is nothing here not properly adapted to secure the interest of the
                                   respondents as lenders.
              e.        The “indenture” is substantially a mortgage of the collateral delivered by K.N. &
                        K. to the trustees to secure the performance of the “agreement.” It certainly does
                        not strengthen the claim that the respondents were partners.
              f.        The “option” permits the trustees, of any of them, or their assignees or nominees
                        to enter the firm at a later date if they desire to do so by buying 50 percent or less
                        of the interests therein of all or any of the member at a stated price. Or a
                        corporation may, if the trustees and members agree, be formed in the place of the
                        firm.
                        (1)        This provision is somewhat unusual, yet it is not enough in itself to
                                   show that on June 4, 1921, a present partnership was created, nor taking
                                   these various papers as a whole do we reach such a result.
     3.       The risk of liability for Peyton, Perkins, and Freeman would have been avoided if K.N. &
              K. had been organized as a corporation.
              a.        Under that form of organization, the equity investors (the counterparts of
                        partners) enjoy “limited liability”– that is, they are not personally liable for the
                        debts of the firm and therefore stand to lose only the amount they have invested
                        in it.
              b.        The same would be true if they had formed a limited liability company or limited
                        liability partnership. These forms of business organization, however, were
                        unavailable at the time this transaction occurred.
C.   Partnership v. Contract
     1.       Southex Exhibitions, Inc. v. Rhode Island Builders Association, Inc. (1st Cir. 2002).
              a.        Under Rhode Island law, a “partnership” is “an association of two (2) or more
                        persons to carry on as co-owners a business for profit...”
              b.        The record evidence indicating a nonpartner relationship cannot be dismissed as
                        insubstantial:

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                       (1)        Southex insists that the 1974 Agreement contains ample indicia that a
                                  partnership was formed, including: (1) a 55-45% sharing of profits; (2)
                                  mutual control over designated business operations, such as show dates,
                                  admission prices, choice of exhibitors, and “partnership” bank accounts;
                                  and (3) the respective contributions of valuable property to the
                                  partnership by the partners.
                       (2)        The 1974 Agreement is simply entitled “Agreement,” rather than
                                  “Partnership Agreement.”
                       (3)        Rather than an agreement for an indefinite duration, it prescribed a
                                  fixed (albeit renewable) term.
                       (4)        Rather than undertake to share operating costs with RIBA, SEM not
                                  only agreed to advance all monies required to produce the shows, but to
                                  indemnify RIBA for all show-related losses as well.
                                  (a)       State law normally presumes that partners share equally or at
                                            least proportionately in partnership losses.
                       (5)        Southex not only entered into contract but conducted business with
                                  third parties, in its own name, rather than in the name of the putative
                                  partnership. As a matter of fact, their mutual association was never
                                  given a name.
                       (6)        Similarly, the evidence as to whether either SEM or RIBA contributed
                                  any corporate property, with the intent that it become jointly-owned
                                  partnership property is highly speculative, particularly since their mutual
                                  endeavor simply involved a periodic event, i.e., an annual home show,
                                  which neither generated, nor necessitated, ownership interests in
                                  significant tangible properties, aside from cash receipts.
              c.       “Partnership” is a notoriously imprecise term, whose definition is especially
                       elusive in practice. Since a partnership can be created absent any written
                       formalities whatsoever, its existence vel non normally must be assessed under a
                       “totality-of-the-circumstances” test.
              d.       Profit Sharing Does Not Have to Compel Finding of Partnership. Similarly, even
                       though the UPA explicitly identifies profit sharing as a particularly probative
                       indicium of partnership formation, and some courts have even held the absence of
                       profit sharing compels a finding that no partnership existed, it does not necessarily
                       follow that evidence of profit sharing compels a finding of partnership
                       information.
                       (1)        Even though the UPA specifies five instances in which profit sharing
                                  does not create a presumption of partnership formation, Southex cites
                                  (and we have found) no authority for the proposition that the
                                  evidentiary presumption created by profit sharing can be overcome only
                                  by establishing these five exceptions, rather than by competent evidence
                                  of other pertinent factors indicating the absence of an intent to form a
                                  partnership (e.g., lack of mutual control over business operations, failure
                                  to file partnership tax returns, failure to prescribe loss-sharing).
              e.       The term “partner” is frequently defined with a view to its context. More
                       importantly, the labels the parties assign, while probative of partnership
                       formation, are not necessarily dispositive as a matter of law, particularly in the
                       presence of countervailing evidence.
D.   Partnership by Estoppel
     1.       Young v. Jones (D.S.C. 1992)
              a.       Plaintiffs assert that PW-Bahamas and PW-US [the Price W aterhouse partnership
                       in the United States] operate as a partnership, i.e., constitute an association of
                       persons to carry on, as owners, business for profit. In the alternative, plaintiffs
                       contend that if the two associations are not actually operating as partners they are
                       operating as partners by estoppel.

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                             b.     As a general rule, persons who are not partners as to each other are not partners as
                                    to third persons.
                                    (1)        Partnership by Estoppel. However, a person who represents himself, or
                                               permits another to represent him, to anyone as a partner in an existing
                                               partnership or with other not actual partners, is liable to any such person
                                               to whom such a representation is made who has, on the faith of the
                                               representation, given credit to the actual or apparent partnership.
II.      The Fiduciary Obligations of Partners
         A.      Introduction
                 1.       Meinhard v. Salmon (N.Y. 1928). 15
                          a.        Duty of Loyalty. Joint adventurers, like copartners, owe to one another, while the
                                    enterprise continues, the duty of the finest loyalty. Many forms of conduct
                                    permissible in a workaday world for those acting at arm’s length, are forbidden to
                                    those bound by fiduciary ties. A trustee is held to something stricter than the
                                    morals of the market place. Not honesty alone, but the punctilio of an honor the
                                    most sensitive, is then the standard of behavior.
                          b.        Uncompromising rigidity has been the attitude of courts of equity when
                                    petitioned to undermine the rule of undivided loyalty by the “disintegrating
                                    erosion” of particular exceptions.
                          c.        The trouble with Salmon’s conduct is that he excluded his coadventurer from any
                                    chance to compete, from any chance to enjoy the opportunity for benefit that had
                                    come to him alone by virtue of his agency.
                                    (1)        All these opportunities were cut away from the plaintiff through
                                               another’s intervention.
                                    (2)        The very fact that Salmon was in control with exclusive powers of
                                               discretion charged him the more obviously with the duty of disclosure,
                                               since only through disclosure could opportunity be equalized.
                          d.        A different question would be here if there were lacking any nexus of relation
                                    between the business conducted by the manager and the opportunity brought to
                                    him as an incident of manager.
                                    (1)        Here the subject-matter of the new lease was an extension and
                                               enlargement of the subject-matter of the old one. A managing
                                               coadventurer appropriating the benefit of such a lease without warning
                                               to his partner might fairly expect to be reproached with conduct that
                                               was underhand, or lacking, to say the least, in reasonable candor, if the
                                               partner were to surprise him in the act of signing the new instrument.
                          e.        Judge Andrews’ Dissent
                                    (1)        It seems to me that the venture . . . had in view a limited object and was
                                               to end at a limited time. There was no intent to expand it into a far
                                               greater undertaking lasting for many years. Doubtless in it Mr.
                                               Meinhard has an equitable interest, but in it alone.
                 2.       Revised Uniform Partnership Act § 404. General Standards of Partner’s
                          Conduct.
                          (a) The only fiduciary duties a partner owes to the partnership and the other partners are the duty of
                          loyalty and the duty of care set forth in subsections (b) and (c).
                          (b) A partner's duty of loyalty to the partnership and the other partners is limited to the following:
                                    (1) to account to the partnership and hold as trustee for it any property, profit, or benefit
                                    derived by the partner in the conduct and winding up of the partnership business or derived
                                    from a use by the partner of partnership property, including the appropriation of a
                                    partnership opportunity;


        15
            Although Meinhard v. Salmon involved a joint venture rather than a partnership, Cardozo’s words are
equally applicable to partnerships.

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                                                                                                     JR C /Fall 2010/Fendler/B usiness A ssoc .

                                       (2) to refrain from dealing with the partnership in the conduct or winding up of the
                                       partnership business as or on behalf of a party having an interest adverse to the partnership;
                                       and
                                       (3) to refrain from competing with the partnership in the conduct of the partnership business
                                       before the dissolution of the partnership.
                            (c) A partner's duty of care to the partnership and the other partners in the conduct and winding up of
                            the partnership business is limited to refraining from engaging in grossly negligent or reckless conduct,
                            intentional misconduct, or a knowing violation of law.
                            (d) A partner shall discharge the duties to the partnership and the other partners under this [Act] or
                            under the partnership agreement and exercise any rights consistently with the obligation of good faith
                            and fair dealing.
                            (e) A partner does not violate a duty or obligation under this [Act] or under the partnership agreement
                            merely because the partner's conduct furthers the partner's own interest.
                            (f) A partner may lend money to and transact other business with the partnership, and as to each loan
                            or transaction the rights and obligations of the partner are the same as those of a person who is not a
                            partner, subject to other applicable law.
                            (g) This section applies to a person winding up the partnership business as the personal or legal
                            representative of the last surviving partner as if the person were a partner.
         B.         Opting Out of Fiduciary Duties
                    1.      Perretta v. Promethus Development Company, Inc. (9th Cir. 2008).
                            a.         Under California law, the general partner of a limited partnership has the same
                                       fiduciary duties as a partner in any other partnership. 16
                            b.         Not all self-interested transactions violate the duty of loyalty. The question is not
                                       whether the interested partner is benefitted, but whether the partnership or the
                                       other partners are harmed.
                                       (1)        Partnerships is a fiduciary relationship, and partners may not take
                                                  advantages for themselves at the expense of the partnership. Thus, a partner
                                                  who seek a business advantage over another partner bears the burden of
                                                  showing complete good faith and fairness to the other.
                                                  (a)        Ratification. One way a self-interested partner may meet this
                                                             burden is to have disinterested partners ratify its actions. 17
                                                             Upon a showing of proper ratification by the partners, any
                                                             claim against the partner for a violation of the duty of loyalty is
                                                             extinguished.
                            c.         Under California law, a transaction with an interested partner would be
                                       inconsistent with the interested partner’s duty of loyalty and would require
                                       unanimous approval of the partners–unless the partnership agreement provides
                                       differently.
                                       (1)        California law permits a partnership agreement to vary or permit
                                                  ratifications of the duty of loyalty only if the provision doing so is not



         16
              (b) A partner’s duty of loyalty to the partnership and the other partners includes all of the following:
                    (1) To account to the partnership and hold as trustee for it any property, profit or benefit derived by
                    the partner in the conduct and winding up of the partnership business or derived from a use by the
                    partner of partnership property or information, including the appropriation of a partnership
                    opportunity.
                    (2) To refrain from dealing with the partnership in the conduct or winding up of the partnership
                    business as or on behalf of a party having an interest adverse to the partnership...

         17
             There is no breach of fiduciary duty if there has been a full and complete disclosure, if the partner who
deals with the partnership property first discloses all of the facts surrounding the transaction to the other partners and
secures their approval and consent.

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                      “manifestly unreasonable.”
                      (a)        A comment to the 2001 Uniform Limited Partnership Act,
                                 explaining the provision allowing ratification upon a specified
                                 vote of the limited partners, notes: “The Act does not require
                                 that the authorization or ratification be by disinterested partners,
                                 although the partnership agreement may so provide.
                                 i)           The court disagrees. To the extent ratification
                                              represents an exception to California’s general policy
                                              of “thorough and relentless” scrutiny of self-dealing,
                                              we are confident that a California court would
                                              construe it narrowly, with particular skepticism
                                              toward any aspect that might hint of unfairness.
                                 ii)          California statutes in related areas of the law support
                                              the idea that interested partners should not be allowed
                                              to count their votes in a ratification vote.
                                 iii)         Allowing an interested partner to participate in a
                                              ratification election subverts the very purpose of
                                              ratification itself.
                      (b)        W e hold that a partnership agreement provision that allows an
                                 interested partner to count its votes in a ratification vote would
                                 be “manifestly unreasonable” within the meaning of the statute.
2.   Revised Uniform Partnership Act § 103. Effect of Partnership Agreement;
     Nonwaivable Provisions.
            (a) Except as otherwise provided in subsection (b), relations among the partners and
            between the partners and the partnership are governed by the partnership agreement. To the
            extent the partnership agreement does not otherwise provide, this [Act] governs relations
            among the partners and between the partners and the partnership.
            (b) The partnership agreement may not:
                      (1) vary the rights and duties under Section 105 except to eliminate the duty to
                      provide copies of statements to all of the partners;
                      (2) unreasonably restrict the right of access to books and records under Section
                      403(b);
                      (3) eliminate the duty of loyalty under Section 404(b) or 603(b)(3), but:
                                 (i) the partnership agreement may identify specific types or categories of
                                 activities that do not violate the duty of loyalty, if not manifestly
                                 unreasonable; or
                                 (ii) all of the partners or a number or percentage specified in the
                                 partnership agreement may authorize or ratify, after full disclosure of all
                                 material facts, a specific act or transaction that otherwise would violate
                                 the duty of loyalty;
                      (4) unreasonably reduce the duty of care under Section 404(c) or 603(b)(3);
                      (5) eliminate the obligation of good faith and fair dealing under Section 404(d),
                      but the partnership agreement may prescribe the standards by which the
                      performance of the obligation is to be measured, if the standards are not
                      manifestly unreasonable;
                      (6) vary the power to dissociate as a partner under Section 602(a), except to
                      require the notice under Section 601(1) to be in writing;
                      (7) vary the right of a court to expel a partner in the events specified in Section
                      601(5);
                      (8) vary the requirement to wind up the partnership business in cases specified in
                      Section 801(4), (5), or (6);
                      (9) vary the law applicable to a limited liability partnership under Section
                      106(b); or
                      (10) restrict rights of third parties under this [Act].

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       C.       Grabbing and Leaving
                1.          Meehan v. Shaughnessy (Mass. 1989).
                            a.         It is well settled that partners owe each other a fiduciary duty of the utmost good
                                       faith and loyalty. As a fiduciary, a partner must consider his or her partners’
                                       welfare, and refrain from acting for purely private gain.
                            b.         W e have stated that fiduciaries may plan to compete with the entity to which
                                       they owe allegiance provided that in the course of such arrangements they do not
                                       otherwise act in violation of their fiduciary duties.
                            c.         A partner has an obligation to render on demand true and full information of all
                                       things affecting the partnership to any partner.
                            d.         ABA Committee on Ethics and Professional Responsibility Informal Opinion
                                       1457 sets forth ethical standards for attorneys announcing a change in professional
                                       association.
                                       (1)        The ethical standard provides any notice explain to a client that he or
                                                  she has the right to decide who will continue the representation.
III.   Partnership Property
       A.       Putnam v. Shoaf (Ct. App. Tenn. 1981).
                1.          Under the Uniform Partnership Act, ... her partnership property rights consisted of her (1)
                            rights in specific partnership property, (2) interest in the partnership and (3) right to
                            participate in management.
                            a.         The right in “specific partnership property” is the partnership tenancy possessory
                                       right of equal use or possession by partners for partnership purposes. This
                                       possessory right is incident to the partnership and the possessory right does not
                                       exist absent the partnership.
                            b.         The real interest of a partner, as opposed to that incidental possessory right before
                                       discussed, is the partner’s interest in the partnership which is defined as “his share
                                       of the profits and surplus and the same is personal property.” Therefore, a co-
                                       partner owns no personal specific interest in any specific property or asset of the
                                       partnership. The partnership owns the property or the asset. The partner’s
                                       interest is an undivided interest, as a co-tenant in all partnership property. That
                                       interest is the partner’s pro rata share of the net value or deficit of the partnership.
                                       (1)        For this reason a conveyance of partnership property held in the name of
                                                  the partnership is made in the name of the partnership and not as a
                                                  conveyance of the individual interests of the partners.
       B.       Revised Uniform Partnership Act § 201. Partnership as Entity.
                (a) A partnership is an entity distinct from its partners.
                (b) A limited liability partnership continues to be the same entity that existed before the filing of a statement of
                qualification under Section 1001.
       C.       Revised Uniform Partnership Act § 203. Partnership Property.
                Property acquired by a partnership is property of the partnership and not of the partners individually.
       D.       Revised Uniform Partnership Act § 204. W hen Property is Partnership Property.
                (a) Property is partnership property if acquired in the name of:
                            (1) the partnership; or
                            (2) one or more partners with an indication in the instrument transferring title to the property of the
                            person's capacity as a partner or of the existence of a partnership but without an indication of the
                            name of the partnership.
                (b) Property is acquired in the name of the partnership by a transfer to:
                            (1) the partnership in its name; or
                            (2) one or more partners in their capacity as partners in the partnership, if the name of the partnership
                            is indicated in the instrument transferring title to the property.
                (c) Property is presumed to be partnership property if purchased with partnership assets, even if not acquired in
                the name of the partnership or of one or more partners with an indication in the instrument transferring title to
                the property of the person's capacity as a partner or of the existence of a partnership.
                (d) Property acquired in the name of one or more of the partners, without an indication in the instrument

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              transferring title to the property of the person's capacity as a partner or of the existence of a partnership and
              without use of partnership assets, is presumed to be separate property, even if used for partnership purposes.
      E.      Revised Uniform Partnership Act § 501. Partner Not Co-Owner of Partnership
              Property.
              A partner is not a co-owner of partnership property and has no interest in partnership property which can be
              transferred, either voluntarily or involuntarily.
      F.      Revised Uniform Partnership Act § 502. Partner’s Transferable Interest in Partnership.
              The only transferable interest of a partner in the partnership is the partner's share of the profits and losses of the
              partnership and the partner's right to receive distributions. The interest is personal property.
      G.      Revised Uniform Partnership Act § 503. Transfer of Partner’s Transferable Interest.
              (a) A transfer, in whole or in part, of a partner's transferable interest in the partnership:
                         (1) is permissible;
                         (2) does not by itself cause the partner's dissociation or a dissolution and winding up of the partnership
                         business; and
                         (3) does not, as against the other partners or the partnership, entitle the transferee, during the
                         continuance of the partnership, to participate in the management or conduct of the partnership
                         business, to require access to information concerning partnership transactions, or to inspect or copy the
                         partnership books or records.
              (b) A transferee of a partner's transferable interest in the partnership has a right:
                         (1) to receive, in accordance with the transfer, distributions to which the transferor would otherwise be
                         entitled;
                         (2) to receive upon the dissolution and winding up of the partnership business, in accordance with the
                         transfer, the net amount otherwise distributable to the transferor; and
                         (3) to seek under Section 801(6) a judicial determination that it is equitable to wind up the
                         partnership business.
              (c) In a dissolution and winding up, a transferee is entitled to an account of partnership transactions only from
              the date of the latest account agreed to by all of the partners.
              (d) Upon transfer, the transferor retains the rights and duties of a partner other than the interest in distributions
              transferred.
              (e) A partnership need not give effect to a transferee's rights under this section until it has notice of the transfer.
              (f) A transfer of a partner's transferable interest in the partnership in violation of a restriction on transfer
              contained in the partnership agreement is ineffective as to a person having notice of the restriction at the time of
              transfer.
IV.   Raising Additional Capital*
V.    The Rights of Partners in Management
      A.      Revised Uniform Partnership Act § 401. Partner’s Rights and Duties.
              (a) Each partner is deemed to have an account that is:
                         (1) credited with an amount equal to the money plus the value of any other property, net of the
                         amount of any liabilities, the partner contributes to the partnership and the partner's share of the
                         partnership profits; and
                         (2) charged with an amount equal to the money plus the value of any other property, net of the
                         amount of any liabilities, distributed by the partnership to the partner and the partner's share of the
                         partnership losses.
              (b) Each partner is entitled to an equal share of the partnership profits and is chargeable with a share of the
              partnership losses in proportion to the partner's share of the profits.
              (c) A partnership shall reimburse a partner for payments made and indemnify a partner for liabilities incurred by
              the partner in the ordinary course of the business of the partnership or for the preservation of its business or
              property.
              (d) A partnership shall reimburse a partner for an advance to the partnership beyond the amount of capital the
              partner agreed to contribute.
              (e) A payment or advance made by a partner which gives rise to a partnership obligation under subsection (c) or
              (d) constitutes a loan to the partnership which accrues interest from the date of the payment or advance.
              (f) Each partner has equal rights in the management and conduct of the partnership business.
              (g) A partner may use or possess partnership property only on behalf of the partnership.

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           (h) A partner is not entitled to remuneration for services performed for the partnership, except for reasonable
           compensation for services rendered in winding up the business of the partnership.
           (i) A person may become a partner only with the consent of all of the partners.
           (j) A difference arising as to a matter in the ordinary course of business of a partnership may be decided by a
           majority of the partners. An act outside the ordinary course of business of a partnership and an amendment to
           the partnership agreement may be undertaken only with the consent of all of the partners.
           (k) This section does not affect the obligations of a partnership to other persons under Section 301.
B.         UPA § 18(e) states that “all partners have equal rights in the management and conduct of the
           partnership business,” and § 18(h) provides that “any difference arising as to ordinary matters
           connected with the partnership business may be decided by a majority of the partners.” 18
           1.         Thus, if there are three partners and they disagree as to an “ordinary” matter, the decision
                      of the majority controls. The majority can deprive the minority partner.
           2.         If however, there are only two partners, there can be no majority vote that will be
                      effective to deprive either partner of authority to act for the partnership.
C.         National Biscuit Company v. Stroud (N.C. 1959).
           1.         In Johnson v. Bernheim, this Court said: A and B are general partners to do some given
                      business; the partnership is, by operation of law, a power to each to bind the partnership in
                      any manner legitimate to the business. If one partner goes to a third person to buy an
                      article on time for the partnership, the other partner cannot prevent it by writing to the
                      third person not to sell to him on time. And what is true in regard to buying is true in
                      regard to selling. W hat either partner does with a third person is binding on the partnership.
                      a.         It is otherwise where the partnership is not general, but is upon special terms, as
                                 that purchases and sales must be with and for cash. There the power to each is
                                 special, in regard to all dealings with third persons at least who have notice of the
                                 terms.
           2.         G.S. § 59.39(1). Partner Agent of Partnership as to Partnership Business
                      a.         “Every partner is an agent of the partnership for the purpose of its business, and
                                 the act of every partner, including the execution in the partnership name of any
                                 instrument, for apparently carrying on in the usual way the business of the
                                 partnership of which he is a member binds the partnership, unless the partner so
                                 acting has in fact no authority to act for the partnership in the particular matter,
                                 and the person with whom he is dealing has knowledge of the fact that he has no
                                 such authority.”
           3.         G.S. § 59.45 provides that “all partners are jointly and severally liable for the acts and
                      obligations of the partnership.”
           4.         G.S. § 59.48. Rules Determining Rights and Duties of Partners.
                      a.         (e) All partners have equal rights in the management and conduct of the
                                 partnership business.”
                      b.         (h) Any difference arising as to ordinary business matters connected with the
                                 partnership business may be decided by a majority of the partners; but no act in
                                 contravention of any agreement between the partners may be done rightfully
                                 without the consent of all the partners.
           5.         Freeman, as a general partner with Stroud, with no restrictions on his authority to act
                      within the scope of the partnership business so far as the agreed statement of facts shows,
                      had under the Uniform Partnership Act “equal rights in the management and conduct of
                      the partnership business.” Stroud, his co-partner, could not restrict the power and
                      authority of Freeman to buy bread for the partnership as a going concern, for such a
                      purchase was an “ordinary matter connected with the partnership business,” for the
                      purpose of its business and within its scope, because in the very nature of things Stroud was
                      not, and could not be, a majority of the partners.
           6.         In Crane on Partnership it is said: “In cases of an even division of the partners as to whether


18
     To the same effect is RUPA §§ 103, 401(f) and (j).

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              or not an act within the scope of the business should be done, of which disagreement a
              third person has knowledge, it seems that logically no restriction can be placed upon the
              power to act. The partnership being a going concern, activities within the scope of the
              business should not be limited, save by the expressed will of the majority deciding a
              disputed question; half of the members are not a majority.”
D.   Summers v. Dooley (Idaho 1971).
     1.       UPA § 18(h) provides: “Any difference arising as to ordinary matters connected with the
              partnership business may be decided by a majority of the partners.”
     2.       UPA § 18(e) provides: “The rights and duties of the partners in relation to the partnership
              shall be determined, subject to any agreement between them, by the following rules . . .
              All partners have equal rights in the management and conduct of the business.”
              a.        This section bestows equal rights in the management and conduct of the
                        partnership business upon all of the partners. The concept of equality between
                        partners with respect to management of business affairs is a central theme and
                        recurs throughout the Uniform Partnership law.
                        (1)        Thus, the only reasonable interpretation of § 18(h) is that business
                                   difference must be decided by a majority of the partners provided no
                                   other agreement between the partners speaks to the issues.
     3.       In the case at bar one of the partners continually voiced objection to the hiring of the third
              man. He did not sit idly by and acquiesce in the actions of his partner. Under these
              circumstances it is manifestly unjust to permit recovery of an expense which was incurred
              individually and not for the benefit of the partnership but rather for the benefit of one
              partner.
E.   Day v. Sidley & Austin (D.D.C. 1975).
     1.       Fraud.
              a.        The misrepresentation regarding plaintiff’s status cannot support a cause of action
                        for fraud, however, because plaintiff was not deprived of any legal right as a result
                        of his reliance on this statement.
              b.        Plaintiff’s allegations of an unwritten understanding cannot now be heard to
                        contravene the provisions of the Partnership Agreement which seemingly
                        embodied the complete intentions of the parties as to the manner in which the
                        firm was to be operated and managed.
              c.        Nor can plaintiff have reasonably believed that no changes would be made in the
                        W ashington office since the S & A Agreement gave complete authority to the
                        executive committee to decide questions of firm policy, which would clearly
                        include establishment of committees and the appointment of members and
                        chairpersons.
     2.       Breach of Fiduciary Duty
              a.        An examination of the case law on a partner’s fiduciary duties reveal that courts
                        have been primarily concerned with partners who make secret profits at the
                        expense of the partnership.
                        (1)        Partners have a duty to make a full and fair disclosure to other partners
                                   of all information which may be of value to the partnership.
                        (2)        The essence of a breach of fiduciary duty is that one partner has
                                   advantaged himself at the expense of the firm.
                        (3)        The basic fiduciary duties are:
                                   (a)        a partner must account for any profit acquired in a manner
                                              injurious to the interests of the partnership, such as
                                              commissions or purchases on the sale of partnership property.
                                   (b)        a partner cannot without the consent of the other partners,
                                              acquire for himself a partnership asset, nor may he divert to his
                                              own use a partnership opportunity.
                                   (c)        he must not compete with the partnership within the scope of
                                              business.

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                           b.      W hat plaintiff is alleging in the instant case, however, concerns failure to reveal
                                   information regarding changes in the internal structure of the firm. No court has
                                   recognized a fiduciary duty to disclose this type of information, the concealment
                                   of which does not produce any profit for the offending partners nor any financial
                                   loss for the partnership as a whole.
                                   (1)         Note. Day would have been in better shape under the Revised Uniform
                                               Partnership Act § 403(c)(1) which provides: “Each partner and the
                                               partnership shall furnish to a partner, and to the legal representative of a deceased
                                               partner or partner under legal disability: (1) without demand, any information
                                               concerning the partnership's business and affairs reasonably required for the proper
                                               exercise of the partner's rights and duties under the partnership agreement or this
                                               [Act].”
      F.       Technically, under the UPA §§ 29 and 31, the old partnership is dissolved by the retirement of any
               partner and when the remaining partners continue their practice a new partnership is formed.
               1.       “Continuation” agreement: an agreement obligating the remaining partners to continue to
                        associate with one another as partners under the existing agreement (or, perhaps, some
                        variation of it).
      G.       Under RUPA § 601, if a partner retires pursuant to an appropriate provision in the partnership
               agreement (and in various other situations), there is a “dissociation” rather than a “dissolution.”
               1.       The partnership continues as to the remaining partners and the dissociated partner is
                        entitled, in the absence of an agreement to the contrary, to be paid an amount determined
                        as if “on the date of dissociation, the assets of the partnership were sold at a price equal to
                        the greater of the liquidation value or the value based on a sale of the entire business as a
                        going concern without the dissociated partner,” plus the interest from the date of
                        dissociation. § 701(a) and (b).
VI.   Partnership Dissolution
      A.       The Right to Dissolve
               1.       Uniform Partnership Act § 31. Causes of Dissolution.
                        Dissolution is caused:
                        (1) W ithout violation of the agreement between the partners,
                                   (a) By the termination of the definite term or particular undertaking specified in the
                                   agreement,
                                   (b) By the express will of any partner when no definite term or particular undertaking is
                                   specified,
                                   (c) By the express will of all the partners who have not assigned their interests or suffered
                                   them to be charged for their separate debts, either before or after the termination of any
                                   specified term or particular undertaking,
                                   (d) By the expulsion of any partner from the business bona fide in accordance with such a
                                   power conferred by the agreement between the partners;
                        (2) In contravention of the agreement between the partners, where the circumstances do not permit a
                        dissolution under any other provision of this section, by the express will of any partner at any time;
                        (3) By any event which makes it unlawful for the business of the partnership to be carried on or for
                        the members to carry it on in partnership;
                        (4) By the death of any partner;
                        (5) By the bankruptcy of any partner or the partnership;
                        (6) By decree of court under section 32.
               2.       Uniform Partnership Act § 32. Dissolution by Decree of Court.
                        (1) On application by or for a partner the court shall decree a dissolution whenever:
                                   (a) A partner has been declared a lunatic in any judicial proceeding or is shown to be of
                                   unsound mind,
                                   (b) A partner becomes in any other way incapable of performing his part of the partnership
                                   contract,
                                   (c) A partner has been guilty of such conduct as tends to affect prejudicially the carrying on
                                   of the business,

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                 (d) A partner wilfully or persistently commits a breach of the partnership agreement, or
                 otherwise so conducts himself in matters relating to the partnership business that it is not
                 reasonably practicable to carry on the business in partnership with him,
                 (e) The business of the partnership can only be carried on at a loss,
                 (f) Other circumstances render a dissolution equitable.
     (2) On the application of the purchaser of a partner's interest under sections 28 or 29[in original;
     probably should read “section 27 or 28.”]:
                 (a) After the termination of the specified term or particular undertaking,
                 (b) At any time if the partnership was a partnership at will when the interest was assigned
                 or when the charging order was issued.
3.   Revised Uniform Partnership Act § 601. Events Causing Partner’s Dissociation.
     A partner is dissociated from a partnership upon the occurrence of any of the following events:
     (1) the partnership's having notice of the partner's express will to withdraw as a partner or on a later
     date specified by the partner;
     (2) an event agreed to in the partnership agreement as causing the partner's dissociation;
     (3) the partner's expulsion pursuant to the partnership agreement;
     (4) the partner's expulsion by the unanimous vote of the other partners if:
                 (i) it is unlawful to carry on the partnership business with that partner;
                 (ii) there has been a transfer of all or substantially all of that partner's transferable interest
                 in the partnership, other than a transfer for security purposes, or a court order charging the
                 partner's interest, which has not been foreclosed;
                 (iii) within 90 days after the partnership notifies a corporate partner that it will be expelled
                 because it has filed a certificate of dissolution or the equivalent, its charter has been revoked,
                 or its right to conduct business has been suspended by the jurisdiction of its incorporation,
                 there is no revocation of the certificate of dissolution or no reinstatement of its charter or its
                 right to conduct business; or
                 (iv) a partnership that is a partner has been dissolved and its business is being wound up;
     (5) on application by the partnership or another partner, the partner's expulsion by judicial
     determination because:
                 (i) the partner engaged in wrongful conduct that adversely and materially affected the
                 partnership business;
                 (ii) the partner willfully or persistently committed a material breach of the partnership
                 agreement or of a duty owed to the partnership or the other partners under Section 404; or
                 (iii) the partner engaged in conduct relating to the partnership business which makes it not
                 reasonably practicable to carry on the business in partnership with the partner;
     (6) the partner's:
                 (i) becoming a debtor in bankruptcy;
                 (ii) executing an assignment for the benefit of creditors;
                 (iii) seeking, consenting to, or acquiescing in the appointment of a trustee, receiver, or
                 liquidator of that partner or of all or substantially all of that partner's property; or
                 (iv) failing, within 90 days after the appointment, to have vacated or stayed the
                 appointment of a trustee, receiver, or liquidator of the partner or of all or substantially all of
                 the partner's property obtained without the partner's consent or acquiescence, or failing
                 within 90 days after the expiration of a stay to have the appointment vacated;
     (7) in the case of a partner who is an individual:
                 (i) the partner's death;
                 (ii) the appointment of a guardian or general conservator for the partner; or
                 (iii) a judicial determination that the partner has otherwise become incapable of performing
                 the partner's duties under the partnership agreement;
     (8) in the case of a partner that is a trust or is acting as a partner by virtue of being a trustee of a
     trust, distribution of the trust's entire transferable interest in the partnership, but not merely by reason
     of the substitution of a successor trustee;
     (9) in the case of a partner that is an estate or is acting as a partner by virtue of being a personal
     representative of an estate, distribution of the estate's entire transferable interest in the partnership, but

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     not merely by reason of the substitution of a successor personal representative; or
     (10) termination of a partner who is not an individual, partnership, corporation, trust, or estate.
4.   Revised Uniform Partnership Act § 602. Partner’s Power to Dissociate;
     W rongful Dissociation.
     (a) A partner has the power to dissociate at any time, rightfully or wrongfully, by express will
     pursuant to Section 601(1).
     (b) A partner's dissociation is wrongful only if:
                (1) it is in breach of an express provision of the partnership agreement; or
                (2) in the case of a partnership for a definite term or particular undertaking, before the
                expiration of the term or the completion of the undertaking:
                            (i) the partner withdraws by express will, unless the withdrawal follows within
                            90 days after another partner's dissociation by death or otherwise under Section
                            601(6) through (10) or wrongful dissociation under this subsection;
                            (ii) the partner is expelled by judicial determination under Section 601(5);
                            (iii) the partner is dissociated by becoming a debtor in bankruptcy; or
                            (iv) in the case of a partner who is not an individual, trust other than a business
                            trust, or estate, the partner is expelled or otherwise dissociated because it willfully
                            dissolved or terminated.
     (c) A partner who wrongfully dissociates is liable to the partnership and to the other partners for
     damages caused by the dissociation. The liability is in addition to any other obligation of the partner
     to the partnership or to the other partners.
5.   Owen v. Cohen (Cal. 1941).
     a.         General rule that trifling and minor differences and grievances which involve no
                permanent mischief will not authorize a court to decree a dissolution of a
                partnership.
     b.         However, courts of equity may order the dissolution of a partnership where there
                are quarrels and disagreements of such a nature and to such extent that all
                confidence and cooperation between the parties has been destroyed or where one
                of the parties by his misbehavior hinders a proper conduct of the partnership
                business.
                (1)         It is not only large affairs which produce trouble. The continuation of
                            overbearing and vexatious petty treatment of one partner by another
                            frequently is more serious in its disruptive character than would be larger
                            differences which would be discussed and settled.
     c.         UPA § 32.
                (1)         “(1) On application by or for a partner the court shall decree a
                            dissolution whenever...(d) ... it is not reasonably practicable to carry on the
                            business in partnership with [the other partner].”
6.   Buyout of Dissociated Partner. If a partner’s dissociation does not result in dissolution,
     RUPA § 7.01 provides as a default rule that the dissociated partner is entitled to be bought
     out: “the partnership shall cause the dissociated partner’s interest in the partnership to be
     purchased.” Unless otherwise provided in the partnership agreement, “[t]he buyout is
     mandatory. The ‘cause to be purchased language is intended to accommodate a purchase
     by the partnership, one or more of the remaining partners, or a third party.”
7.   Revised Uniform Partnership Act § 801. Events Causing Dissolution and
     W inding Up of Partnership Business.
     A partnership is dissolved, and its business must be wound up, only upon the occurrence of any of the
     following events:
     (1) in a partnership at will, the partnership's having notice from a partner, other than a partner who is
     dissociated under Section 601(2) through (10), of that partner's express will to withdraw as a partner,
     or on a later date specified by the partner;
     (2) in a partnership for a definite term or particular undertaking:
                (i) within 90 days after a partner's dissociation by death or otherwise under Section 601(6)
                through (10) or wrongful dissociation under Section 602(b), the express will of at least half

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                  of the remaining partners to wind up the partnership business, for which purpose a partner's
                  rightful dissociation pursuant to Section 602(b)(2)(i) constitutes the expression of that
                  partner's will to wind up the partnership business;
                  (ii) the express will of all of the partners to wind up the partnership business; or
                  (iii) the expiration of the term or the completion of the undertaking;
      (3) an event agreed to in the partnership agreement resulting in the winding up of the partnership
      business;
      (4) an event that makes it unlawful for all or substantially all of the business of the partnership to be
      continued, but a cure of illegality within 90 days after notice to the partnership of the event is effective
      retroactively to the date of the event for purposes of this section;
      (5) on application by a partner, a judicial determination that:
                  (i) the economic purpose of the partnership is likely to be unreasonably frustrated;
                  (ii) another partner has engaged in conduct relating to the partnership business which makes
                  it not reasonably practicable to carry on the business in partnership with that partner; or
                  (iii) it is not otherwise reasonably practicable to carry on the partnership business in
                  conformity with the partnership agreement; or
      (6) on application by a transferee of a partner's transferable interest, a judicial determination that it is
      equitable to wind up the partnership business:
                  (i) after the expiration of the term or completion of the undertaking, if the partnership was
                  for a definite term or particular undertaking at the time of the transfer or entry of the
                  charging order that gave rise to the transfer; or
                  (ii) at any time, if the partnership was a partnership at will at the time of the transfer or
                  entry of the charging order that gave rise to the transfer.
8.    Revised Uniform Partnership Act § 802. Partnership Continues After
      Dissolution.
      (a) Subject to subsection (b), a partnership continues after dissolution only for the purpose of winding
      up its business. The partnership is terminated when the winding up of its business is completed.
      (b) At any time after the dissolution of a partnership and before the winding up of its business is
      completed, all of the partners, including any dissociating partner other than a wrongfully dissociating
      partner, may waive the right to have the partnership's business wound up and the partnership
      terminated.
      In that event:
                  (1) the partnership resumes carrying on its business as if dissolution had never occurred, and
                  any liability incurred by the partnership or a partner after the dissolution and before the
                  waiver is determined as if dissolution had never occurred; and
                  (2) the rights of a third party accruing under Section 804(1) or arising out of conduct in
                  reliance on the dissolution before the third party knew or received a notification of the waiver
                  may not be adversely affected.
9.    Collins v. Lewis (Tex. 1955).
      a.          Power to Dissolve But Not a Right. W e agree with the appellants that there is no
                  such thing as an indissoluble partnership only in the sense that there always exists
                  the power, as opposed to the right, of dissolution. But legal right to dissolution
                  rests in equity, as does the right to relief from the provisions of any legal contract.
10.   Page v. Page (Cal. 1961).
      a.          The Uniform Partnership Act provides that a partnership may be dissolved “By
                  the express will of any partner when no definite term or particular undertaking is
                  specified.”
      b.          In Owen v. Cohen, the court held that when a partner advances a sum of money
                  to a partnership with the understanding that the amount contributed was to be a
                  loan to the partnership and was to be repaid as soon as feasible from the
                  prospective profits of the business, the partnership is for the term reasonably
                  required to pay the loan.
                  (1)          It is true that these cases hold that partners may impliedly agree to
                               continue in business until a certain sum of money is earned, or one or

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                                  more partners recoup their investments, or until certain debts are paid,
                                  or until certain property could be disposed of on favorable terms.
                                  (a)        In each of these cases, however, the implied agreement found
                                             support in the evidence.
                                  (b)        In the instant case, however, defendants failed to prove any
                                             facts from which an agreement to continue the partnership for a
                                             term may be implied.
            c.         Power to Dissolve Must Be Exercised in Good Faith. Even though the Uniform
                       Partnership Act provides that a partnership at will may be dissolved by the express
                       will of any partner, this power, like any other power held by a fiduciary, must be
                       exercised in good faith.
                       (1)        A partner at will is not bound to remain in a partnership, regardless of
                                  whether the business is profitable or unprofitable. A partner may not,
                                  however, by use of adverse pressure “freeze out” a co-partner and
                                  appropriate the business to his own use. A partner may not dissolve a
                                  partnership to gain the benefits of the business for himself, unless he fully
                                  compensates his co-partner for his share of the prospective business
                                  opportunity.
B.   The Consequences of Dissolution
     1.     Prentiss v. Sheffel (Ariz. 1973).
            a.         Facts. Plaintiffs owned a 42 ½ % interest each in the partnership (a shopping,
                       while the defendant owned a 15 % interest. The plaintiffs alleged that the
                       defendant derelict in his duties, in particular that he had failed to contribute his
                       share of the losses. The plaintiffs sought to dissolve the partnership. The trial
                       court held that a partnership-at-will existed and that it was terminated when the
                       plaintiff froze-out the defendant. The court ordered a sale and the plaintiffs were
                       the high bidders.
            b.         Issue. W hether two majority partners in a three-man partnership-at-will, who
                       have excluded the third partner from partnership management and affairs, should
                       be allowed to purchase the partnership assets at a judicially supervised dissolution
                       sale.
            c.         W rongful Purpose Necessary. W hile the trial court did find that the defendant was
                       excluded from the management of the partnership, there was no indication that
                       such exclusion was done for the wrongful purpose of obtaining the partnership assets in
                       bad faith rather than merely being the result of the inability of the partners to
                       harmoniously function in a partnership relation.
            d.         Not Injured by Partners’ Participation in Sale. Moreover, the defendant has failed to
                       demonstrate how he was injured by the participation of the plaintiffs in the
                       judicial sale.
                       (1)        Because of the plaintiffs’ bidding in the judicial sale, it appears that the
                                  defendant’s 15% interest in the partnership was considerably enhanced by
                                  the plaintiff’s participation.
            e.         The defendant has cited no cases, nor has this court found any, which have
                       prohibited a partner from bidding at a judicial sale of the partnership assets.
                       (1)        Not an Attack on the Order to Sell. It should be emphasized that on this
                                  appeal the defendant does not attack the fact that the trial court ordered
                                  a sale of the assets. The only area of attack is that plaintiffs have been
                                  allowed to participate and bid in that sale.




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                 2.       Uniform Partnership Act § 38. Rights of Partners to Application of Partnership
                          Property. 19
                          (1) W hen dissolution is caused in any way, except in contravention of the partnership agreement,
                          each partner, as against his co-partners and all persons claiming through them in respect of their
                          interests in the partnership, unless otherwise agreed, may have the partnership property applied to
                          discharge its liabilities, and the surplus applied to pay in cash the net amount owing to the respective
                          partners. But if dissolution is caused by expulsion of a partner, bona fide under the partnership
                          agreement and if the expelled partner is discharged from all partnership liabilities, either by payment
                          or agreement under section 36(2), he shall receive in cash only the net amount due him from the
                          partnership.
                          (2) W hen dissolution is caused in contravention of the partnership agreement the rights of the partners
                          shall be as follows:
                                      (a) Each partner who has not caused dissolution wrongfully shall have,
                                                   I. All the rights specified in paragraph (1) of this section, and
                                                   II. The right, as against each partner who has caused the dissolution wrongfully,
                                                   to damages for breach of the agreement.
                                      (b) The partners who have not caused the dissolution wrongfully, if they all desire to
                                      continue the business in the same name, either by themselves or jointly with others, may do
                                      so, during the agreed term for the partnership and for that purpose may possess the
                                      partnership property, provided they secure the payment by bond approved by the court, or
                                      pay to any partner who has caused the dissolution wrongfully, the value of his interest in
                                      the partnership at the dissolution, less any damages recoverable under clause (2a II) of this
                                      section, and in like manner indemnify him against all present or future partnership
                                      liabilities.
                                      (c) A partner who has caused the dissolution wrongfully shall have:
                                                   I. If the business is not continued under the provisions of paragraph (2b) all the
                                                   rights of a partner under paragraph (1), subject to clause (2a II), of this section,
                                                   II. If the business is continued under paragraph (2b) of this section the right as
                                                   against his co-partners and all claiming through them in respect of their interests
                                                   in the partnership, to have the value of his interest in the partnership, less any
                                                   damages caused to his co-partners by the dissolution, ascertained and paid to him
                                                   in cash, or the payment secured by bond approved by the court, and to be released
                                                   from all existing liabilities of the partnership; but in ascertaining the value of the
                                                   partner's interest the value of the good-will of the business shall not be considered.
                 3.       Pav-Saver Corporation v. Vasso Corporation (Ill. 1986).
                          a.          Facts. PSC owned the trademark and patents for concrete paving machines.
                                      Dale, the inventor of a machine and majority shareholder of PSC and Meersman,
                                      owner and shareholder of Vasso, formed Pav-Saver Manufacturing. Dale
                                      contributed services, PSC contributed the patents and trademarks, and Meersman
                                      obtained financing. The partnership agreement contained language granting Pav-
                                      Saver the exclusive right to use PSC’s trademarks and patents. The agreement
                                      also stated that if either party terminated, the terminating party would pay
                                      liquidated damages. In 1976, the agreement was replaced with an identical one,
                                      but eliminating the individual partners. PSC terminated the partnership in 1983.
                                      The trial court ruled that Vasso was entitled to continue the business and possess
                                      the partnership assets, including the trademark and patents.
                          b.          Uniform Partnership Act § 38 provides:
                                      (2) W hen dissolution is caused in contravention of the partnership agreement the
                                      rights of the partners shall be as follows:
                                                   (a) Each partner who has not cause dissolution wrongfully shall have,


        19
            RUPA is essentially the same as UPA. However, a wrongfully dissociate partner is entitled to have
goodwill included in the calculation.

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                                                                           ***
                                II. The right, as against each partner who has cause dissolution
                                wrongfully, to damages for breach of the agreement.
                                (b) The partners who have not cause the dissolution wrongfully, I they
                                all desire to continue the business in the same name, either themselves or
                                jointly with others, may do so, during the agreed term for the
                                partnership and for that purpose may possess the partnership property,
                                provided they secure the payment by bond approved by the court, or
                                pay to any partner who has caused the dissolution wrongfully, the value
                                of his interest in the partnership at dissolution, less any damages
                                recoverable under clause (2a II) of this section, and in like manner
                                indemnify him against all present or future partnership liabilities.
                                (c) A partner who has caused the dissolution wrongfully shall have:
                                                                           ***
                                (II) If the business is continue under paragraph (2b) of this section the
                                right as against his co-partners and all claiming through them in respect
                                of their interest in the partnership, to have the value of his interest in the
                                partnership, less any damages caused to his co-partners by the
                                dissolution, ascertained and paid to him in cash, or the payment secured
                                by bond approved by the court and to be released from all existing
                                liabilities of the partnership; but in ascertaining the value of the partner’s
                                interest the value of the good will of the business shall not be
                                considered.
             c.        Despite the parties’ contractual direction that PSC’s patents would be returned to
                       it upon the mutually approved expiration of the partnership, the right to possess
                       the partnership property and continue in business upon a wrongful termination
                       must be derived from and is controlled by the statute.
             d.        Dissent/Concurrence
                       (1)      The partnership agreement is a contract, and event though a partner may
                                have the power to dissolve, he does no necessarily have the right to do
                                so. Therefore, if the dissolution he causes is a violation of the
                                agreement, he is liable for any damages sustained by the innocent
                                partners as a result.
                                (a)         The innocent partner also has the option to continue the
                                            business in the firm name provided they pay the partner cause
                                            the dissolution the value of the interest of his partnership.
                       (2)      W hile the rights and duties of the partners in relation to the partnership
                                are governed by the Uniform Partnership Act, the uniform act also
                                provides that such rules are subject to any agreement between the parties
                                (a)         The partnership agreement entered into by PSC and Vasso in
                                            pertinent part provides:
                                            i)        “the property [patents, etc.] shall be returned to PSC at the
                                                      expiration of this partnership.”
                                            ii)       The majority holds this provision is unenforceable
                                                      because its enforcement would affect defendant’s
                                                      option to continue the business. No authority is cited
                                                      for such a rule.
                       (3)      I think it clear the parties agreed the partnership only be allowed the use
                                of the patents during the term of the agreement. The agreement having
                                been terminated, the right to use the patents is terminated.
C.   The Sharing of Losses*
D.   Buyout Agreements
     1.      A buy-out, or buy-sell, agreement is an agreement that allows a partner to end her or his
             relationship with other partners and receive a cash payment, or series of payment, or some

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                   assets of the firm, in return for her or his interest in the firm.
          2.       Issues
                   a.         Trigger Events: (1) Death; (2) Disability; (3) W ill of any partner
                   b.         Obligation to Buy v. Option: (1) Firm; (2) Other Investors; (3) Consequences of
                              Refusal to Buy [If there is an obligation]/[If there is no obligation].
                   c.         Price: (1) Book value; (2) Appraisal; (3) Formula (e.g., five times earnings); (4) Set
                              price each year; (5) Relation to duration (e.g., lower price in first five years)
                   d.         Method of Payment: (1) Cash; (2) Installments (with interest?)
                   e.         Protection Against Debts of Partnership
                   f.         Procedure for Offering Either to Buy or Sell: (1) First mover sets price to buy or sell;
                              (2) First mover forces others to set price
          3.       G & S Investments v. Belman (Ariz. 1984).
                   a.         Facts. Century Park was a limited partnership formed to receive ownership of an
                              apartment complex. Nordale had a 25.5% interest. Nordale became a cokehead
                              and a hermit. He had coke rage all the time and threatened the other partners.
                              He totally hit on jailbait and refused to pay rent on the apartment the partnership
                              let him use after his divorce. Nordale starting make irrational demands. The
                              other partners finally sought a dissolution of the partnership which would allow
                              them to carry on the business and buy out Nordale’s interest. Nordale died after
                              the filing of the complaint. The complaint was amended to invoke their right to
                              continue the partnership and acquire Nordale’s interest under article 19 of the
                              partnership’s Articles of Limited Partnership.
                   b.         Uniform Partnership Act § 32 authorizes the court to dissolve a partnership
                              when:
                                                                       ***
                              (2) A partner becomes in any other way incapable of performing his part of the
                              partnership contract.
                              (3) A partner has been guilty of such conduct as tends to affect prejudicially the
                              carrying on of the business.
                              (4) A partner willfully or persistently commits a breach of the partnership
                              agreement, or otherwise so conducts himself in matters relating to the partnership
                              business that it is not reasonably practicable to carry on the business in partnership
                              with him.
                   c.         Mere Filing of Complaint Does Not Dissolve. In Cooper v. Isaacs, the court was met
                              with the same contention made here, to-wit, that the mere filing of the complaint
                              acted as a dissolution. The court rejected this contention. Dissolution would
                              occur only when decreed by the court or when brought about by other acts.
                   d.         Gibson and Smith testified that the parties actually intended and understood
                              “capital account” to mean exactly what it literally says, the account which shows
                              a partner’s capital contribution to the partnership plus profit minus losses.
                              (1)        The capital amount is also reduced by the amount of any distributions.
                              (2)        The words “capital account” are not ambiguous and clearly mean the
                                         partner’s capital account as it appears on the books of the partnership.
                   e.         Partnership buy-out agreements are valid and binding although the purchase price
                              agreed upon is less or more than the actual value of the interest at the time of
                              death.
                              (1)        Modern business practice mandates that the parties be bound by the
                                         contract they enter into, absent fraud or duress. It is not the province of
                                         this court to act as a post-transaction guardian of either party.
E.        Partnership Capital Accounts 20
          1.       Capital Account. As part of the settling-up process, partners are paid the amounts owed “in


20
     See Partnership Capital Accounts Handout.

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                                                                                               JR C /Fall 2010/Fendler/B usiness A ssoc .

                             respect of capital.” The bookkeeping devices that track the amount the partnership owes
                             each partner “in respect of capital” are called capital accounts.
                  2.         Contribution/Distribution. Property contributed to the partnership increases the
                             contributing partner’s capital account by an amount equal to the fair market value of the
                             asset as of the time of contribution, as do profits allocated to partners from ongoing
                             activities. Distributions made to partners decreased their respective capital account, as do
                             losses allocated to partners from ongoing activities.
                  3.         Appreciation/Depreciation. Post-contribution appreciation of depreciation of a contributed
                             asset does not affect the contributing partner’s capital account. The contribution severs the
                             contributor’s direct connection to the asset; subsequent vicissitudes in the asset’s value are
                             “for the partnership’s account.”
VII.     Limited Partnership
         A.       Holzman v. De Escamilla.(Cal. App. 1948).
                  1.         Facts. Russell and Andrews were limited partners in Hacienda Farms with Escamilla, the
                             general partner. Holzman, the trustee in bankruptcy, brought an action to determine that
                             Russell and Andrews were liable as general partners to the creditors of the partnership.
                             The evidence showed that Escamilla consulted Russell and Andrews as to which crops to
                             grow and was even overruled as to some of those decisions. In addition, Andrews and
                             Russell asked Escamilla to resign as manager and appointed his replacement. Furthermore,
                             checks drawn on Hacienda’s accounts had to be signed by two of the three partners,
                             therefore, Escamilla had no power to withdraw funds without the signature of at least one
                             of the other partners.
                  2.         Section 2483 of the Civil Code provides as follows: “A limited partner shall not become
                             liable as a general partner, unless, in addition to the exercise of his rights and powers as a
                             limited partner, he takes part in the control of the business.”
                  3.         The foregoing illustrations sufficiently show that Russell and Andrews both took “part in
                             the control of the business.”
                             a.         The manner of withdrawing money from the bank accounts is particularly
                                        illuminating. The two men had absolute power to withdraw all the partnership
                                        funds in the banks without the knowledge or consent of the general partner.
                             b.         They required him to resign as manager and selected his successor. They were
                                        active in dictating the crops to be planted, some of them against the wish of the
                                        general partner.
         B.       Revised Uniform Limited Partnership Act § 303(a) now provides that:
                  1.         “a limited partner is not liable for the obligations of a limited partnership unless the limited
                             partner is also a general partner or, in addition to the exercise of his rights and powers as a
                             limited partner, he takes part in the control of the business. However, if the limited
                             partner takes part in the control of the business and is not also a general partner, the limited
                             partner is liable only to person who transact business with the limited partnership and who
                             reasonably believe, based upon the limited partner’s conduct, that the limited partner is a
                             general partner.
         C.       Revised Uniform Limited Partnership Act § 303(b) also provides that a limited partner does not
                  participate in control “solely by . . . (2) consulting with and advising a general partner with respect
                  to the business of the limited partnership.”
C H A PTER T H R EE : T H E N A TU R E O F TH E C O R PO R A TIO N
I.       Promoters and the Corporate Entity
         A.       Promoter. A “promoter” is a term of art referring to a person who identifies a business opportunity
                  and puts together a deal, forming a corporation as the vehicle for investment by other people.
                  1.         Preincorporation. Promoters may enter into contracts on behalf of the venture being
                             promoted either before or after articles of incorporation have been filed.
                             a.         Corporation Bound? A corporation is not bound by a contract made on its behalf
                                        before it was incorporated unless the corporation agrees to be bound. The




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                                                                                               JR C /Fall 2010/Fendler/B usiness A ssoc .
                                                                               21
                                      corporation must “adopt” the contract.
                                      (1)        Express or Implied. It may do so expressly, e.g., where its board of
                                                 directors passes a resolution expressly adopting the contract. Or it may
                                                 do so impliedly, by knowingly accepting the benefits of the contract.
                                      (2)        Quasi-Contract/Unjust Enrichment. The other party to the contract may
                                                 be able to assert quasi-contract or estoppel claims against the
                                                 corporation.
                  2.        Promoter’s Liability. W hether a promoter is personally liable on the contract he makes for
                            the corporation that has not been formed depends on the parties’ (the third party and
                            promoter’s) intent.
                            a.        Corporation Never Comes Into Existence:
                                      (1)        Presumption Promoter Liable. The presumption is that the parties intend
                                                 the promoter to be personally liable, so that if the corporation is never
                                                 formed, the third party can hold the promoter liable for breach of the
                                                 contract.
                                                 (a)        Different Intent. The parties may intend that the promoter is
                                                            not liable on the contract, but instead the corporation will be
                                                            bound to the contract after it is formed and adopts the contract.
                                                            But this is unlikely, because it would mean that there really
                                                            wasn’t a contract at all.
                                      (2)        Breach of a Separate Promise. The promoter may have expressly or
                                                 impliedly promised the third party that she (the promoter) would use
                                                 her best efforts to cause the corporation to be formed and to adopt the
                                                 contract. If the corporation is never formed and the third party can
                                                 prove that this was because the promoter failed to use her best efforts,
                                                 the third party can hold the promoter liable.
                            b.        Promoter’s Liability After the Corporation is Formed:
                                      (1)        Novation. The presumption that the parties intend the promoter to be
                                                 liable on the pre-incorporation contract continues even after the
                                                 corporation is formed and even if the corporation adopts the contract.
                                                 However, the parties may have a different intent: they may intend that
                                                 once the corporation is formed and adopts the contract, the promoter
                                                 will be released from liability. This is called a novation: the creditor
                                                 agrees to accept a new debtor in place of the old.
                                                 (a)        Still Must Prove Intent. The intent to enter into a novation must
                                                            be proved. If it is not, the presumption of the promoter’s
                                                            liability will stand.
                            c.        Defective Incorporation:
                                      (1)        If the corporation has not been properly formed, logically then, the
                                                 business must be operating as a sole proprietorship or a general
                                                 partnership–neither of which afford its owners (shareholders) limited
                                                 liability. This would give the third party–who made the contract in the
                                                 belief that he was dealing with a corporation, not an individual–an
                                                 undeserved windfall.
                                      (2)        The common law came up with two theories to deal with cases like this:
                                                 (a)        De Facto Corporation. W here there has been a defect in the
                                                            incorporation process that prevents the business from being
                                                            treated as a de jure corporation, but (1) the
                                                            promoter/shareholder made a good faith effort to incorporate
                                                            the business, and (2) carried on the business as though it were a


         21
           Some courts describe this action as “ratification,” but technically a corporation cannot ratify acts that
occurred before its existence.

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                                              corporation, some courts treat the firm as a de facto corporation.
                                              i)        The State can contest the corporate existence of a de
                                                        facto corporation but no one else can.
                                    (b)       Corporation By Estoppel. Someone who deals with the firm as
                                              though it were a corporation is estopped to deny the
                                              corporation’s existence even though there has been no
                                              colorable attempt to incorporate.
               d.       Statutory Efforts
                        (1)      MBCA § 2.04. Liability for Preincorporation Transactions.
                                 All persons purporting to act as or on behalf of a corporation, knowing there was
                                 not incorporation under this Act, are jointly and severally liable for all liabilities
                                 created while so acting.
                        (2)      On its face, this statute creates promoter liability in all cases in which the
                                 promoter knew, at the time she made the contract, that the corporation
                                 was not in existence. The promoter would not be liable if she
                                 mistakenly believed the corporation was in existence at the time she
                                 made the contract.
                        (3)      The promoter is protected in defective incorporation cases, even if there
                                 was no good-faith attempt to form the business (e.g., an attorney was
                                 hired to incorporate the business and never attempted to do so).
                        (4)      Comments to the MBCA indicate that the principles of estoppel can
                                 change the result that the statute would otherwise indicate (e.g., where
                                 the third party urged that the contract be made in the name of the
                                 nonexistent corporation, the third party may be estopped to impose
                                 personal liability on the shareholder/promoter, even though the
                                 shareholder/promoter knew that the corporation did not yet exist at the
                                 time of contracting).
     3.       Fiduciary Duties. Promoters of a venture own fiduciary duties to each other and to the
              corporation. The duty is essentially the same as the duties owed by a partner to a
              partnership or partners. A duty of full disclosure is owed to subsequent investors.
              a.        To Corporation. After the corporation is formed it may obtain from the promoter
                        any benefits or rights the promoter obtained on its behalf.
              b.        To Fellow Promoters. Promoters are essentially partners in the promotion of the
                        venture, and any benefits or rights one promoter obtains must be shared with co-
                        promoters.
              c.        To Subsequent Investors. (Based on Old Dominion Copper Mining & Smelting Co. v.
                        Bigelow (Mass. 1909) & Old Dominion Copper Mining & Smelting Co. v. Lewisohn
                        (U.S. 1908)).
                        (1)      Under the Massachusetts rule, a corporation may attack an earlier
                                 transaction if the subsequent sale to public investors was contemplated at
                                 the time of the earlier transaction.
                                 (a)       More widely followed
                                 (b)       Arguably, the real issue in these cases is whether there was full
                                           disclosure of the transaction at the time the public investors
                                           decided to make their investments.
                        (2)      Under the federal rule, the corporation may not attack an earlier
                                 transaction because all the stockholders at the time consented to the
                                 transaction.
              d.        To Creditors. Fiduciary concepts may also protect creditors against unfair or
                        fraudulent transactions by promoters. Most of theses transactions also may be
                        attacked on the ground they constitute fraud on creditors.
B.   Southern-Gulf Marine Co. No. 9, Inc. v. Camcraft, Inc.
     1.       W e believe the defendant, having given its promise to construct the vessel, should not be
              permitted to escape performance by raising an issue as to the character of the organization

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                          to which it is obligated, unless its substantial rights might thereby be affected.
                          a.        Estoppel. It is settled, by an overwhelming array of indisputable precedents that,
                                    as a rule, one who contracts with what he acknowledges to be and treats as a
                                    corporation, incurring obligations in its favor, is estopped from denying its
                                    corporate existence, particularly when the obligations are sought to be enforced. 22
II.      The Corporate Entity and Limited Liability
         A.     Piercing the Corporate Veil
                1.        Closely Held Corporations. Piercing is exclusively a doctrine applicable to closely held
                          corporations. But piercing may be applied to subsidiary corporations owned by a publicly
                          held parent corporation. But in these cases, the separate existence of the subsidiary and not
                          the parent is ignored. 23
                2.        Legal Tests 24:
                          a.        Alter Ego and Instrumentality
                                    (1)        Requires (a) such unity of ownership and interest between corporation
                                               and stockholder that the corporation has ceased to have separate
                                               existence, and (b) recognition of the separate existence of the
                                               corporation sanctions fraud or leads to an inequitable result.
                          b.        Others: (1) Misrepresentation and Fraud; (2) Personal Guaranty; (3)
                                    Undercapitalization; (4) Operation on the Edge of Insolvency; (5) Commingling
                                    and Confusion; (6) Artificial Division of Business Entity; (7) Mere Continuation;
                                    and (8) Failure to Follow Corporate Formalities
         B.     W hy Allow Incorporation to Escape Personal Liability
                1.        Less money available to invest if limited liability was not available
                2.        Maximizes the amount to be invested. Encourages investment. (Portfolio Theory).
                3.        Management can take more risk in operating the business.
                4.        Costs:
                          a.        Creditors can incur a cost.
                          b.        Externalities.
         C.     Bartle v. Home Owners Cooperative, Inc. (N.Y. 1955).
                1.        Facts. Defendant (Home Owners) was a co-operative corporation composed of veterans
                          for the purpose of providing low-cost housing to its members. Defendant was unable to
                          secure a contractor for construction so it organized W esterlea for that purpose. W esterlea
                          found itself in financial difficulties and four years later went bankrupt. The plaintiff



         22
              In Casey v. Galli, 94 U.S. 673 (1877), the rule was stated as follows:
                    “W here a party has contracted with a corporation, and is sued upon the contract, neither is
                    permitted to deny the existence, or the legal validity of such corporation. To hold
                    otherwise would be contrary to the plainest principles of reason and good faith, and
                    involve a mockery of justice.”

         23
              No reported case of piercing has ever involved the shareholders of a public traded corporation.

         24
              Courts have articulated different tests for piercing the corporate veil, such as the “instrumentality”
doctrine of the “alter ego” test. These test focus on the use of control or ownership to “commit a fraud or perpetuate
a dishonest act” or to “defeat justice and equity.” But these tests provide little guidance, and results in particular cases
do not seem to turn on which test a court employs.
              Rather, particular piercing factors seem more relevant even though no one fact emerges as determinative.
It is generally believed that courts are more likely to pierce in the following situations: (1) the business is a closely held
corporation; (2) the plaintiff is an involuntary (tort) creditor; (3) the defendant is a corporate shareholder (as opposed
to an individual); (4) insiders failed to follow corporate formalities; (5) insiders commingled business assets/affairs with
individual assets/affair; (6) insiders did not adequately capitalize the business; (7) the defendant actively participated in
the business; and (8) insiders deceived creditors.

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              contended that the corporate veil should be pierced.
     2.       The law permits the incorporation of a business for the very purpose of escaping personal
              liability.
     3.       Generally speaking, the doctrine of “piercing the corporate veil” is invoked to prevent
              fraud or to achieve equity.
              a.         In the instant case there has been neither fraud, misrepresentation, nor illegality.
                         Defendant’s purpose in placing its construction operation into a separate
                         corporation was clearly within the limits of our public policy.
     4.       Dissent. Not only was W esterlea allowed no opportunity to make money, but it was
              placed in a position such that if its business were successful and times remained good, it
              would break even, otherwise it would inevitably become insolvent.
D.   W alkovszky v. Carlton (N.Y. 1966).
     1.       Facts. Plaintiff was injured when he was run down by a taxi owned by Seon Cab
              Corporation. Carlton, the individual defendant, was claimed to be a stockholder of 10
              corporations, including Seon, each of which had two taxis registered in its name and the
              minimum insurance required by law on each taxi. The corporations were alleged to be
              operated as a single entity, unit and enterprise.
     2.       The law permits the incorporation of a business for the very purpose of enabling its
              proprietors to escape personal liability but, manifestly the privilege is not without its limits.
              a.         Piercing the Corporate Veil. Broadly speaking, the courts will disregard the
                         corporate form, or, to use accepted terminology, “pierce the corporate veil”,
                         whenever necessary to prevent fraud or to achieve equity.
                         (1)        In determining whether liability should be extended to reach assets
                                    beyond those belonging to the corporation, we are guided, as Judge
                                    Cardozo noted, by general rules of agency. In other words, whenever
                                    anyone uses control of the corporation to further his own rather than the
                                    corporation’s business, his will be liable for the corporation’s act upon
                                    the principle of respondeat superior applicable even where the agent is a
                                    natural person.
                                    (a)      It is one thing to assert that a corporation is a fragment of a
                                             larger corporate combine which actually conducts the business.
                                             It is quite another to claim that the corporation is a “dummy”
                                             for its individual stockholders who are in reality carrying on the
                                             business in their personal capacities for purely personal rather
                                             than corporate ends.
                                             i)         Either circumstance would justify treating the
                                                        corporation as an agent and piercing the corporate veil
                                                        to reach the principal but a different result would
                                                        follow in each case.
                                                        a)        In the first, only a larger corporate entity
                                                                  would be held financially responsible while,
                                                                  in the other the stockholder would be
                                                                  personally liable. Either the stockholder is
                                                                  conducting the business in his individual
                                                                  capacity or he is not. If he is, he will be
                                                                  liable; if he is not, then it does not
                                                                  matter–insofar as his personal liability is
                                                                  concerned–that the enterprise is actually
                                                                  being carried on by a larger “enterprise
                                                                  entity.”
              b.         The individual defendant is charged with having “organized, managed,
                         dominated and controlled” a fragmented corporate entity but there are no
                         allegations that he was conducting business in his individual capacity.
                         (1)        Had the taxicab fleet been owned by a single corporation, it would be

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                                    readily apparent that plaintiff would face formidable barriers in
                                    attempting to establish personal liability on the part of the corporation’s
                                    stockholders. The fact that the fleet ownership has been deliberately
                                    split up among many corporations does not ease the plaintiff’s burden in
                                    that respect.
                          (2)       The corporate form may not be disregarded merely because the assets of
                                    the corporation, together with the mandatory insurance coverage of the
                                    vehicle which struck the plaintiff, are insufficient to assure him the
                                    recovery sought.
                          (3)       In point of fact, the principle relied upon in the complaint to sustain the
                                    imposition of personal liability is not agency but fraud. Such a cause of
                                    action cannot withstand analysis. If it is not fraudulent for the owner-
                                    operator of a single cab operation to take out only the minimum
                                    required liability insurance , the enterprise does not become either illicit
                                    or fraudulent merely because it consists of many such corporations.
                                    (a)         Plaintiff Erroneously Relied on Fraud Allegation Instead of Agency.
                                                W hatever right he may be able to assert against the parties
                                                other than the registered owner of the vehicle come into being
                                                not because he has been defrauded but because, under the
                                                principle of respondeat superior, he is entitled to hold the who
                                                enterprise responsible for the acts of its agents.
                c.        Dissent. The issue presented by this action is whether the policy of this State,
                          which affords those desiring to engage in a business enterprise the privilege of
                          limited liability through the use of the corporate device, is so strong that it will
                          permit that privilege to continue no matter how much it is abused, no matter
                          how irresponsibly the corporation is operated, no matter what the cost to the
                          public. I do not believe that it is.
                          (1)       The Legislature [in enacting the minimum liability law] certainly could
                                    not have intended to shield those individuals who organized
                                    corporations, with the specific intent of avoiding responsibility to the
                                    public, where the operation of the corporate enterprise yielded profits
                                    sufficient to purchase additional insurance.
                          (2)       W hat I would merely hold is that a shareholder of a corporation vested
                                    with a public interest, organized with capital insufficient to meet
                                    liabilities which are certain to arise in the ordinary course of the
                                    corporation’s business, may be held personally responsible for such
                                    liabilities.
E.   There are three legal doctrine that the plaintiff might invoke in a case like W alkovszky: (a) enterprise
     liability; (b) respondeat superior (agency); and (c) disregard of the corporate entity (“piercing the
     corporate veil”).
F.   Sea-Land Services, Inc. v. Pepper Source (7th Cir. 1991).
     1.         Facts. Sea-Land shipped peppers on behalf of The Pepper Source. PS then skipped out on
                the freight bill which was substantial. The district court entered a default judgment against
                PS for $86,767.70. PS, however, had dissolved in mid 1987 for failure to pay its annual
                state franchise tax. In addition, PS had no assets. Therefore, Sea-Land brought an action
                against Marchese and five business entities he owned: PS, Caribe Crown, Jamar Corp., and
                Salescaster Distributors. Sea-Land sought to pierce the corporate veil and hold Marchese
                personally liable and then reverse pierce and hold Marchese’s other corporations liable.
                These corporations, Sea-Land alleged, were alter egos of each other and of Marchese and
                used to defraud creditors. Sea-Land amended its complaint to add Tie-Net, of which
                Marchese owned only half the stock along with Andre. The district court granted Sea-
                Land’s motion for summary judgment.
     2.         A corporate entity will be disregarded and the veil of limited liability pierced when two
                requirements are met: First, there must be such unity of interest and ownership that the

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     separate personalities of the corporation and the individual [or other corporation] no
     longer exist; and second, circumstances must be such that adherence to the fiction of
     separate corporate existence would sanction a fraud or promote justice.
     a.        As for determining whether a corporation is so controlled by another to justify
               disregarding their separate identities, the Illinois cases focus on four factors:
               (1)        The failure to maintain adequate corporate records or to comply with
                          corporate formalities;
               (2)        The commingling of funds or assets;
               (3)        Undercapitalization; and
               (4)        One corporation treating the assets of another corporation as its own.
3.   Marchese’s Playthings. These corporate defendants are, indeed, little but Marchese’s
     playthings. Marchese is the sole shareholder of PS, Caribe Crown, Jamar and Salescaster.
     He is one of two shareholders of Tie-Net. Except for Tie-Net, none of the corporations
     ever held a single corporate meeting. During his deposition, Marchese did not remember
     any of these corporations ever passing articles of incorporation, bylaws, or other
     agreements. Marchese runs all of the corporations out of the same, single office, with the
     same phone line, the same expense accounts, and the like. Marchese “borrows” money
     from these corporations, and they borrow money from each other. Marchese used the
     bank accounts of the corporations to pay multiple personal expenses.
4.   First Prong. In sum, we agree with the district court that there can be no doubt that the
     “shared control/unity of interest and ownership” part of the test is met in this case:
     a.        Corporate records and formalities have not been maintained; funds and assets
               have been commingled with abandon; PS, the offending corporation, and perhaps
               others have been undercapitalized; and corporate assets have been moved and
               tapped and “borrowed” without regard to their source.
5.   Second Prong. “Unity of interest and ownership” is not enough; Sea-Land must also show
     that honoring the separate corporate existences of the defendants “would sanction a fraud
     or promote injustice.”
     a.        Although an intent to defraud creditors would surely play a part if established, the
               Illinois test does not require proof of such intent. Once the first element of the
               test is established, either the sanctioning of a fraud (intentional wrongdoing) or the
               promotion of injustice, will satisfy the second element.
               (1)        Promoting Injustice. The prospect of an unsatisfied judgment looms in
                          every veil-piercing action; why else would a plaintiff bring such an
                          action? Thus, if an unsatisfied judgment is enough for the “promote
                          injustice” feature of the test, then every plaintiff will pass on that score,
                          and the test collapses into a one-step “unity of interest and ownership”
                          test.
                          (a)       In Pederson v. Paragon, the court offered the following
                                    summary: “Some element of unfairness, something akin to
                                    fraud or deception or the existence of a compelling public
                                    interest must be present in order to disregard the corporate
                                    fiction.”
                          (b)       Generalizing from other Illinois cases, we see that courts that
                                    have properly pierced corporate veils to avoid “promoting
                                    injustice” have found that, unless it did so, some “wrong”
                                    beyond a creditor’s liability to collect would result: the
                                    common sense rules of adverse possession would be
                                    undermined; former partners would be permitted to skirt the
                                    legal rules concerning monetary obligation; a party would be
                                    unjustly enriched; a parent corporation that caused a sub’s
                                    liabilities and its inability to pay for them would escape those
                                    liabilities; or an intentional scheme to squirrel assets into a
                                    liability-free corporation while heaping liabilities upon an asset-

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                                                free corporation would be successful.
G.   Roman Catholic Archbishop of San Francisco v. Sheffield (Cal. App. 1971).
     1.         Facts. Sheffield entered into an agreement to buy a St. Bernard dog from Fr. Cretton of
                the Canons Regular of St. Augustine in Switzerland. The price was $175 to be paid in
                $20 installments with the dog being shipped upon payment of the first installment. In
                addition, Sheffield agreed to pay the $125 freight charge for the dog to be shipped from
                Geneva to Los Angeles. Sheffield paid a total of $60 but did not receive the dog. The
                monastery told Sheffield that the dog would not be shipped until Sheffield paid the entire
                amount plus additional “fees.” Sheffield was also told that his $60 would not be refunded
                because of the costs of keeping his account on the books. Sheffield filed suit against the
                Archbishop of S.F., the Pope, the Vatican, the Canons, and Fr. Cretton under an “alter
                ego” theory.
     2.         Alter Ego/Piercing the Veil. The terminology “alter ego” or “piercing the corporate veil”
                refers to situations where there has been an abuse of corporate privilege, because of which
                the equitable owner of a corporation will be held liable for the actions of the corporation.
                The requirements for applying the “alter ego” principle are thus stated:
                a.         Requirements for Alter Ego Claim. It must be made to appear that the corporation
                           is not only influenced and governed by that person [or other entity], but that there is
                           such a unity of interest and ownership that the individuality, or separateness, of such
                           person and corporation has ceased, and the facts are such that an adherence to the
                           fiction of the separate existence of the corporation would, under the particular
                           circumstances, sanction a fraud or promote injustice.
                           (1)       Factors to Consider. Among the factors to be considered in applying the
                                     doctrine are the commingling of funds and other assets of the two
                                     entities, the holding out by one entity that it is liable for the debts of the
                                     other, identical equitable ownership in the two entities, use of the same
                                     offices and employees, and use of one as a mere shell or conduit for the
                                     same affairs of the other.
     3.         Alter Ego Does Not Make Subsidiaries Liable to Other Subsidiaries. The “alter ego” theory
                makes a “parent” liable for the actions of a “subsidiary” which it controls, but it does not
                mean that where a “parent” controls several subsidiaries each subsidiary then becomes
                liable for the actions of all other subsidiaries. There is no respondeat superior between the
                subagents.
     4.         Unsatisfied Creditor Not Enough to Lead to Inequitable Result (2 nd Prong). In almost every
                instance where a plaintiff has attempted to invoke the doctrine he is an unsatisfied creditor.
                The purpose of the doctrine is not to protect every unsatisfied creditor, but rather to afford
                him protection, where some conduct amounting to bad faith makes it inequitable... for the
                equitable owner of a corporation to hide behind its corporate veil.
H.   Parent Corporation/Subsidiary Corporation v. Single Corporation with Divisions
     1.         Generally, the parent, like any other shareholder, is not liable for the debts of the
                subsidiary, so the parent can undertake an activity without putting at risk its own assets,
                beyond those it decides to commit to the subsidiary. Like an individual shareholder,
                however, a corporate shareholder must be aware of the danger that if not careful, the
                creditors of the subsidiary may be able to pierce the corporate veil of the subsidiary. The
                parent must also be careful not to become directly liable by virtue of its participation in the
                activities of the subsidiary.
I.   In re Silicone Gel Breast Implants Products Liability Litigation (N.D. Ala. 1995).
     1.         Facts. MEC became, in 1982, a Delaware corporation, wholly owned by Bristol. In 1988
                Bristol bought two other breast-implant manufacturers, Natural Y and Aesthetech. The
                purchase price was paid from a Bristol account though charged to MEC. MEC had a
                board of directors, consisting of Bristol’s Health Care Group President. He could not be
                outvoted by the other two MEC board members. Former MEC presidents could not
                recall MEC having a board. MEC board resolutions were prepared by Bristol officials.
                Bristol was involved in much of MEC’s operations including: budgeting, employment

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                            policies and wages, executive hiring, scientific research, testing, legal counsel, public
                            relations, marketing (with Bristol’s name and logo), and consolidated federal tax returns.
                  2.        Corporate Control
                            a.        The evaluation of corporate control claims cannot, however, disregard the fact
                                      that, no different from other stockholders, a parent corporation is
                                      expected–indeed required–to exert some control over its subsidiary. Limited
                                      liability is the rule, not the exception.
                                      (1)         However, when a corporation is so controlled as to be the alter ego or
                                                  mere instrumentality of its stockholder, the corporate form may be
                                                  disregarded in the interests of justice.
                                      (2)         Veil-Piercing on Summary Judgment. Ordinarily, the fact-intensive nature
                                                  of the issue will require that it be resolved only through a trial.
                                                  Summary judgment, however, can be proper if the evidence presented
                                                  could lead to but one result.
                                      (3)         The totality of the circumstances must be evaluated in determining
                                                  whether a subsidiary may be found to be the alter ego or mere
                                                  instrumentality of the parent corporation. Although the standards are
                                                  not identical in each states, all jurisdictions require a showing of
                                                  substantial domination.25
                                      (4)         Fraud or Like Misconduct (Injustice Requirement). Delaware courts do not
                                                  necessarily require a showing of fraud if a subsidiary is found to be the
                                                  mere instrumentality or alter ago of its stockholder.
                                                  (a)        No Showing Required in Tort Cases. In addition, many
                                                             jurisdictions that require a showing of fraud, injustice, or
                                                             inequity in a contract case do not in a tort situation.
                                                             i)        A rational distinction can be drawn between tort and
                                                                       contract cases. In actions based on contract, the
                                                                       creditor has willingly transacted business with the
                                                                       subsidiary although it could have insisted on
                                                                       assurances that would make the parent also
                                                                       responsible. In a tort situation, however, the injured
                                                                       party had no such choice; the limitations on corporate
                                                                       liability were, from its standpoint, fortuitous and non-
                                                                       consensual.
                            b.        Direct Liability Claims
                                      (1)         Restatement (Second) of Torts § 324A: One who undertakes,
                                                  gratuitously or for consideration, to render services to another which he
                                                  should recognize as necessary for the protection of a third person or his
                                                  things, is subject to liability to the third person for physical harm
                                                  resulting from his failure to exercise reasonable care to perform his
                                                  undertakings, if


         25
              Among the factors to be considered are whether: (a) the parent and the subsidiary have common directors
or officers; (b) the parent and the subsidiary have common business departments; (c) the parent and the subsidiary file
consolidate financial statements and tax returns; (d) the parent finances the subsidiary; (e) the parent caused the
incorporation of the subsidiary; (f) the subsidiary operates with grossly inadequate capital*; (g) the parent pays the
salaries and other expenses of the subsidiary*; (h) the subsidiary receives no business except that given to it by the
parent; (i) the parent uses the subsidiary’s property as its own*; (j) the daily operation of the two corporations are not
kept separate; (k) the subsidiary does no observe the basic corporate formalities, such as keeping separate books and
records and holding shareholder and board meetings*.
              * Indicates those factors which Fendler considers relevant. The court does not explain why the other
factors are relevant to its determination. Most of the remaining factors are present in every parent/subsidiary
relationship.

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                                              (a) his failure to exercise reasonable care increases the risk of
                                              harm, or
                                              (b) he has undertaken to perform a duty owed by the other to
                                              the third person, or
                                              (c) the harm is suffered because of a reliance of the other or the
                                              third person upon the undertaking.
                                    (a)       Under this theory, frequently applied in connection with safety
                                              inspectors by insurers or with third-party repairs to equipment
                                              or premises, a duty that would not otherwise have existed can
                                              arise when an individual or company nevertheless undertakes to
                                              perform some action.
                                    (b)       Doctrinally, a cause of action under § 324A does not involve
                                              an assertion of derivative liability but one of direct liability,
                                              since it is based on the actions of the defendant itself. The
                                              existence of a parent-subsidiary relationship, while not
                                              required, is obviously no defense to such a claim.
J.   Frigidaire Sales Corp. v. Union Properties, Inc. (W ash. 1977)
     1.         Facts. Frigidaire entered into a contract with Commercial Investors. Mannon and Baxter
                were limited partners of Commercial. They were also officers, directors, and shareholders
                of Union Properties, Inc., the only general partner of Commercial. Mannon and Baxter
                controlled Union and through that control, they controlled Commercial. Commercial
                breached the contract and Frigidaire brought suit against Mannon, Baxter, and Union.
     2.         Petitioner does not contend that respondent acted improperly by setting up the limited
                partnership with a corporation as the sole general partner. Limited partnerships are a
                statutory form of business organization, and parties creating a limited partnership must
                follow the statutory requirements.
                a.        In W ashington, parties may form a limited partnership with a corporation as the
                          sole general partner.
     3.         The concern with minimal capitalization is not peculiar to limited partnerships with
                corporate general partners, but may arise anytime a creditor deals with a corporation.
                a.        Because out limited partnership statutes permit parties to form a limited
                          partnership with a corporation as the sole general partner, this concern about
                          minimal capitalization, standing by itself, does not justify a finding that the limited
                          partners incur general liability for their control of the corporate general partner.
                b.        If a corporate general partner is inadequately capitalized, the rights of a creditor
                          are adequately protected under the “piercing the corporate veil” doctrine of
                          corporation law.
     4.         Respondents scrupulously separated their actions on behalf of the corporation from their
                personal actions, therefore, petitioner never mistakenly assumed that respondents were
                general partners with general liability.
K.   In re USACafes, L.P. Litigation, (Del. 1991).
     1.         W hile I find no corporation law precedents directly addressing the question whether
                directors of a corporate general partner owe fiduciary duties to the partnership and its
                limited partners, the answer to it seems to be clearly indicated by general principles and by
                analogy to trust law.
                a.        W hile the parties cite no case treating the specific question whether directors of a
                          corporate general partner are fiduciaries for the limited partnership, a large
                          number of trust cases do stand for a principle that would extend a fiduciary duty
                          to such persons in certain circumstances
                          (1)       The problem comes up in trust law because modernly corporations may
                                    serve as trustees of express trusts.
                                    (a)       “The directors and officers of [a corporate trustee] are certainly
                                              under a duty to the beneficiaries not to convert to their own
                                              use property of the trust administered by the corporation...

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                                                      Furthermore, the directors and officers are under a duty to the
                                                      beneficiaries of trusts administered by the corporation not to
                                                      cause the corporation to misappropriate the property... The
                                                      breach of trust need not, however, be a misappropriation...
                                                      Any officer who knowingly causes the corporation to commit a
                                                      breach of trust causing loss...is personally liable to the
                                                      beneficiary of the trust...”
                                             (b)      The theory underlying fiduciary duties is consistent with
                                                      recognition that a director of a corporate general partner bears
                                                      such a duty towards the limited partnership.
                                                      i)       That duty, of course, extends only to dealings with
                                                               the partnership’s property or affecting its business, but,
                                                               so limited, its existence seems apparent on a number
                                                               of circumstances..
III.   Shareholder Derivative Actions
       A.      Introduction
               1.       The derivative suit is a nineteenth-century equity jurisdiction’s ingenious solution the
                        dilemma created by two inconsistent tenets of corporate law: (1) corporate fiduciaries owe
                        their duties to the corporation as a whole, not individual shareholders, and (2) the board of
                        directors manages the corporation’s business, which includes authorizing lawsuits in the
                        corporate name.
               2.       Derivative Suit v. Direct Claim. Unlike a derivative suit, a direct action is not brought on
                        behalf of the corporation. In a direct action, the loss is to the shareholder directly, while in
                        a derivative suit, the loss to the shareholder is the result of a loss to the corporation.
               3.       Cohen v. Beneficial Industrial Loan Corp. (U.S. 1949). (Shareholder Derivative Suits’ Origin)
                        a.        Facts. Plaintiff, shareholder, brought suit against corporation and its directors for
                                  waste amounting to over $100,000,000. New Jersey had enacted a statute whose
                                  general effect was to make a plaintiff having so small an interest (The plaintiff held
                                  an approximated 0.0125% of the outstanding stock) liable for the reasonable
                                  expenses and attorney’s fees of the defense if he fails to make good his complaint
                                  and to entitle the corporation to indemnity before the case can be prosecuted.
                        b.        Equity came to the relief of the stockholder, who had no standing to bring civil
                                  action at law against faithless directors and managers. Equity, however, allowed
                                  him to step into the corporation’s shoes and to seek in its right the restitution he
                                  could not demand on his own.
                                  (1)       It required him first to demand that the corporation vindicate its own
                                            rights, but when, as was usual, those who perpetrated the wrongs were
                                            also able to obstruct any remedy, equity would hear and adjudge the
                                            corporation’s cause through its stockholder with the corporation as a
                                            defendant, albeit a rather nominal one.
                        c.        Unfortunately, the remedy itself provided opportunity for abuse, which was not
                                  neglected. Suits sometimes were brought not to redress real wrongs, but to
                                  realize upon their nuisance.
                        d.        A stockholder who brings suit on a cause of action derived from the corporation
                                  assumes a position, not technically as a trustee perhaps, but one of a fiduciary
                                  character. He sues, not for himself alone, but as representative of a class
                                  comprising all who are similarly situated.
                                  (1)       The Federal Constitution does not oblige the state to place its litigating
                                            and adjudicating processes at the disposal of such a representative, at least
                                            without imposing standards of responsibility, liability and accountability
                                            which it considers will protect the interests he elects himself to represent.
                                            W e conclude that the state has plenary power over this type of litigation.
                        e.        Due Process. A state may set the terms on which it will permit litigations in its
                                  courts. No type of litigation is more susceptible of regulation than that of a

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                                      fiduciary nature. And it cannot seriously be said that a state make such
                                      unreasonable use of its power as to violate the Constitution when it provides
                                      liability and security for payment of reasonable expenses if a litigation of this
                                      character is adjudged unsustainable.
                            f.        Equal Protection. W e do not think the state is forbidden to use the amount of
                                      one’s financial interest, which measure his individual injury from the misconduct
                                      to be redressed, as some measure of the good faith and responsibility of one who
                                      seeks at his own election to act as custodian of the interests of all stockholders,
                                      and as an indication that he volunteers for the large burdens of the litigation from
                                      a real sense of grievance and is not putting forward a claim to capitalize personally
                                      on it harassment value.
                            g.        Erie Doctrine: Substantive or Procedural? Even if we were to agree that the New
                                      Jersey statute is procedural, it would not determine that it is not applicable.
                                      (1)        This statute is not merely a regulation of procedure. W ith it or without
                                                 it the main action takes the same course. However, it creates a new
                                                 liability where none existed before, for it makes a stockholder who
                                                 institutes a derivative action liable for the expense to which he puts the
                                                 corporation and other defendants, if he does not make good his claims.
                                                 Such liability is not usual and it goes beyond payment of what we know
                                                 as “costs.” W e do not think a statute which so conditions the stockholder’s
                                                 actions can be disregarded by the federal court as a mere procedural device.
                  4.        Eisenberg v. Flying Tiger Line, Inc. (2d Cir. 1971) 26
                            a.        Cohen v. Beneficial Industrial Loan Corp. instructs that a federal court with diversity
                                      jurisdiction must apply a state statute providing security for costs if the state court
                                      would require the security in similar circumstances.
                            b.        Derivative v. Individual. If the gravamen of the complaint is injury to the
                                      corporation the suit is derivative, but “if the injury is one to the plaintiff as a
                                      stockholder and to him individually and not to the corporation,” the suit is
                                      individual in nature and may take the form of a representative class action.
                                      Fletcher, Private Corporation § 5911.
                            c.        Gordon v. Elliman Test. The test formulated by the majority in that case was
                                      “whether the object of the lawsuit is to recover upon a chose in action belonging
                                      directly to the stockholders, or whether it is to compel the performance of
                                      corporate acts which good faith requires the directors to take in order to perform
                                      a duty which they own to the corporation, and through it, to its stockholders.”
                                      (1)        Flying Tiger argues that if the directors had a duty not to merge the
                                                 corporation, that duty was owed to the corporation and only
                                                 derivatively to its stockholders.
                                      (2)        This test was condemned by commentators. It had the effect of
                                                 sweeping away the distinction between a representative and a derivative
                                                 action–in effect classifying all stockholder class actions as derivative. The
                                                 case has been limited to its facts by lower New York courts.
                            d.        Lazare v. Knolls Cooperative Section No. 2, Inc. The court stated that security for
                                      costs could not be required where a plaintiff “does not challenge acts of the
                                      management on behalf of the corporation. He challenges the right of the present
                                      management to exclude him and other stockholders from proper participation in
                                      the affairs of the corporation. He claims that the defendants are interfering with
                                      the plaintiff’s rights and privileges as stockholders.”
                            e.        New York legislature, in its recodification of corporate statutes, added three


          26
             W hen a shareholder sues in his own capacity, as well as on behalf of other shareholders similarly situated,
the suit is not a derivative action but a class action. In effect, all of the members of the class have banded together
through a representative to bring their individual direct actions in one large direct action.

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                                      words to the definition of derivative suits contained in § 626. Suits are now
                                      derivative only if brought in the right of a corporation to procure a judgment “in
                                      its favor.”
                           f.         In routine merger circumstances the stockholders retain a voice in the operation
                                      of the company, albeit a corporation other than their original choice.
                                      (1)        Here, however, the reorganization deprived him and other minority
                                                 stockholders of any voice in the affairs of their previously existing
                                                 operating company.
                                      (2)        Is it thus clear that Gordon is factually distinguishable from the instant
                                                 case. Moreover, a close analysis of other New York cases, the
                                                 amendment to § 626 and the other major treatises, lead us to conclude
                                                 that Gordon has lost its viability as stating a broad principle of law.
                    5.     Special Injury Test. In Delaware, many courts long used the so-called “special injury test to
                           determine whether a suit was direct or derivative. A special injury was defined as a wrong
                           that “is separate and distinct from that suffered by other shareholders, ... or a wrong
                           involving a contractual right of a shareholder, such as the right to vote, or to assert
                           majority control, which exists independently of any right of the corporation.” Moran v.
                           Household Int’l, Inc. (Del. Ch. 1985).
                           a.         Rejection of Special Injury Test. The Delaware Supreme Court rejected the special
                                      injury test in favor of a two-pronged standard 27: (1) who suffered the alleged
                                      harm, the corporation or the suing stockholders, individually; and (2) who would
                                      receive the benefit of any recovery or other remedy, the corporation or the
                                      stockholders, individually.
                    6.     Settlement and Attorneys Fees
                           a.         Settled Before Judgment. The corporation can pay the legal fees of the plaintiff and
                                      of the defendants.
                           b.         Judgment for Money Damages Imposed on Defendants. Except to the extent covered
                                      by insurance, the defendants will be required to pay those damages and to bear
                                      the cost of their defense as well.
                                      (1)        The corporation may pay the defendants’ expense only if the court
                                                 determines that “despite the adjudication of liability but in view of all
                                                 the circumstances of the case, [the defendant] is fairly entitled to
                                                 indemnity.”
                    7.     Individual Recovery in a Derivative Action
                           a.         Sometimes a court awards an individual recovery in a derivative action. In Lynch
                                      v. Patterson (W yo. 1985), the trial court award the plaintiff damages as a individual
                                      in the amount of 30 percent of $266,000, or $79,8000. The W yoming Supreme
                                      Court upheld this judgment noting that “corporate recovery would simply return
                                      the funds to the control of the wrongdoers.”
         B.         The Requirement of Demand on the Directors
                    1.     Grimes v. Donald (Del. Sup. Ct. 1996).
                           a.         Distinction Between Direct and Derivative Claims. Although the tests have been
                                      articulated many times, it is often difficult to distinguish between a derivative and
                                      an individual action. The distinction depends upon the nature of the wrong
                                      alleged and the relief, if any, which could result if plaintiff were to prevail. 28



         27
              Tooley v. Donaldson, Lufkin & Jenrette (Del. 2004).

         28
            In Tooley v. Donaldson, Lufkin, & Jenrette, Inc. (Del. 2004), the Delaware Supreme Court clarified the
standard, holding that in determining whether a stockholder’s claim is derivative or direct, the issue must turn solely
on the following questions: (1) who suffered the alleged harm, the corporation or the suing stockholders, individually;
and (2) who would receive the benefit of any recovery or other remedy, the corporation of the stockholders,

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                           b.       Abdication. Directors may not delegate duties which lie “at the heart of the
                                    management of the corporation.” A court cannot give legal sanction to
                                    agreements which have the effect of removing from directors in a very substantial
                                    way their duty to use their own best judgment on management affairs.
                                    (1)        W ith certain exceptions, an informed decision to delegate a task is as
                                               much an exercise in business judgment as any other. Likewise, business
                                               decisions are not an abdication of directorial authority merely because
                                               they limit a board’s freedom of future action. A board which has
                                               decided to manufacture bricks has less freedom to decide to make
                                               bottles. In a world of scarcity, a decision to do one thing will commit a
                                               board to a certain course of action and make it costly and difficult
                                               (indeed, sometimes impossible) to change course and do another. This
                                               is an inevitable fact of life and is not an abdication of directorial duty.
                                    (2)        If an independent and informed board, acting in good faith, determines
                                               that the services of a particular individual warrant large amounts of
                                               money, whether in the form of current salary or severance provisions,
                                               the board has made a business judgment decision.
                                               (a)         That judgment normally will receive the protection of the
                                                           business judgment rule unless the fact show that such amounts,
                                                           compared with the services to be received in exchange,
                                                           constitute waste or could not otherwise be the product of a
                                                           valid exercise of business judgment.
                           c.       Demand Requirement. If a claim belongs to the corporation, it is the corporation,
                                    acting through its board of directors, which must make the decision whether or
                                    not to assert the claim. The derivative action impinges on the managerial
                                    freedom of directors. The demand requirement is a recognition of the fundamental
                                    precept that directors manage the business and affairs of the corporation.
                                    (1)        A stockholder filing a derivative suit must allege either that the board
                                               rejected his pre-suit demand that the board assert the corporation’s claim
                                               or allege with particularity why the stockholder was justified in not
                                               having made the effort to obtain board action.
                                               (a)         Grounds for alleging with particularity that demand would be
                                                           futile:
                                                           i)        Reasonable Doubt. “Reasonable doubt” 29 exists that
                                                                     the board is capable of making an independent
                                                                     decision to assert the claim if demand were made.
                                                                     The basis for claiming excusal would normally be that:
                                                                     a)       A majority of the board has a material
                                                                              financial or familial interest.;
                                                                     b)       A majority of the board is incapable of acting
                                                                              independently for some other reason such as
                                                                              domination of control; or
                                                                     c)       The underlying transaction is not the product
                                                                              of a valid exercise of business judgment.




individually.

         29
              Some courts and commentators have questioned why a concept normally present in criminal prosecution
would find its way into derivative litigation. Yet the term is apt and achieves proper balance. Reasonable doubt can
be said to mean that there is reason to doubt. This concept is sufficiently flexible and workable to provide the
stockholder with “the keys to the courthouse” in an appropriate case where the claim is not based on mere suspicions
or state solely in conclusory terms.

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              (2)        Purposes of the Demand Requirement
                         (a)       By requiring exhaustion of intracorporate remedies, the
                                   demand requirement invokes a species of alternative dispute
                                   resolution procedure which might avoid litigation altogether.
                         (b)       If litigation is beneficial, the corporation can control the
                                   proceedings.
                         (c)       If demand is excused or wrongfully refused, the stockholder
                                   will normally control the proceedings.
              (3)        W rongful Refusal Distinguished from Excusal. A stockholder who makes a
                         demand is entitled to know promptly what action the board has taken in
                         response to the demand. A stockholder who makes a serious demand
                         and receives only a peremptory refusal has the right to use the “tools at
                         hand” to obtain the relevant corporate records, such as reports or
                         minutes, reflecting the corporate action and related information in order
                         to determine whether or not there is a basis to assert that demand
                         wrongfully refused.
                         (a)       The stockholder does not, by making demand, waive the right
                                   to claim that demand has been wrongfully refused.
                         (b)       Demand W aives Demand Excusal Argument. A stockholder who
                                   makes a demand can no longer argue that demand is excused.
                                   Permitting a stockholder to demand action involving only one
                                   theory or remedy and to argue later that demand is excused as
                                   to other legal theories or remedies arising out of the same set of
                                   circumstances as set forth in the demand letter would create an
                                   undue risk of harassment.
2.   Marx v. Akers (N.Y. 1996).
     a.       New York Business Corporation Law § 626(c) provides that in any shareholders’
              derivative action, “the complaint shall set forth with particularity the efforts of the
              plaintiff to secure the initiation of such action by the board or the reasons for not
              making such an effort.”
              (1)        Codified a rule of equity developed in early shareholder derivative
                         action requiring plaintiffs to demand that the corporation initiate an
                         action, unless such demand was futile, before commencing an action on
                         the corporation’s behalf.
              (2)        Purposes of the Demand Requirement. (1) relieve courts from deciding
                         matters of internal corporate governance by providing corporate
                         directors with opportunities to correct alleged abuses, (2) provide
                         corporate boards with reasonable protection from harassment by
                         litigation on matters clearly within the discretion of directors, and (3)
                         discourage “strike suits” commenced by shareholders for personal gain
                         rather than for the benefit of the corporation.
     b.       Various Approaches to the Demand Futility Exception:
              (1)        The Delaware Approach:
                         (a)       The two branches of the Delaware test are disjunctive. Once
                                   director interest has been established, the business judgment
                                   rule becomes inapplicable and the demand excused without
                                   further inquiry. Whether a board has validly exercise its
                                   business judgment must be evaluated by determining whether
                                   the directors exercised procedural (informed decisions) and
                                   substantive (terms of the transactions) due care.
              (2)        Universal Demand
                         (a)       W ould dispense with the necessity of making case-specific
                                   determinations and impose an easily applied bright-line rule.
              (3)        New York’s Approach to Demand Futility

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                                      (a)      A demand would be futile if a complaint alleges with
                                               particularity that:
                                               i)         A majority of the directors are interested in the
                                                          transaction, or
                                                          a)        Director interest may either be self-interest in
                                                                    the transaction at issue, or a loss of
                                                                    independence because a director with no
                                                                    direct interest in a transaction is “controlled”
                                                                    by a self-interested director.
                                               ii)        The directors failed to inform themselves to a degree
                                                          reasonably necessary about the transactions, or
                                               iii)       The directors failed to exercise their business
                                                          judgment in approving the transaction.
                 c.        A complaint challenging the excessiveness of director compensation must–to
                           survive a dismissal motion–allege compensation rates excessive on their face or
                           other facts which call into question whether the compensation was fair to the
                           corporation when approved, the good faith of the directors setting those rates, or
                           that a decision to set the compensation could not have been the product of valid
                           business judgment.
C.        The Role of Special Committees 30
          1.     Auerbach v. Bennett (N.Y. 1979).
                 a.        The business judgment rule does not foreclose inquiry by the courts into the
                           disinterested independence of those members of the board chosen by it to make
                           the corporate decision on its behalf–here the members of the special litigation
                           committee. Indeed the rule shields the deliberations and conclusions of the
                           chosen representatives of the board only if they possess a disinterest independence
                           and do not stand in a dual relation which prevents an unprejudicial exercise of
                           judgment.
                 b.        Courts have consistently held that the business judgment rule applies where some
                           directors are charged with wrongdoing, so long as the remaining directors making
                           the decision are disinterested and independent.
                 c.        The action of the special litigation committee comprised two components:
                           (1)       First, there was the selection of procedures appropriate to the pursuit of
                                     its charge.
                                     (a)       As to the methodologies and procedures best suited to the
                                               conduct of an investigation of facts and the determination of
                                               legal liability, the courts are well equipped by long and
                                               continuing experience and practice to make determinations.
                                     (b)       W hile the court may properly inquire as to the adequacy and
                                               appropriateness of the committee’s investigative procedures and
                                               methodologies, it may not under the guise of consideration of
                                               such factors trespass in the domain of business judgment.
                                               i)         At the same time those responsible for the procedures
                                                          by which the business judgment is reached may
                                                          responsibly be required to show that they have
                                                          pursued their chosen investigative methods in good
                                                          faith.
                                                          a)        W hat evidentiary proof may be required to
                                                                    this end will, of course, depend on the nature
                                                                    of the particular investigation, and the proper
                                                                    reach of disclosure at the instance of the


30
     See also Handout/Chart

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                                                                       JR C /Fall 2010/Fendler/B usiness A ssoc .

                                                      shareholders will relate inversely to the
                                                      showing made by the corporate
                                                      representatives themselves.
                                  ii)       Proof, however, that the investigation has been so
                                            restricted in scope, so shallow in execution, or
                                            otherwise so pro forma or halfhearted as to constitute a
                                            pretext or sham, consistent with the principles
                                            underlying the application of the business judgment
                                            doctrine, would raise questions of good faith or
                                            conceivably fraud which would never be shielded by
                                            that doctrine.
             (2)       Second, there was the ultimate substantive decision, predicated on the
                       procedures chosen and the date produced thereby, not to pursue the
                       claims advanced in the shareholders’ derivative actions.
                       (a)        The substantive decision falls squarely within the embrace of
                                  the business judgment doctrine, involving as it did the
                                  weighing and balancing of legal, ethical, commercial,
                                  promotional, public relations, fiscal and other factors familiar to
                                  the resolution of many if not most corporate problems.
2.   Zapata Corp. v. Maldonado (Del. 1981).
     a.      Directors of Delaware corporations derive their managerial decision making
             power, which encompasses decisions whether to initiate, or refrain from entering,
             litigation from 8 Del.C. § 141(a).
             (1)       The business judgment rule, however, is a judicial creation that
                       presumes propriety, under certain circumstances, in a board’s decision.
                       Viewed defensively, it does not create authority. In this sense the
                       “business judgment” rule is not relevant in corporate decision making
                       until after a decision is made. It is generally used as a defense to an
                       attack on the decision’s soundness.
             (2)       The two, § 141(a) and the business judgment rule, are related because
                       the rule evolved to give recognition to the directors’ business expertise
                       when exercising their managerial power under § 141(a).
     b.      Right of a Plaintiff Stockholder in a Derivative Action. W e find that the Chancery
             Court’s determination that a stockholder, once demand is made and refused,
             possesses an independent, individual right to continue a derivative suit for
             breaches of fiduciary duty over objection by the corporation, as an absolute rule,
             is erroneous.
             (1)       The language in Sohland v. Baker relied on by the Vice Chancellor
                       negates the contention that the case stands for the broad rule of
                       stockholder right which evolved below. The Court therein stated that
                       “a stockholder may sue in his own name for the purpose of enforcing
                       corporate rights in a proper case if the corporation on the demand of the
                       stockholder refuses to bring suit.” Thus, the precise language only
                       supports the stockholder’s right to initiate the lawsuit. It does not
                       support an absolute right to continue to control it.
             (2)       In McKee v. Rogers, it was stated as a “general rule” that “a stockholder
                       cannot be permitted to invade the discretionary field committed to the
                       judgment of the directors and sue in the corporation’s behalf when the
                       managing body refuses. This rule is a well settled one.
                       (a)        Should not be read so broadly that the board’s refusal will be
                                  determinative in every case. Board members, owing a well-
                                  established fiduciary duty to the corporation, will not be
                                  allowed to cause a derivative suit to be dismissed when it
                                  would be a breach of their fiduciary duty.

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     (3)       W rongful Board Refusal. A board decision to cause a derivative suit to be
               dismissed as detrimental to the company, after demand has been made
               and refused, will be respected unless it was wrongful. Absent a wrongful
               refusal, the stockholder in such a situation simply lacks managerial
               power.
     (4)       Demand Futility. A stockholder may sue in equity in his derivative right
               to assert a cause of action in behalf of the corporation, without prior
               demand upon the directors to sue, when it is apparent that a demand
               would be futile, that the officers are under an influence that sterilizes
               discretion and could not be proper persons to conduct the litigation.
c.   W e see no inherent reason why the “two phases” of a derivative suit, the
     stockholder's suit to compel the corporation to sue and the corporation's suit
     should automatically result in the placement in the hands of the litigating
     stockholder sole control of the corporate right throughout the litigation. To the
     contrary, it seems to us that such an inflexible rule would recognize the interest of
     one person or group to the exclusion of all others within the corporate entity.
     (1)       W hen should an authorized board committee be permitted to cause
               litigation, properly initiated by a derivative stockholder in his own right,
               to be dismissed? Even when demand is excusable, circumstances may
               arise when continuation of the litigation would not be in the
               corporation's best interests. Our inquiry is whether, under such
               circumstances, there is a permissible procedure under s 141(a) by which
               a corporation can rid itself of detrimental litigation. If there is not, a
               single stockholder in an extreme case might control the destiny of the
               entire corporation.
d.   Delegation of Authority to Independent Committee. Section 141(c) allows a board to
     delegate all of its authority to a committee. Accordingly, a committee with
     properly delegate authority would have the power to move for dismissal or
     summary judgment if the entire board did.
     (1)       Under an express provision of the statute, § 141(c), a committee can
               exercise all of the authority of the board to the extent provided in the
               resolution of the board. Moreover, at least by analogy to our statutory
               section on interested directors, 8 Del.C. § 144, it seems clear that the
               Delaware statute is designed to permit disinterested directors to act for
               the board.
               (a)        Interested Board Majority/Independent Committee. W e do not
                          think that the interest taint of the board majority is per se a
                          legal bar to the delegation of the board's power to an
                          independent committee composed of disinterested board
                          members. The committee can properly act for the corporation
                          to move to dismiss derivative litigation that is believed to be
                          detrimental to the corporation's best interest.
e.   Power of Derivative Suit to Continue In Face of Independent Committee’s Dismissal. It
     appears desirable to us to find a balancing point where bona fide stockholder
     power to bring corporate causes of action cannot be unfairly trampled on by the
     board of directors, but the corporation can rid itself of detrimental litigation.
     (1)       The question has been treated by other courts as one of the “business
               judgment” of the board committee. If a “committee, composed of
               independent and disinterested directors, conducted a proper review of
               the matters before it, considered a variety of factors and reached, in good
               faith, a business judgment that the action was not in the best interest of
               the corporation”, the action must be dismissed.
               (a)        W e are not satisfied, however, that acceptance of the “business
                          judgment” rationale at this stage of derivative litigation is a

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                                                      proper balancing point
                                  (2)      W e thus steer a middle course between those cases which yield to the
                                           independent business judgment of a board committee and this case as
                                           determined below which would yield to unbridled plaintiff stockholder
                                           control. In pursuit of the course, we recognize that “the final substantive
                                           judgment whether a particular lawsuit should be maintained requires a
                                           balance of many factors ethical, commercial, promotional, public
                                           relations, employee relations, fiscal as well as legal.”
                                           (a)        Pre-trial motion by the independent committee to dismiss.
                                                      This will require a two-step inquiry by the court:
                                                      i)        The independence and good faith of the committee
                                                                and the bases supporting its conclusion.
                                                                a)       The corporation should have the burden fo
                                                                         proving independence, good faith, and
                                                                         reasonableness.
                                                      ii)       Determine, applying its own independent business
                                                                judgment, whether the motion should be granted.
                                                                a)       Intended to thwart instances where corporate
                                                                         actions meet the criteria of step one, but the
                                                                         result does not appear to satisfy its spirit, or
                                                                         where corporate actions would simply
                                                                         prematurely terminate a stockholder
                                                                         grievance deserving of further consideration
                                                                         in the corporation’s interest.
             3.       In re Oracle Corp. Derivative Litigation (Del. Ch. 2003).
                      a.        Structural Bias. The Delaware court fully adopts the structural bias argument–the
                                criticism that the use of a committee of “independent” directors is that such
                                directors are not really “independent,” in a psychological sense.
                      b.        The independent inquiry should not “ignore the social nature of humans.”
                                Corporate directors are “generally the sort of people deeply enmeshed in social
                                institutions,” and such directors should not be assumed to be “persons of unusual
                                social bravery, who operate heedless to the inhibitions that social norms generate
                                for ordinary folk.”
IV.   The Role and Purposes of Corporations
      A.     A.P. Smith Mfg. Co. v. Barlow (N.J. 1953).
             1.       Facts. Stockholders objected the giving of $1,500 to Princeton University. The
                      corporation instituted a declaratory judgment action. The stockholders took the position
                      that (1) the plaintiff’s certificate of incorporation does not expressly authorize the
                      contribution and under common-law principles the company does not possess any implied
                      or incidental power to make it, and (2) the New Jersey statutes which expressly authorize
                      the contribution may not constitutionally be applied to the plaintiff, a corporation created
                      long before their enacted.
             2.       The common-law rule developed that those who managed the corporation could not
                      disburse any corporate funds for philanthropic or other worthy public cause unless the
                      expenditure would benefit the corporation.
                      a.        In many instances such contributions have been sustained by the courts within the
                                common-law doctrine upon liberal findings that the donations tended reasonably
                                to promote the corporate objectives.
             3.       It seems to us that just as the conditions prevailing when corporations were originally
                      created required that they serve public as well as private interests, modern conditions
                      require that corporations acknowledge and discharge social as well as private
                      responsibilities as members of the community within which they operate.
             4.       New Jersey doctrine that although the reserved power permits alterations in the public
                      interest of the contract between the state and the corporation, it has no effect on the

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                             contractual rights between the corporation and its stockholder and between stockholders
                             inter se.
                             a.        Although later cases have not disavowed the doctrine, it is noteworthy that they
                                       have repeatedly recognized that where justified by the advancement of the public
                                       interest the reserved power may be invoked to sustain later charter alterations
                                       even though they affect contractual rights between the corporation and its
                                       stockholders and between stockholder inter se.
                             b.        State legislation adopted in the public interest and applied to preexisting
                                       corporations under the reserved power has repeatedly been sustained by the
                                       United States Supreme Court above the contention that it impairs the rights of
                                       stockholders and violates constitutional guarantees under the Federal
                                       Constitution.
         B.        Business Judgment Rule. The courts have been extremely tolerant in accepting the business judgment
                   of the officers and directors of corporation, including their business judgment about whether a
                   charitable donation will be good for the corporation in the long run.
         C.        Internal Affairs Rule. The basic rule of corporate choice of law in all states is that the law of the state
                   of incorporation controls on issues relating to a corporation’s “internal affairs,” which includes
                   responsibilities of directors to shareholders.
         D.        Dodge v. Ford Motor Co. (Mich. 1919).
                   1.        Power of Court to Interfere in Declaring Dividend. It is a well-recognized principle of law that
                             the directors of a corporation, and they alone, have the power to declare a dividend of the
                             earnings of the corporation, and to determine its amount. Courts of equity will not
                             interfere in the management of the directors unless it is clearly made to appear that they are
                             guilty of fraud or misappropriation of the corporate funds, or refuse to declare a dividend
                             when the corporation has a surplus of net profits which it can, without detriment to its
                             business, divide among its stockholders, and when a refusal to do so would amount to such
                             an abuse of discretion as would constitute a fraud, or breach of that good faith which they
                             are bound to exercise towards the stockholders.
                   2.        Purpose of Business Organization. A business corporation is organized and carried on
                             primarily for the profit of the stockholders. The powers of the directors are to be
                             employed for that end. The discretion of directors is to be exercised in the choice of
                             means to attain that end, and does not extend to a change in the end itself, to the
                             reduction of profits, or to the nondistribution of profits among stockholders in order to
                             devote them to other purposes.
                   3.        W ithin Business Judgement. W e are not, however, persuaded that we should interfere with
                             the proposed expansion of the business of the Ford Motor Co. In the view of the fact that
                             the selling price of products may be increased at any time, the ultimate results of the larger
                             business cannot be certainly estimated. The judges are not business experts. It is
                             recognized that plans must often be made for a long future, for expected competition, for a
                             continuing as well as an immediately profitable venture. The experience of the Ford
                             Motor Co. is evidence of capable management of its affairs.
         E.        Shlensky v. W rigley (Ill. 1968).
                   1.        It appears to us that the effect on the surrounding neighborhood might well be considered
                             by a director who was considering the patrons who would or would not attend the games
                             if the park were in a poor neighborhood.
                   2.        The response which courts make to such applications is that it is not their function to
                             resolve for corporations questions of policy and business management. The directors are
                             chose to pass upon such questions and their judgment unless shown to be tainted with fraud is
                             accepted as final. The judgment of the directors of corporations enjoys the benefit of a
                             presumption that it was formed in good faith and was designed to promote the best
                             interests of the corporation.


C H A PTER F O U R : T H E L IM ITED L IABILITY C O M PA N Y

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I.       Formation
         A.      History and Law of Limited Liability Companies
                 1.       Recently Created Form of Bus. Org. Before 1988,31 the world of unincorporated business
                          organizations had two main players: ordinary general partnership and ordinary limited
                          partnerships.
                          a.         Limited Liability Company. The first LLC statute was enacted in Wyoming. The
                                     limited liability company is an alternative form of business organization that
                                     combines certain features of the corporate form with others more closely
                                     resembling general partnerships.
                 2.       The Players. In an LLC the investors are called "members." Like the traditional
                          corporation, the LCC provides a liability shield for its members. It allows somewhat more
                          flexibility than the corporation in developing rules for management and control.
                          a.         Member-Managed/Manager-Managed. Most LLC statutes dichotomize governance
                                     between “member-managed” LLCs and “manager-managed” LLCs.
                                     (1)        Governance in a member-managed LLC resembles governance in a
                                                general partnership. Governance in a manager-managed LLC resembles
                                                governance in a limited partnership.32
                          b.         Single-Member LLC. LLCs can be single-member LLCs (as can a corporation;
                                     partnerships, by definition, cannot).
                 3.       Formalities
                          a.         Articles of Organization. The public filing of which will create the limited liability
                                     company as a legal person.
                                     (1)        Most LLC statutes require the articles to state whether the LCC is
                                                member-managed or manager-managed, a characterization that has
                                                important power-to-bind implications. 33
                                     (2)        Arkansas’ default rule is that an LLC is member-managed.
                          b.         Operating Agreement. Like a partnership agreement in a general or limited
                                     partnership, an LLC’s operating agreement serves as the foundational contract
                                     among the entity’s owners.
                 4.       Tax Treatment
                          a.         Corporations. Corporate stockholders face “double taxation” on any dividends
                                     they receive.
                                     (1)        First, the corporation pays income tax on any profits it earns. Dividends
                                                to shareholders are therefore made in “after-tax” dollars. Second,
                                                dividends are then taxed as they are received by the shareholders.
                          b.         Other Entities. Partnerships, LLCs, Subchapter S Corporations 34 are subject to



        31
             In 1988, the IRS issued Revenue Procedure 88-76 which classified a W yoming LLC as a partnership, and
caused legislatures around the country to consider seriously the LLC phenomenon.

        32
             The resemblance is not complete. For example, managers in a manager-managed LLC are not required
by statute to be members, although they usually are. In contrast, the managers of a limited partnership–i.e., the
general partners–are necessarily partners.

        33
          In a member-managed LLC, all members have the power to bind absent contrary agreement. In a
manager-managed LLC, managers have the power to bind while the members do not.

        34
             The following requirements must be for a corporation to elect to be taxed as a partnership: (1) for most
practical purposes, all shareholders must be either U.S. citizens or resident aliens; (2) the corporation cannot be a
certain business type or structure, including foreign corporations, a bank or savings and loan association, or an
insurance company; (4) there can only be one class of stock; and (5) there can be no more than 100 individual
shareholders, though certain tax-exempt entities such as employee stock ownership plans, pension plans, and charities

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                                      “pass through” taxation–the business’ profits (whether distributed or not)
                                      allocated and taxable directly to the members.
                  5.       Limited Liability. Because a limited liability company is “an entity distinct from its
                           member,” its assets and obligations pertain legally to it and not to its members. As a result,
                           absent extraordinary circumstances, an LLC’s members are not answerable qua members
                           for the debts and other obligations of the LLC.
                  6.       Permissible Purposes. At one time, most if not all LLC statutes required an LLC have a
                           business purpose35 , but the modern trend is to permit an LLC to have any lawful purpose.
                           “Any lawful purpose” language also permits an LLC to be organized for nonprofit
                           purposes.
                  7.       Various LLC Acts
                           a.         ABA Model Prototype LLC Act, adopted by Arkansas has many gaps and
                                      ambiguities. The ABA has since promulgated a New Prototype Act.
                           b.         Uniform Limited Liability Company Act (“ULLCA”), was only adopted by eight
                                      states.
                           c.         Revised Uniform Limited Liability Company Act (“RULLCA”) was approved in
                                      2006.
                                      (1)        Arkansas Adoption? RULLCA was recently recommended by the
                                                 Arkansas Bar Associations’ Committee on Uniform State Laws to be
                                                 included in the legislative bar packet. The Board of Governors denied
                                                 this request. It is likely that in the future it will be adopted.
         B.       W ater, W aste & Land, Inc. d/b/a W estec v. Lanham (Colo. 1998).
                  1.       Facts. Clark and Lanham were managers and members of the limited liability company
                           P.I.I. Clark contacted W estec about hiring it for eng. work for a dev. project known as
                           Taco Cabana. Clark gave his business card, which included Lanham’s address that was also
                           listed as the principal office and place of business in its art. of org., to representatives of
                           W estec. The letters P.I.I. appeared on the card but there was no indication as to what the
                           acronym meant or that it was an LLC. An oral agreement was reached on the project and
                           Clark asked W estec to send a written proposal, which W estec did. W estec never received
                           the contract but received verbal authorization from Clark to begin work. W estec
                           completed the work and billed Lanham. No payments were made.
                  2.       The LLC has become a popular form of business organization because it offers member the
                           limited liability protection of a corporation, together with the single-tier tax treatment of a
                           partnership along with considerable flexibility in management and financing.
                           a.         LLC Avoids Double Taxation. The ability to avoid two-levels of income taxation
                                      [that is, a tax collected from a corporation on its income plus a tax collected from
                                      the shareholders on dividend distributions by the corporation from the remaining
                                      income] is an especially attractive feature of organization as a limited liability
                                      company.
                  3.       The district court’s analysis assumed that the LLC Act displaced certain common law
                           agency doctrines, at least insofar otherwise would be applicable to suits by third parties
                           seeking to hold the agents of a limited liability company liable for their personal actions as
                           agents.
                           a.         W e hold, however, that the statutory notice provision applies only where a third
                                      party seeks to impose liability on an LLC’s members or managers simply due to
                                      their status as members or managers of the LLC. W here a third party sues a
                                      manager or member of an LLC under an agency theory, the principles of agency




can be shareholders.

        35
           Partnerships, by definition, are formed for a business purpose (“association of two or more person to carry
on as co-owners a business for profit).

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                                       law apply notwithstanding the LCC Act’s statutory notice rules.
                   4.        Under the common law of agency, an agent is liable on a contract entered on behalf of a
                             principal if the principal is not fully disclosed. In other words, an agent who negotiates a
                             contract with a third party can be sued, for any breach of the contract unless the agent
                             discloses both the fact that he or she is acting on behalf of a principal and the identity of
                             the principal. 36
                             a.        This somewhat counterintuitive proposition–that an agent is liable even when the
                                       third party knows that the agent is acting on behalf of an unidentified
                                       principal–has been recognized as sound by the courts of this state, and it is well
                                       established rule under the common law.
                             b.        W hether a principal is partially or completely disclosed is a question of fact.
                             c.        W e conclude, however, that the LLC Act’s notice provision was not intended to alter the
                                       partially disclosed principal doctrine.
                                       (1)        Section 7-80-208 states: “The fact that the articles of organization are on
                                                  file in the office of the secretary of state is notice that the limited liability
                                                  company is a limited liability company and is notice of all other facts set
                                                  forth therein which are required to be set forth in the articles of
                                                  organization.”
                                                  (a)         In order to relieve Lanham of liability, this provision would
                                                              have to be read to establish a conclusive presumption that a
                                                              third party who deals with the agent of a limited liability
                                                              company always has constructive notice of the existence of the
                                                              agent’s principal. W e are not persuaded that the statute can
                                                              bear such an interpretation.37
                                                              i)        Exaggerates Plain Meaning. The statute could be read
                                                                        to state that third parties who deal with a limited
                                                                        liability company are always on constructive notice of
                                                                        the company’s limited liability status, without regard
                                                                        to whether any part of the company’s name or even
                                                                        the fact of its existence has been disclosed. However,
                                                                        an equally plausible interpretation of the words used
                                                                        in the statute is that once the limited liability
                                                                        company’s name is known to the third party,
                                                                        constructive notice of the company’s limited liability
                                                                        has been given, as well as the fact that managers and
                                                                        members will not be liable simply due to their status as
                                                                        managers or members.
                                                              ii)       Invitation to Fraud. It would leave the agent of a
                                                                        limited liability company free to mislead third parties
                                                                        into the belief that the agent would bear personal
                                                                        financial responsibility under any contract.



         36
            “If both the existence and identity of the agent’s principal are fully disclosed to the other party, the agent
does not become a party to any contract which he negotiates. But where the principal is partially disclosed (i.e., the
existence of a principal is known but his identity is not), it is usually inferred that the agent is a party to the contract.”
Reuchlein and Gregory, The Law of Agency and Partnership § 118 (2d ed. 1990).

         37
             Other LLC Act provisions reinforce the conclusion that the legislature did not intend the notice language
of § 7-80-208 to relieve the agent of a limited liability company of the duty to disclose its identity in order to avoid
personal liability. For example, § 7-80-201(1) requires limited liability companies to use the words “Limited Liability
Company” or the initials “LLC” as part of their names, implying that the legislature intended to compel any entity
seeking to claim the benefits of the LLC Act to identify itself clearly as a limited liability company.

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                                                         iii)    Derogation of the Common Law. Statutes in derogation
                                                                 of the common law are to be strictly construed.
                5.        The “missing link” between the limited disclosure made by Clark and the protection of
                          the notice statute was the failure to state that “P.I.I.,” the Company, stood for “Preferred
                          Income Investors, LLC.”
II.      The Operating Agreement
         A.     Elf Atochem North America, Inc. v. Jaffari (Del. 1999).
                1.        Facts. Elf manufactured solvent-based maskants to the aerospace and aviation industries.
                          Jaffari was the president of Malek, Inc., which developed environmentally-friendly
                          solvent-based maskants. The EPA soon classified solvent-base maskants as hazardous
                          chemicals and Elf began looking for alternatives. They found Malek. Elf approached
                          Malek and Jaffari, finding the offer attractive, caused Malek LLC to be formed in
                          Delaware.38 The parties then entered into a series of agreements, of which Malek LLC
                          was not a signatory of, which included an Exclusive Distributorship Agreement, that Jaffari
                          would manage Malek, and that Jaffari would be the CEO of Malek. Elf contributed $1
                          million for a 30 percent interest, while Malek, Inc. contributed its rights to the maskant for
                          a 70 percent interest. The Agreement also contained an arbitration clause and forum
                          selection clause. In 1998, Elf sued Jaffari and Malek LLC, individually and derivatively
                          alleging breach of fiduciary duties, breach of contract, tortious interference with
                          prospective business relations, and fraud. The Del. Court of Chancery dismissed citing
                          lack of subject matter jurisdiction because of the Agreement’s arbitration clause.
                2.        The Limited Liability Company and Flexibility. The Delaware LCC Act was adopted in
                          October 1992. The LCC is an attractive form of business entity because it combines
                          corporate-type limited liability with partnership-type flexibility and tax advantages. The
                          Act can be characterized as a “flexible statute” because it generally permits members to
                          engage in private ordering with substantial freedom of contract to govern their
                          relationship, provided they do not contravene any mandatory provisions of the Act.
                          a.        LLC Act Modeled on LP Act. The Delaware Act has been modeled on the popular
                                    Delaware LP Act. In fact, its architecture and much of its wording is almost
                                    identical to that of the Delaware LP Act. Under the Act, a member of an LLC is
                                    treated much like a limited partner under the LP Act. The police of freedom of
                                    contract underlies both the Act an the LP Act.
                3.        Basic Approach. The basic approach of the Delaware Act is to provide members with broad
                          discretion in drafting the Agreement and to furnish default provisions when the members’
                          agreement is silent. The Act is replete with fundamental provisions made subject to
                          modification in the Agreement (e.g., “unless otherwise provided in a limited liability
                          company agreement . . .”).
                4.        Section 18-1101(b) of the Act, like the essentially identical Section 17-1101(c) of the LP
                          Act, provides that “[i]t is the policy of [the Act] to give the maximum effect to the
                          principle of freedom of contract and to the enforceability of limited liability company
                          agreements.”
                          a.        In General, Only Mandatory Provisions Trump Agreement. In general, the
                                    commentators observe that only where the agreement is inconsistent with
                                    mandatory statutory provisions will the members’ agreement be invalidated.
                                    Such statutory provisions are likely to be those intended to protect third parties,
                                    not necessarily the contracting members.
                5.        Malek LLC Not a Signatory to Agreement? Section 18-101(7) defines the limited liability
                          company as “any agreement, written or oral, of the member or members as to the affairs of


          38
             The certificate of formation is a relatively brief and formal document that is the first statutory step in
creating the LLC as a separate legal entity. The certificate does no contain a comprehensive agreement among the
parties, and the statute contemplates that the certificate of formation is to be complemented by the terms of the
Agreement.

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                           a limited liability company and the conduct of its business.”
                           a.         The Act is a statute designed to permit members maximum flexibility in entering
                                      into an agreement to govern their relationship. It is the members who are the
                                      real parties in interest. The LLC is simply their joint business vehicle. This is the
                                      contemplation of the statute in prescribing the outlines of a limited liability
                                      company agreement.
                  6.       Derivative Nature of Suit Irrelevant. Although Elf correctly points out that Delaware law
                           allows for derivative suits against management of an LLC, Elf contracted away its right to
                           bring such an action in Delaware an agreed instead to dispute resolution in California. 39
                           a.         The Agreement does not distinguish between direct and derivative claims. They
                                      simply state that the members may not initiate any claims outside of California.
                  7.       Court of Chancery “Special Jurisdiction” Notwithstanding Agreement? Elf is correct that
                           Delaware statutes vest jurisdiction with the Court of Chancery in actions involving
                           removal of managers and interpreting, applying or enforcing LLC agreements respectively.
                           Such a grant of jurisdiction may have been constitutionally necessary if the claims do not
                           fall within the traditional equity jurisdiction.
                           a.         Merely a Default Provision Modifiable By Agreement. Nevertheless, for the purpose
                                      of designating a more convenient forum, we find no reason why the members
                                      cannot alter the default jurisdictional provisions of the statute and contract away
                                      their right to file suit in Delaware.
                           b.         Conclusion is bolstered by the fact that Delaware recognizes a strong public
                                      policy in favor of arbitration. Normally, doubts on the issue of whether a
                                      particular issue is arbitrable will be resolved in favor of arbitration.
III.     Piercing the “LLC” Veil
         A.       Kaycee Land and Livestock v. Flahive (W yo. 2002).
                  1.       Facts. Flahive Oil & Gas was a W yoming LLC, of which Roger Flahive was the manager,
                           and possessed no assets at the time of litigation. Kaycee had entered into a contract with
                           Flahive to use the surface of its real property. However, Kaycee alleged that the property
                           had been contaminated by Flahive and sought to pierce the veil of the LLC and hold
                           Roger Flahive personally liable for the contamination.
                  2.       Piercing is an Equitable Doctrine. We have long recognized that piercing is an equitable
                           doctrine. The concept developed through common law and is absent from the statutes
                           governing corporate organization.
                  3.       Corporation Act’s Language v. LLC Act’s Language. Section 17-16-622(b)–a provision from
                           the Model Business Corporation Act–reads: “Unless otherwise provided in the articles of
                           incorporation, a shareholder of a corporation is not personally liable for the acts or debts of
                           the corporation except that he may become personally liable by reason of his own acts or
                           conduct.”
                           a.         The LCC statute reads “Neither the members of a limited liability company nor
                                      the managers of a limited liability company managed by a manager are liable
                                      under a judgment, decree or order of a court, or in any other manner, for a debt,
                                      obligation or liability of the limited liability company.” § 17-15-113.
                                      (1)       However, we agree with the commentary that; “It is difficult to read
                                                statutory § 17-15-113 as intended to preclude courts from deciding to
                                                disregard the veil of an improperly used LLC.” Gelb, Liabilities of
                                                Members and Managers of W yoming Limited Liability Companies, 31 Land &
                                                W ater L. Rev. 133 (1996).
                                      (2)       W yoming’s statute is very short and establishes only minimal
                                                requirements for creating and operating LLCS. It seems highly unlikely


          39
             Section 13.8 of the Agreement specifically provided that the parties (i.e., Elf) agreed to institute, “[n]o
action at law or in equity based upon any claim arising out of or related to this Agreement” except as action to
compel arbitration or to enforce an arbitration award.

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                                           that the W yoming legislature gave any consideration to whether the
                                           common-law doctrine of piercing the veil should apply to the liability
                                           limitation granted by that fledgling statute.
                                           (a)       It is true that some other states have adopted specific legislation
                                                     extending the doctrine to LLCs while Wyoming has not.
                                                     However, that situation seems more attributable to the fact that
                                                     W yoming was a pioneer in the LLC arena and states which
                                                     adopted LLC statutes much later had the benefit of years of
                                                     practical experience during which this issue was likely raised.
                                 (3)       It stands to reason that, because it is an equitable doctrine, “[t]he paucity
                                           of statutory authority for LLC piercing should not be considered a
                                           barrier to its application.” Lack of explicit statutory language should not
                                           be considered an indication of the legislature’s desire to make LLC
                                           members impermeable.
                        b.       W e can discern no reason, in either law or policy, to treat LLCs differently than
                                 we treat corporations. If the members and officers of an LLC fail to treat it as a
                                 separate entity as contemplated by statute, they should not enjoy immunity from
                                 individual liability for the LLC’s acts that cause damage to third parties.
IV.   Fiduciary Obligation
      A.       McConnell v. Hunt Sports Enterprises (Oh. 1999).
               1.       Facts. Columbus Hockey Limited LLC (CHL), of which McConnell and Hunt were
                        investors, was formed to seek an NHL team in Columbus, OH. In order to secure a
                        franchise, CHL sought public financing for an arena but taxpayers rejected a sales tax
                        increase. Nationwide Insurance then expressed a desire to build an arena and lease it. A
                        lease proposal was extended but reject by Hunt. McConnell, however, stated that if Hunt
                        would not agree, he would. Relying on this backup offer, the NHL expansion committee
                        recommended Columbus be awarded a team. Hunt and his allies still found the lease
                        unacceptable while McConnell and his allies accepted the lease and signed an agreement in
                        their own names. McConnell’s group filed suit asking for a declaratory judgment to
                        establish its right to the franchise without the inclusion of Hunt or CHL. A directed
                        verdict was granted to McConnell.
               2.       The term “fiduciary relationship” has been defined as a relationship in which special
                        confidence and trust is reposed in the integrity and fidelity of another, and there is a
                        resulting position of superiority and influence acquired by virtue of this special trust.
                        a.        In the case at bar, a limited liability company is involved which, like a
                                  partnership, involves a fiduciary relationship. Normally, the presence of such a
                                  relationship would preclude direct competition between members of the
                                  company. However, we have an operating agreement that by its very terms allows
                                  members to compete with the business of the company.
               3.       Issue. W hether an Operating Agreement of an LLC May Limit or Define Scope of
                        Fiduciary Duty?
                        a.        In becoming members of CHL, appellant and appellees agreed to abide by the
                                  terms of the operating agreement, and such agreement specifically allowed
                                  competition with the company by its members. As such, the duties created
                                  pursuant to such undertaking did not include a duty not to compete. Therefore,
                                  there was no duty on the part of appellees to refrain from subjecting appellant to
                                  the injury complained of herein.
                        b.        In so concluding, we are not stating that no act related to such obtaining could be
                                  considered a breach of fiduciary duty. In general terms, members of limited
                                  liability companies owe one another the duty of utmost trust and loyalty.
                                  However, such general duty in this case must be considered in the context of
                                  members’ ability, pursuant to operating agreement, to compete with the
                                  company.
               4.       Tortious Interference with a Business Relationship. Tortious interference with a business

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             relationship occurs when a person, without a privilege to do so, induces or otherwise
             purposely causes a third person not to enter into or continue a business relationship with
             another.
             a.         The evidence does not show that appellees induced or otherwise purposely
                        caused Nationwide and the NHL not to enter into or continue a business
                        relationship with appellant. Indeed, the evidence shows McConnell stated he
                        would lease the arena and obtain the franchise only if appellant did not. It was
                        only after appellant rejected the lease proposal on several occasions that
                        McConnell stepped in.
     5.      Breach of Contract Claim Against Hunt for Unilateral Rejection/Failure to Negotiate in Good
             Faith. There was no evidence at trial that appellant was the operating member of CHL.
             The operating agreement, which sets forth the entire agreement between the members of
             CHL, does not name any person or entity the operating or managing member of CHL.
             a.         Section 4.1(b) of the operating agreement requires at least a majority approval
                        prior to taking any action on behalf of CHL. Further, the approval of the
                        members as to any action on behalf of CHL must have been evidenced by
                        minutes of a meeting properly notice and held or by an action in writing signed
                        by the requisite number of members.
             b.         Section 4.4's provision, relating to liability only for wilful misconduct, are in the
                        context of member carrying out their duties under the operating agreement.
                        There was no duty on appellant’s part to unilaterally file the actions at issue.
B.   K.C. Properties v. Lowell (Ark. 2008)
     1.      Simplified Facts. A and B set up a Limited Liability Company (LLC) called ABLLC to
             construct and operate a water park. They sign an operating agreement. ABLLC is a
             manager-managed LLC, and B is the manager. A owns a 49% membership interest in the
             LLC, and B owns a 51% interest. B also owns Blackacre, the land that the parties intend to
             acquire for the LLC, on which the water park is to be built. Although ABLLC has no
             written contract to purchase Blackacre, the parties' intentions are undisputed. B, as
             manager, acting on behalf of ABLLC, even makes a contract with a contractor owned by
             A to construct the water park on Blackacre. At the same time that these negotiations and
             transactions between A and B are taking place, B is secretly negotiating to sell Blackacre to
             a third party for a higher price. And that is what she does, without informing A in advance
             of her decision to do so. A responds by suing B for damages for breach of fiduciary duty.
     2.      § 4-32-402. Liability to Company; Duties
             Unless otherwise provided in an operating agreement:
                        (1) A member or manager shall not be liable, responsible, or accountable in damages or
                        otherwise to the limited liability company or to the members of the limited liability company
                        for any action taken or failure to act on behalf of the limited liability company unless the act
                        or omission constitutes gross negligence or willful misconduct; [and]
                        (2) Every member and manager must account to the limited liability company and hold as
                        trustee for it any profit or benefit derived by that person without the consent of more than
                        one-half (1/2) by number of the disinterested managers or members, or other persons
                        participating in the management of the business or affairs of the limited liability company,
                        from any transaction connected with the conduct or winding up of the limited liability
                        company or any use by the member or manager of its property, including, but not limited
                        to, confidential or proprietary information of the limited liability company or other matters
                        entrusted to the person as a result of his or her status as manager or member...
     3.      The court relied on subsection (1) of the statute to hold that K.C. Properties could not sue
             anyone except Ozark's other member, LIP, and Ozark's manager, PMS. The court then
             observed that neither LIP nor PMS sold the 34 acres to another party, and therefore
             “neither PMS nor LIP committed any act or failure to act constituting gross negligence or
             willful misconduct for which they could be held liable under § 4-32-402(1).
     4.      Court Pinned Decision on Duty of Care. W hat is remarkable is that the court pinned its
             rejection of the breach of fiduciary duty claim solely on subsection (1) of Arkansas Code

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                       Annotated section 4-32-402. Subsection (1) of the statute addresses only the fiduciary duty
                       of care.
                       a.       Court Should Have Looked to the Duty of Loyalty. As is evident from the fact that
                                they were on both the buy side and the sell side of the planned transaction in this
                                case, the individual defendants were engaged in self-interested behavior.
                                Therefore, it is the other principal fiduciary duty— the duty of loyalty— that was
                                at issue. The duty of loyalty is addressed by subsection (2) of Arkansas Code
                                Annotated section 4-32-402, set out above. Again, quoting from the drafters of
                                the Prototype Act, “Subsection [(2)], which is based on UPA § 21, sets forth the
                                duty of loyalty of LLC managers and managing members— that is, the duty to act
                                without being subject to an obvious conflict of interest . . . .”
                       b.       Analogous to Limited Partnership Law. In In re USACafes, a Delaware court held
                                that the directors of the corporate general partner owed some degree of fiduciary
                                duty directly to the limited partners. W hile the court did not define the limits of
                                the directors' obligation, it concluded that “it surely entails the duty not to use
                                control over the partnership's property to advantage the corporate director at the
                                expense of the partnership.”
V.   Dissolution
     A.       New Horizons Supply Cooperative v. Haack (W is. App. 1999)
              1.      Facts. Kickapoo Valley Freight, LLC was the “Patron” under a Cardtrol Agreement issued
                      by New Horizon’s predecessor. Kickapoo agreed to be responsible for all fuel purchased
                      with the card. The agreement was signed by Haack with no indication of whether she was
                      signing individually or in a representative capacity. The account soon was in arrears and
                      when contacted about payment, Haack said she would pay $100 per month but no
                      payment was ever received. Haack was contacted again but Haack inform New Horizons
                      that Kickapoo had dissolved and that she was a partner and that Robert, her brother, had
                      moved out of state and that she would begin payments. No payment was ever received
                      and subsequent attempts to collect payment proved fruitless. Horizons instituted an action
                      to recover against Haack.
              2.      Members of LLCs Not Personally Liable. W is. Stat. § 183.0304 provides that “a member of
                      manager of a limited liability company is not personally liable for any debt, obligation or
                      liability of the limited liability company.”
                      a.         May Borrow From Common Law Corporation Principles. W is. Stat. § 183.0304(2)
                                 provides: “Notwithstanding sub. (1) [which sets forth the limitation on member
                                 liability], nothing in this chapter shall preclude a court from ignoring the limited
                                 liability company entity under principles of common law of this state that are
                                 similar to those applicable to business corporations and shareholders in this state
                                 and under circumstances that are not inconsistent with the purposes of this
                                 chapter.”
              3.      The court disagrees with the trial court’s comments that implied that it erroneously
                      deemed Kickapoo Valley’s treatment as a partnership for tax purposes to be conclusive.
                      There is little in the record, moreover, to support a conclusion that Haack “organized,
                      controlled and conducted” company affairs to the extent that it had “no separate existence
                      which she “used to evade an obligation, to gain an unjust advantage or to commit an
                      injustice.”
                      a.         Defendant Failed to Shield Herself After Dissolution. Rather we conclude that entry
                                 of judgment against Haack on the claim was proper because she failed to establish
                                 that she took appropriate steps to shield herself from liability for the company’s
                                 debts following its dissolution and the distribution of its assets.
                                 (1)        The record is devoid of any evidence showing that appropriate steps
                                            were taken upon the dissolution of the company to shield its members
                                            from liability for the entity’s obligations.
                                            (a)      A dissolved limited liability company may “dispose of known
                                                     claims against it” by filing articles of dissolution, and then

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                                                            providing written notice to its known creditors containing
                                                            information regarding the filing of claims. W is. Stat. §
                                                            183.0907.
                                                   (b)      W is. Stat. § 183.0909 provides that a claim not barred under §
                                                            183.0907 or 183.0908 may be enforced under this section
                                                            against any of the following:
                                                            i)         “If the dissolved limited liability company’s assets have
                                                                       been distributed in liquidation, a member of the
                                                                       limited liability company to the extent of the
                                                                       member’s proportionate share of the claim or to the
                                                                       extent of the assets of the limited liability company
                                                                       distributed to the member in liquidation, whichever is
                                                                       less, but a member’s total liability for all claims under
                                                                       this section may not exceed the total value of assets
                                                                       distributed to the member in liquidation.”
C H A PTER F IVE : T H E D U TIES O F O FFIC ERS , D IR EC TO R S , A N D O TH ER I N SIDER S
I.       The Obligations of Control: Duty of Care
         A.        Kamin v. American Express Company (N.Y. 1976).
                   1.        Facts. The shareholders’ derivative action complaint alleges that in 1972, AmEx acquired
                             nearly 2 million shares of DLJ for $30 million. It was alleged that the market value of
                             those shares was only $4 million. In 1974, AmEx declared a special dividend to distribute
                             shares of DLJ in kind. A sale of the DLJ shares on the market would sustain a capital loss
                             of $25 million which would be an offset against taxable capital gains on other investments.
                             The plaintiffs demanded that the directors rescind the distribution and take steps to
                             preserve the capital loss. This was rejected by the Board of Directors.
                   2.        Grounds for a Claim for Actionable W rongdoing. In actions by stockholders, which assail the
                             acts of their directors or trustees, courts will not interfere unless the powers have been
                             illegally or unconscientiously executed; or unless it be made to appear that the acts were
                             fraudulent or collusive, and destructive of the rights of the stockholders. Mere errors of
                             judgment are not sufficient as grounds for equity interference, for the powers of those
                             entrusted with corporate managements are largely discretionary.
                   3.        Business Judgment for Declaring Dividend. Courts will not interfere with such discretion
                             unless it be first made to appear that the directors have acted or are about to act in bad
                             faith and for a dishonest purpose. It is for directors to say, acting in good faith of course,
                             when and to what extent dividends shall be declared. The statute confers upon the
                             directors this power, and the minority stockholders are not in a position to question this
                             right, so long a the directors are acting in good faith.
                   4.        Merely Alleging Better Course of Action Insufficient. A complaint must be dismissed if all that
                             is presented is a decision to pay dividends rather than pursuing some other course of
                             conduct. A complaint which alleges merely that some course of action other than that
                             pursued by the Board of Directors would have been more advantageous gives rise to no
                             cognizable cause of action.
                             a.         The directors’ room rather than the courtroom is the appropriate forum for
                                        thrashing out purely business questions which will have an impact on profits,
                                        market prices, competitive situations, or tax advantages.
                   5.        The statute permits an action against directors for “the neglect of, or failure to perform, or
                             other violation of his duties in the management and disposition of corporate assets
                             committed to his charge.”
                             a.         Improper Decision Insufficient for Neglect. This does not mean that a director is
                                        chargeable with ordinary negligence for having made an improper decision, or
                                        having acted imprudently. The “neglect” referred to in the statute is neglect of
                                        duties (i.e., malfeasance or nonfeasance) and not misjudgment. To allege that a
                                        director “negligently permitted the declaration and payment of a divided without
                                        alleging fraud, dishonesty or nonfeasance, is to state merely that a decision was

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                                        take with which on disagrees.
                            b.          Courts will not interfere unless a clear case is made out of fraud, oppression,
                                        arbitrary action, or breach of trust.
                                        (1)        If the business judgment rule is overcome then the court will determine
                                                   if the decision was fair to the corporation.
         B.       Smith v. Van Gorkom (Del. 1985).
                  1.         The court recited a litany of errors by a board composed of five management directors and
                             five eminently qualified outside directors. According to the court, the directors had failed
                             to inquire into Van Gorkom’s role in setting the merger’s terms; failed to review the
                             merger documents; had not inquired into the fairness of the $55 price and the value of the
                             company’s significant, but unused, investment tax credits; accepted without inquiry the
                             view of the company’s chief financial officer (Romans) that the $55 price was within a fair
                             range; had not sought an outside opinion from an investment bank on the fairness of the
                             $55 price; and acted at a two-hour meeting without prior notice and without there being
                             an emergency.
                  2.         Under Delaware law, the business judgment rule is the offspring of the fundamental
                             principle that the business and affairs of a Delaware corporation are managed by or under
                             its board of directors.
                             a.         The rule itself is a presumption that in making a business decision, the directors of
                                        a corporation acted on an informed basis, in good faith and in the honest belief
                                        that the action taken was in the best interest of the company.
                                        (1)        Thus, the party attacking a board decision as uninformed must rebut the
                                                   presumption that its business judgment was an informed one.
                             b.         The determination of whether a business judgment is an informed one turns on
                                        whether the directors have informed themselves prior to making a business
                                        decision, of all material information reasonably available to them.
                                        (1)        In the specified context of a proposed merger of domestic corporations,
                                                   a director has a duty, along with his fellow directors, to act in an
                                                   informed and deliberate manner in determining whether to approve an
                                                   agreement of merger before submitting the proposal to the stockholders.
                                                   Certainly in the merger context, a director may not abdicate that duty
                                                   by leaving to the shareholders alone the decision to approve or
                                                   disapprove the agreement.
         C.       Legislative Response to the Decision. Del. Gen. Corp. Law § 102(b)(7) was adopted after the Van
                  Gorkom decision and the so-called D&O liability insurance crisis. This new law allowed a provision
                  in a corporation’s articles of incorporation that limited directors’ liability 40:
                             A provision eliminating or limiting the personal liability of a director to the corporation to its
                             stockholders for monetary damages for breach of fiduciary duty as a director, provided that such
                             provision shall not eliminate or limit the liability of a director: (i) For any breach of the director’s duty
                             of loyalty to the corporation or its stockholders; (ii) For acts or omissions not in good faith or which
                             involve intentional misconduct or a knowing violation of law; (iii) Under § 174 of this title [relating
                             to payment of dividends]; or (iv) for any transaction from which the director derived an improper
                             personal benefit
         D.       Francis v. United Jersey Bank
                  1.         Directors Generally Afforded Immunity. Individual liability of a corporate director for acts of
                             the corporation is a prickly problem. Generally, directors are accorded broad immunity
                             and are not insurers of corporate activities. The problem is particular nettlesome when a
                             third party asserts that a director, because of nonfeasance, is liable for losses caused by acts
                             of insiders, who in this case were officers, directors, and shareholders,


         40
             Del. Gen. Corp. Law 102(b)(7) does not permit the reduction of liability for any breach of the duty of
loyalty or for any acts or omissions not in good faith or which involve intentional misconduct or knowing violations
of the law.

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              2.        Duty, Breach, and Causation. Determination of the liability of Pritchard requires findings
                        that she had a duty to the clients of Pritchard & Baird, that she breached that duty and that
                        her breach was a proximate cause of their losses.
              3.        New Jersey Business Corporation Act makes it incumbent upon directors to “discharge
                        their duties in good faith and with that degree of diligence, care and skill which ordinarily
                        prudent men would exercise under similar circumstances in like positions.”
                        a.        Degree of Care Dependent on Business Type. Courts have espoused the principle
                                  that directors owed that degree of care that a business of ordinary prudence
                                  would exercise in the management of his own affairs. In addition to requiring
                                  that directors act honestly and in good faith, the New York courts recognized
                                  that the nature and extent of reasonable care depended upon the type of
                                  corporation, it size and its financial resources.
              4.        Director Must Be Knowledgeable. As a general rule, a director should acquire at least a
                        rudimentary understanding of the business of the corporation. Accordingly, a director
                        should become familiar with the fundamentals of the business in which the corporation is
                        engaged.
                        a.        Because directors are bound to exercise ordinary care, they cannot set up as a
                                  defense lack of the knowledge needed to exercise the requisite degree of care.
                        b.        Directors are under a continuing obligation to keep informed about the activities
                                  of the corporation.
                                  (1)        May not shut their eyes to corporate misconduct and then claim that
                                             because they did not see the misconduct, they did not have a duty to
                                             look.
                        c.        Directorial management does not require a detailed inspection of day-to-day
                                  activities, but rather a general monitoring of corporate affairs and policies.
                                  (1)        Should maintain familiarity with the financial status of the corporation
                                             by a regular review of financial statements.
              5.        Immunity from Reliance in Good Faith. Generally, directors are immune from liability if, in
                        good faith:
                        a.        “They rely upon the opinion of counsel for the corporation or upon written
                                  reports setting forth financial data concerning the corporation and prepared by an
                                  independent public accountant or certified public accountant or firm of such
                                  accountants or reports of the corporation represented to them to be correct by the
                                  president, the officer of the corporation having charge of its books of account, or
                                  the person presiding at a meeting of the board.:”
              6.        Duty to Object & Resign. Upon discovery of an illegal course of action, a director has a
                        duty to object and, if the corporation does not correct the conduct, to resign.
                        a.        Sometimes more may be required, such as seeking advice of counsel or
                                  preventing illegal conduct by co-directors. This may include threat of suit.
              7.        Fiduciary Relationship. In general, the relationship of a corporate director to the
                        corporation and its stockholders is that of a fiduciary.
                        a.        W hile directors may own a fiduciary duty to creditors also, that obligation
                                  generally has not been recognized in the absence of insolvency.
              8.        Causation. Usually, a director can absolve himself from liability by informing the other
                        directors of the impropriety and voting for a proper course of action. Conversely, a
                        director who votes for or concurs in certain actions may be liable to the corporation for
                        the benefit of its creditors or shareholders, to the extent of any injuries suffered by such
                        persons, as a result of any such action.
                        a.        A director who is present at a board meeting is presumed to concur in corporate
                                  action taken at a meeting unless his dissent is entered in the minutes of the
                                  meeting or filed promptly after adjournment.


II.   Duty of Loyalty

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A.   Directors and Managers
     1.       Bayer v. Beran (N.Y. 1944).
              a.       Facts. In 1942, Celanese began a radio advertising campaign costing about $1
                       million a year. It was claimed that the advertising was really merely a vehicle to
                       launch the career of Miss Jean Tennyson, in real life Mrs. Camille Dreyfus, wife
                       of the president of the company. Before ‘42 the company had never advertised
                       on radio. However, in 1937, the FTC promulgated new regulations requiring
                       celanese products to be designated and labeled rayon. Thus, the directors became
                       concerned with how to distinguish their product on the market.
              b.       Business Judgment Rule. “Question of policy and management, expediency of
                       contracts or action, adequacy of consideration, lawful appropriation of corporate
                       funds to advance corporate interests, are left solely to their honest and unselfish
                       decision, for their power therein are without limitation and free from restraint,
                       and the exercise of them for the common and general interests of the corporation
                       may not be questioned, although the results show that what they did was unwise
                       and inexpedient.”
                       (1)       It is only in a most unusual and extraordinary case that directors are held
                                 liable for negligence in the absence of fraud, or improper motive, or
                                 personal interest.
              c.       Business Judgment Rule Subject to Duty of Loyalty. The business judgment rule,
                       however, yields to the rule of undivided loyalty. This great rule of law is
                       designed to avoid the possibility of fraud and to avoid the temptation of self-
                       interest. It is designed to obliterate all divided loyalties which may creep into a
                       fiduciary relation.
                       (1)       Such personal transactions of directors with their corporation, such
                                 transactions as may tend to produce a conflict between self-interest and
                                 fiduciary obligation, are, when challenged, examined with the most
                                 scrupulous care, and if there is any evidence of improvidence or
                                 oppression, any indication of unfairness or undue advantage, the
                                 transactions will be voided.
                       (2)       Their dealings with the corporation are subjected to rigorous scrutiny
                                 and where any of their contracts or engagements are challenged the
                                 burden is on the director not only to prove the good faith of the
                                 transaction but also to show its inherent fairness from the viewpoint of
                                 the corporation and those interested therein.
              d.       Not Improper to Appoint Relative But Action Closely Scrutinized. Of course it is not
                       improper to appoint relative of officers or directors to responsible positions in a
                       company. But where a close relative of the chief executive officer of a
                       corporation, and one of its dominant directors, takes a position closely associated
                       with a new and expensive field of activity, the motives of the director are likely
                       to be questioned.
                       (1)       The board would be placed in a position where selfish, personal interests
                                 might be in conflict with the duty owed to the corporation. That being
                                 so, the entire transaction, if challenged in the courts, must be subjected
                                 to the most rigorous scrutiny to determine whether the action of the
                                 directors was intended or calculated to subserve some outside purpose,
                                 regardless of the consequences to the company, and in a manner
                                 inconsistent with its interests.
                                 (a)        The evidence fails to show that the program was designed to
                                            foster or subsidize the career of Miss Tennyson as an artist or to
                                            furnish a vehicle for her talents. That her participation in the
                                            program may have enhanced her prestige as a singer is no
                                            ground for subjecting the directors to liability, as long as the
                                            advertising served a legitimate purpose and a useful corporate

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                                                         purpose and the company received the full benefit thereof.
                            e.       Directors Acting Separately Cannot Bind Corp. The general rule is that the directors
                                     acting separately and not collectively as a board cannot bind the corporation.
                                     There are two reasons for this: First, that collective procedure is necessary in
                                     order that action may be deliberately taken after an opportunity for discussion and
                                     an interchange of views. Second, that directors are agents of the stockholders and
                                     are given by law no power to act except as a board.
                                     (1)       Liability may not, however, be imposed on directors because they failed
                                               to approve the radio program by resolution at a board meeting.
                                               (a)       Failure to Meet Formalities Not Fatal. The failure to observe the
                                                         formal requirements is by no means fatal. The directorate of
                                                         this company is composed largely of its executive officers. It is
                                                         a close, working directorate. Its members are in daily
                                                         association with one another and their full time is devoted to
                                                         the business of the company with which they have been
                                                         connected for many years. This same informal practice
                                                         followed in this transaction had been the customary procedure
                                                         of the directors in acting on corporate projects of equal or
                                                         greater magnitude. W hile a greater degree of formality should
                                                         undoubtedly be exercised in the future, it is only just and proper to
                                                         point out that these directors, with all their loose procedure, have done
                                                         very well for the corporation.
                   2.       Benihana of Tokyo, Inc. v. Benihana, Inc. (Del. 2006).
                            a.       Facts. The Benihana Protective Trust (BOT) owned 50.9% of Common stock 41
                                     (1 vote per share/75% of directors) and 2% of Class A stock (1/10 vote per
                                     share/25% of directors). In 2003, Aoki, founder of Benihana, married Keiko.
                                     Conflicts arose between Aoki and his children because of a change in his will that
                                     gave his new wife control upon his death. Benihana’s president discussed the
                                     situation with another director. Benihana was also undertaking a Construction
                                     and Renovation Plan however capital was insufficient. A plan was formed to
                                     issue convertible preferred stock 42 to provide funds and put the company in a
                                     better negotiating position. One of the directors, Abdo, was also a director of
                                     BFC. Three other offers were obtained but were deemed inferior to BFC’s.
                                     BFC executed a Stock Purchase Agreement with Benihana.
                            b.       Safe Harbor for Disclosed Relationships/Interests. Section 144 of the Delaware
                                     General Corporation Law provides a safe harbor for interested transactions, like
                                     this one, if “[t]he material facts as to the director’s relationship or interest and as
                                     to the contract or transaction are disclosed or are known to the board of directors
                                     and the board in good faith authorizes the contract or transaction by the
                                     affirmative votes of a majority of the disinterested directors.”
                                     (1)       Board Knew of Abdo’s Interested Status. Thus, although no one ever said,
                                               “Abdo negotiated this deal for BFC,” the directors understood that he
                                               was BFC’s representative in the Transaction.



         41
            Common Stock: The default rule is that each share receives one (1) vote per share. Common stock receives
dividends, shares are treated identically and are entitled to the residual ownership interest (liquidation rights are in the
following order: secured creditors, creditors, preferred stock, and finally common stock). Common stock can be
issued in multiple classes.

         42
            Preferred Stock: Some preference over common stock with regards to dividends and liquidation rights.
Preferred stock can have conversion rights that give preferred shareholders the option to convert their preferred into
other stock of the corporation, usually common stock.

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                          c.      Breach of Fiduciary Duty Trigger Entire Fairness Standard?
                                  (1)        Director with conflict of interest cannot use confidential information for
                                             himself or for others.
                                             (a)       The record does not support BOT’s contention that Abdo used
                                                       any confidential information against Benihana. Abdo did not
                                                       set the terms of the deal; he did not deceive the board; and he
                                                       did not dominate or control the other directors’ approval in the
                                                       Transaction. In short, the record does not support the claim
                                                       that Abdo breached his duty of loyalty.
                         d.       No Entrenchment43 . It is settled law that, “corporate action may not be taken for
                                  the sole or primary purpose of entrenchment.”
                                  (1)        Here, however, the trial court found that the primary purpose of the
                                             Transaction was to provide what the directors subjectively believed to
                                             be the best financing vehicle available for securing the necessary funds
                                             for the agreed upon Construction and Renovation Plan for the
                                             Benihana restaurants.
        B.       Corporate Opportunities
                 1.      Broz v. Cellular Information Systems, Inc. (Del. 1996).
                         a.       Facts. Broz was the president and sole stockholder of RFBC and also a director
                                  of CIS. RFBC owned and operated FCC license area Michigan-4. In 1994,
                                  Mackinac sought to divest itself of Michigan-2. The license was offered to
                                  RFBC but not CIS because it had just emerged from a lengthy and contentious
                                  insolvency reorganization. Also, from 1992 on, CIS had divested itself of fifteen
                                  separate cellular licenses, leaving it with only five, all outside the Midwest. Broz
                                  contacted several CIS directors about his interest in Michigan-2 but all stated that
                                  CIS would not be interested. CIS then entered agreement with PriCellular to
                                  sell CIS. PriCellular obtained an option to purchased Michigan-2 but Broz met
                                  the a term of the option agreement and ultimately purchased the license. Nine
                                  days after the sale, PriCellular closed its tender offer for CIS.
                         b.       Guth v. Loft Corporate Opportunity Test. The doctrine of corporate opportunity
                                  represents but one species of the broad fiduciary duties assumed by a corporate
                                  director or officer. A corporate fiduciary agrees to place the interests of the
                                  corporation before his or her own in appropriate circumstances.
                                  (1)        “if there is presented to a corporate officer of director a business
                                             opportunity which the corporation is (1) financially able to undertake, is,
                                             from its nature, (2) in the line of the corporation’s business (fundamental
                                             knowledge) and is of practical advantage to it, is (3) one in which the
                                             corporation has an interest or a reasonable expectancy , and, (4) by
                                             embracing the opportunity, the self-interest of the officer or director will
                                             be brought into conflict with that of the corporation, the law will not
                                             permit him to seize the opportunity himself.”
                         c.       Mackinac did not offer the property to CIS. Broz became aware of the
                                  opportunity in his individual rather than his corporate capacity. This factual
                                  posture does not present many of the fundamental concerns undergirding the law
                                  of corporate opportunity (e.g., misappropriation of the corporation’s proprietary
                                  information). However, while this lessens to some extent the burden imposed
                                  upon Broz to show adherence to his fiduciary duties, it is not dispositive.
                         d.       Factors. (1) CIS was not financially capable of exploiting the license opportunity;


         43
            A manager who uses the corporate governance machinery to protect his incumbency effectively diverts
control from the shareholders to himself. Besides preventing shareholders from exercising their control
rights–whether by voting or selling to a new owner–management entrenchment undermines the disciplining effect on
management of a robust market in corporate control.

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               (2) CIS was in the business of divesting itself of its cellular license holdings
               therefore it is not clear that CIS had a cognizable interest or expectancy in the
               license; (3) Finally, the corporate opportunity doctrine is implicated only in cases where the
               fiduciary’s seizure of an opportunity results in a conflict between the fiduciary’s duties to the
               corporation and the self-interest of the director is actualized by the exploitation of the
               opportunity.
     e.        Presentation to the Board Unnecessary. A director or officer must analyze the
               situation ex ante to determine whether the opportunity is one rightfully
               belonging to the corporation. If the director or officer believes, based on one of
               the factors articulated above, that the corporation is not entitled to the
               opportunity, then he may take it for himself. Of course, presenting the opportunity
               to the board creates a kind of “safe harbor” for the director, which removes the specter of a
               post hoc judicial determination the director or officer has improperly usurped a corporate
               opportunity. It is not the law of Delaware that presentation to the board is a
               necessary element to a finding that a corporate opportunity has not been usurped.
     f.        The right of a director or officers to engage in business affairs outside of his or her
               fiduciary capacity would be illusory if these individuals were required to consider
               every potential, future occurrence in determining whether a particular business
               strategy would implicate fiduciary duty concerns.
2.   In re eBay, Inc. Shareholders Litigation (Del. Ch. 2004).
     a.        Facts. Omidyar and Skoll founded eBay in 1995. In 1998, Goldman Sachs was
               the lead underwriter on an IPO of common stock. Shares of eBay stock became
               valuable and the price rose considerably. In 1999, a secondary offering was made
               with Goldman Sachs again as the underwriter. Goldman Sachs “rewarded” the
               defendants by allocating to them thousands of IPO shares at the initial offering
               price. The plaintiffs alleged that Goldman Sachs provided these allocations to the
               individual defendants to show appreciation for eBay’s business and to enhance
               Goldman Sachs’ chances of obtaining future eBay business.
     b.        Distinguishing Broz. First, no one disputes that eBay was financially able to exploit
               the opportunities in question. Second, eBay was in the business of investing in
               securities. Thus, investing was a “line of business” of eBay. Third, the fact
               alleged in the complaint suggest that investing was integral to eBay’s cash
               management strategies and a significant part of its business. Finally, it is no
               answer to say, as do defendants, that IPOs are risky investments. It is undisputed
               that eBay was never given an opportunity to turn down the IPO allocations as
               too risky.
     c.        Not Simply a Case of Broker’s Investment Recommendations. This was not an instance
               where a broker offered advice to a director about an investment in a marketable
               security. The conduct challenged here involved a large investment bank that
               regularly did business with a company steering highly lucrative IPO allocations to
               select insider directors and officers at that company, allegedly both to reward
               them for past business and to induce them to direct future business to that
               investment bank. This is a far cry from the defendant’s characterization of the
               conduct in question as merely “a broker’s investment recommendations” to a
               wealthy client.
     d.        Conflict of Interest. One can realistically characterize these IPO allocation as a form
               of commercial discount or rebate for past or future investment banking services.
               Viewed pragmatically, it is easy to understand how steering such commercial
               rebates to certain insider directors places those directors in an obvious conflict
               between their self-interest and the corporation’s interest.
     e.        Agent’s Duty to Account for Profits. An agent is under a duty to account for profits
               personally obtained in connection with transactions related to his or her
               company. Even if this conduct does not run afoul of the corporate opportunity
               doctrine, it may still constitute a breach of the fiduciary duty of loyalty.

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               (1)       Thus, even if one does no consider Goldman Sachs’ IPO allocations to
                         these corporate insiders–allocations that generated millions of dollars in
                         profit–to be a corporate opportunity, the defendant directors were
                         nevertheless not free to accept this consideration from a company,
                         Goldman Sachs, that was doing significant business with eBay and that
                         arguably intended the consideration as an inducement to maintaining the
                         business relationship in the future.
3.   Northeast Harbor Golf Club, Inc. v. Harris (Me. 1995).
     a.        Guth v. Loft Line of Business Test.
               (1)       If there is presented to a corporate officer or director a business
                         opportunity which the corporation is financially able to undertake, is,
                         from its nature, in the line of the corporation’s business and is of
                         practical advantage to it, is one in which the corporation has an interest
                         or a reasonable expectancy, and, by embracing the opportunity, the self-
                         interest of the officer or director will be brought into conflict with that
                         of his corporation, the law will not permit him to seize the opportunity
                         for himself.
               (2)       W eaknesses. (1) The question whether a particular activity is within a
                         corporation’s line of business is conceptually difficult to answer (See In re
                         eBay, Inc. Shareholders’ Litigation); and (2) the Guth test includes as an
                         element the financial ability of the corporation to take advantage of the
                         opportunity. Often, the injection of financial ability into the equation
                         will unduly favor the inside director or executive who has command of
                         the facts relating to the finances of the corporation.
     b.        Fairness Test.
               (1)       The basis of the doctrine rests on the unfairness in the particular
                         circumstances of a director, whose relation to the corporation is
                         fiduciary, taking advantage of an opportunity for her personal profit
                         when the interest of the corporation justly calls for protection. This calls
                         for application of ethical standards of what is fair and equitable ... in
                         particular sets of facts.
               (2)       W eaknesses. Provides little or no practical guidance to the corporate
                         office or director seeking to measure her obligations.
     c.        Line of Business/Fairness Hybrid Test.
               (1)       Two step analysis: (1) Determining whether a particular opportunity is
                         within the corporation’s line of business; and (2) Scrutinizing the
                         equitable consideration existing prior to, at the time of, and following
                         the officer’s acquisition.
               (2)       W eaknesses. Merely piles the uncertainty and vagueness of the fairness
                         test on top of the weaknesses in the line of business test.
     d.        ALI Approach.
               (1)       The ALI Principles take a disclosure-oriented approach that mandates
                         informed corporate rejection before a manager can take a “corporate
                         opportunity.” Under this approach, (1) the manager must have offered
                         the opportunity to the corporation and disclosed his conflicting interest,
                         and (2) the board or shareholder must have rejected it. ALI § 505(a).
               (2)       ALI § 505(b). Definition of a Corporate Opportunity. For purposes of
                         this Section, a corporate opportunity is:
                         (1) Any opportunity to engage in a business activity of which a director or senior
                         executive becomes aware, either:
                         (A) In connection with the performance of functions as a director or senior
                         executive, or under circumstances that should reasonably lead the director or senior
                         executive to believe that the person offering the opportunity expects it to be offered
                         to the corporation; or

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                                 (B) Through the use of corporate information or property, if the resulting
                                 opportunity is one that the director or senior executive should reasonably be
                                 expected to believe would be of interest to the corporation; or
                                 (2) Any opportunity to engage in a business activity of which a senior executive
                                 becomes aware and knows is closely related to a business in which the corporation
                                 is engaged or expects to engage.
C.   Dominant Shareholders
     1.     Sinclair Oil Corp. v. Levien (Del. 1971).
            a.        Facts. Sinclair was in the business of exploring for oil and of producing and
                      marketing crude oil and oil products. It owned about 97% of Sinven’s stock. The
                      plaintiff owned about 3,000 of 120,000 publicly held shares of Sinven. Sinclair
                      nominated all of Sinven’s board of directors. These directors were, almost
                      without exception, officers, directors, or employees in the Sinclair complex. The
                      plaintiff alleged that from 1960 through 1966, Sinven paid out excessive dividend
                      and that Sinven was therefore prevented from industrial development. These
                      dividends exceed earnings.
            b.        The chancellor held that because of Sinclair’s fiduciary duty and its control over
                      Sinven, its relationship with Sinven must meet the test of intrinsic fairness.
                      (1)        Intrinsic fairness. The standard of intrinsic fairness involves both a high
                                 degree of fairness and a shift in the burden of proof. Under this standard
                                 the burden is on Sinclair to prove, subject to careful judicial scrutiny,
                                 that its transactions with Sinven were objectively fair.
            c.        Sinclair argues that the transactions between it and Sinven should be tested, not
                      by the test of intrinsic fairness with the accompanying shift of the burden of
                      proof, but by the business judgment rule.
                      (1)        Sinclair’s argument is misconceived.
                                 (a)         Intrinsic Fairness not Business Judgment Rule. When the situation
                                             involves a parent and a subsidiary, with the parent controlling
                                             the transaction and fixing terms, the test of intrinsic fairness
                                             with its resulting shifting of the burden of proof, is applied.
                                             i)         The basic situation for the application of the rule is
                                                        one in which the parent has received a benefit to the
                                                        exclusion and at the expense of the subsidiary.
                                 (b)         Intrinsic Fairness Not Always Applied in Parent/Subsidiary. A
                                             parent does indeed owe a fiduciary duty to its subsidiary when
                                             there are parent-subsidiary dealings. However, this alone will
                                             not evoke the intrinsic fairness standard. This standard will be
                                             applied when the fiduciary duty is accompanied by self-dealing–the
                                             situation when a parent is on both sides of the transaction with
                                             its subsidiary.
                                             i)         Self-dealing occurs when the parent, by virtue of its
                                                        domination of the subsidiary, cause the subsidiary to
                                                        act in such a way that the parent receives something
                                                        from the subsidiary to the exclusion of, and detriment
                                                        to, the minority stockholders of the subsidiary.
            d.        W e do not accept the argument that the intrinsic fairness test can never be applied
                      to a dividend declaration by a dominated board, although a dividend declaration
                      by a dominated board will not inevitably demand the application of the intrinsic
                      fairness standard.
                      (1)        Business Judgment Rule Should Have Been Applied to Dividends. The
                                 dividends resulted in great sums of money being transferred from Sinven
                                 to Sinclair. However, a proportionate share of this money was received
                                 by the minority shareholders of Sinven (fails exclusion requirement).
                                 Sinclair received nothing from Sinven to the exclusion of its minority

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                          stockholders. As such, these dividends were not self-dealing. Therefore,
                          the business judgment standard should have been applied.
                          (a)        The dividend payment complied with the business judgment
                                     standard. The motives for causing the declaration of dividends
                                     are immaterial unless the plaintiff can show that the dividend
                                     payments resulted from improper motives and amounted to
                                     waste.
              (2)         Intrinsic Fairness Standard Appropriate for Contract Breaches. Clearly,
                          Sinclair’s act of contracting with its dominated subsidiary was self-
                          dealing. Under the contract Sinclair received the products produced by
                          Sinven, and of course the minority shareholders of Sinven were not able
                          to share in the receipt of these products. If the contract was breached,
                          then Sinclair received these products to the detriment of Sinven’s
                          minority shareholders.
                          (a)        Although a parent need not bind itself by a contract with its
                                     dominated subsidiary, Sinclair chose to operate in this manner.
                                     As Sinclair has received the benefits of this contract, so it must
                                     comply with the contractual duties.
                          (b)        Under the intrinsic fairness standard, Sinclair must prove that
                                     its causing Sinven not to enforce the contract was intrinsically
                                     fair to the minority shareholders of Sinven.
2.   Zahn v. Transamerica Corp. (3d Cir. 1947).
     a.       Facts. A corporation had two classes of common shares, class A and class B. The
              class B shares held voting control. The class A shares, which were entitled to
              twice as much liquidation as class B shares, could be redeemed by the corporation
              at any time for $60. The controlling shareholder had the corporation redeem all
              of the minority's class A shares and then liquidate the corporation's assets, which
              had recently tripled in value. The result was that the controlling shareholder
              received the lion's share of the company's liquidation value.
     b.       The circumstances of the case at bar are sui generis and we can find no Kentucky
              decision squarely in point. In our opinion, however, the law of Kentucky
              imposes upon the directors of a corporation or upon those who are in charge of
              its affairs by virtue of majority stock ownership or otherwise the same fiduciary
              relationship in respect to the corporation and to its stockholders as is imposed
              generally by the laws of Kentucky’s sister States or which was imposed by federal
              law prior to Erie R. Co. v. Tompkins.
              (1)         The Supreme Court in Southern Pacific Co. v. Bogert said: “The rule of
                          corporation law and of equity invoked is well settled and has been often
                          applied. The majority has the right to control; but when it does so, it
                          occupies a fiduciary relation toward the minority, as much so as the
                          corporation itself or its officers and directors.”
              (2)         W e must also emphasize that there is a radical difference when a
                          stockholder is voting strictly as a stockholder and when voting as a
                          director; that when voting as a stockholder he may have the legal right
                          to vote with a view of his own benefits and to represent himself only;
                          but that when he votes as a director he represents all the stockholders in
                          the capacity of a trustee for them and cannot use his officer as director
                          for his personal benefit at the expense of the stockholders.
              (3)         W e think that it is the settled law of Kentucky that directors may not
                          declare or withhold the declaration of dividends for the purpose of
                          personal profit or, by analogy, take any corporate action for such a
                          purpose.
                          (a)        The act of the board of directors in calling the Class A stock, an
                                     act which could have been legally consummated by a

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                                                           disinterested board of directors, was here effected at the
                                                           direction of the principal Class B stockholder in order to profit
                                                           it.
       D.      Ratification
               1.        Fliegler v. Lawrence (Del. 1976).
                         a.         Facts. One of the Defendant directors, acting in his individual capacity,
                                    purchased a lease option for antimony (metal) rights. He offered the rights to
                                    Agau but the directors agreed that Agau’s financial position would not allow the
                                    purchase. The director then transferred the rights to a company formed for the
                                    specific purpose of holding those rights. He then gave Agau a long-term option
                                    to purchase the holding company. A few months later, Agau’s directors voted to
                                    exercise the option. A majority of shareholders voted the same way, but the
                                    directors also comprised a majority of shareholders. Plaintiff argued that
                                    Defendant directors usurped a corporate opportunity for their own individual
                                    benefit, and that the transaction was inherently unfair. Defendants responded that
                                    their voted was ratified by shareholders, thereby shifting the burden of proof to
                                    Plaintiff to prove that the transaction was fair, but they also offered proof that it
                                    was fair.
                         b.         Shareholder ratification of an “interested transaction,” although less than
                                    unanimous, shifts the burden of proof to an objecting shareholder to demonstrate
                                    that the terms are so unequal as to amount to a gift or waste of corporate assets.
                                    (1)        “The entire atmosphere is freshened and a new set of rules invoked
                                               where formal approval has been given by a majority of independent,
                                               fully informed [share]holders.”
                         c.         The purported ratification by the Agau shareholders would not affect the burden
                                    of proof in this case because the majority of shares voted in favor of exercising the
                                    option were cast by defendants in their capacity as Agau shareholders. Only
                                    about one-third of the “disinterested” shareholders voted, and we cannot assume
                                    that such non-voting shareholders either approved or disapproved.
                                    (1)        Under these circumstances, we cannot say that “the entire atmosphere
                                               has been freshened” and that departure from the objective fairness test is
                                               permissible.
                         d.         Defendants argue that the transaction here in question is protected by 8 Del.C. §
                                    144(a)(2) which, they contend, does not require that ratifying shareholders be
                                    “disinterested” or “independent”; nor, they argue, is there warrant for reading
                                    such a requirement into the statute.
                                    (1)        W e do not read the statute as providing the broad immunity for which
                                               the defendants contend. It merely removes an “interested director”
                                               cloud when its terms are met and provides against invalidation of an
                                               agreement “solely” because such a director or officer is involved.
                                               Nothing in the statute sanctions unfairness to Agau or removes the
                                               transaction from judicial scrutiny.
III.   The Obligation of Good Faith
       »       The process of giving content to good faith began with the Delaware Supreme Court’s decision in Cede & Co v.
               Technicolor, Inc., (Del. 1993).
                         “To rebut the rule, shareholder plaintiff assumes the burden of providing evidence that directors, in
                         reaching their challenged decision, breach any one of the triads of their fiduciary duty–good faith,
                         loyalty, or due care. If a shareholder plaintiff fails to meet this evidentiary burden, the business
                         judgment rule attaches to protect corporate officers and directors and the decisions they make, and our
                         courts will not second-guess these business judgments. If the rule is rebutted, the burden shifts to the
                         defendant directors, the proponents of the challenged transaction, to prove to the trier of fact the “entire
                         fairness” of the transaction to the shareholder plaintiff.”

       A.        Compensation

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1.   In re The W alt Disney Co. Derivative Litigation (Del. 2006).
     a.        Claims Against Ovitz
               (1)      A de facto officer is one who actually assumes possession of an office
                        under the claim and color of an election or appointment and who is
                        actually discharging the duties of that office, but for some legal reason
                        lack de jure legal title to that office.
     b.        Due Care and Bad Faith as Separate Grounds
               (1)      Our law presumed that “in making a business decision the directors of a
                        corporation acted on an informed basis, in good faith, and in the honest
                        belief that the action taken was in the best interests of the company.”
                        (a)       Those presumptions can be rebutted if the plaintiff shows that
                                  the directors breached their fiduciary duty of care or of loyalty
                                  or acted in bad faith. If that is shown, the burden then shifts to
                                  the director defendants to demonstrate that the challenged act
                                  or transaction was entirely fair to the corporation and its
                                  shareholders.
     c.        Full Disney Board W as Not Required to Consider and Approve OEA
               (1)      The Delaware General Corporation Law expressly empowers a board of
                        directors to appoint committees and to delegate to them a broad range
                        of responsibilities, which may include setting executive compensation.
                        Nothing in the DGCL mandates that the entire board must make those
                        decisions.
     d.        The Good Faith Determinations
               (1)      At least three different categories of fiduciary behavior are candidates for
                        the “bad faith” pejorative label:
                        (a)       Bad Faith. “Subjective bad faith,” that is, fiduciary conduct
                                  motivated by an actual intent to do harm. That such conduct
                                  constitutes classic, quintessential bad faith is a proposition so
                                  well accepted in the liturgy of fiduciary law that it borders on
                                  axiomatic. W e need not dwell further on this category,
                                  because no such conduct is claimed to have occurred, or did
                                  occur, in this case.
                        (b)       Not Bad Faith/Rather, Breach of Duty of Care. Lack of due
                                  care–that is, fiduciary action taken solely by reason of gross
                                  negligence and without any malevolent intent. Both our
                                  legislative history and our common law jurisprudence
                                  distinguish sharply between the duties to exercise due care and
                                  to act in good faith.
                        (c)       Bad Faith. Intentional dereliction of duty, a conscious disregard
                                  for one’s responsibilities. This falls between the first two
                                  categories of (1) conduct motivated by subjective bad intent
                                  and (2) conduct resulting from gross negligence.
                                  i)         Cases have arisen where corporate directors have no
                                             conflicting self-interest in a decision, yet engage in
                                             conduct that is more culpable than simple inattention
                                             or failure to be informed of all facts material to the
                                             decision. To protect the interests of the corporation
                                             and its shareholders, fiduciary conduct of this kind,
                                             which does not involve disloyalty (as traditionally
                                             defined) but it qualitatively more culpable that gross
                                             negligence, should be proscribed. A vehicle is needed to
                                             address such violations doctrinally, and that doctrinal vehicle
                                             is the duty to act in good faith.
                                  ii)        A failure to act in good faith may be shown, for

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                                                     instance, where the fiduciary intentionally acts with a
                                                     purpose other than that of advancing the best interests
                                                     of the corporation, where the fiduciary acts with the
                                                     intent to violate applicable positive law, or where the
                                                     fiduciary intentionally fails to act in the face of a
                                                     known duty to act, demonstrating a conscious
                                                     disregard for his duties.
              e.       W as Action By The New Board Required to Terminate Ovitz?
                       (1)      W hen corporate governing instruments are ambiguous, our case law
                                permits a court to determine their meaning by resorting well-established
                                legal rules of construction, which include the rules governing the
                                interpretation of contracts.
                                (a)       One such rule is that where a contract is ambiguous, the court
                                          must look to extrinsic evidence to determine which of the
                                          reasonable readings the parties intended.
                       (2)      Extrinsic evidence clearly supports the conclusion that the board and Eisner
                                understood that Eisner, as Board Chairman/CEO had concurrent power with
                                the board to terminate Ovitz as President.
              f.       The W aste Claim
                       (1)      Doctrine that a plaintiff who fails to rebut the business judgment rule
                                presumptions is not entitled to any remedy unless the transactions
                                constituted waste.
                                (a)       To recover on a claim of corporate waste, the plaintiffs must
                                          shoulder the burden of proving that the exchange was “so one
                                          sided that no business person or ordinary, sound judgment
                                          could conclude that the corporation has received adequate
                                          consideration.”
                                (2)       A claim of waste will arise only in the rare, “unconscionable
                                          case where directors irrationally squander or give away
                                          corporate assets.” This onerous standard for waste is a corollary
                                          of the proposition that where business judgment presumptions
                                          are applicable, the board’s decisions will be upheld unless it
                                          cannot be “attributed to any rational business purpose.”
                                (3)       The payment of a contractually obligated amount cannot
                                          constitute waste, unless the contractual obligation is itself
                                          wasteful.
B.   Oversight
     1.      Introduction
             a.        At the very least, however, a director must have a rudimentary understanding of
                       the firm’s business and how it works, keep informed about the firm’s activities,
                       engage in a general monitoring of corporate affairs, attend board meetings
                       regularly, and routinely review financial statements.
             b.        Beyond these obligations, however, the question remained as to whether boards
                       must adopt rules and procedures to ensure that corporate officers and other
                       employees do not engage in illegal or unlawful conduct, and must make
                       reasonable efforts to monitor compliance with those rules and procedures.
     2.      Stone v. Ritter (Del. 2006).
             a.        In Caremark, the Court of Chancery recognized that: “generally where a claim of
                       directorial liability for corporate loss is predicated upon ignorance of liability
                       creating activities within the corporation . . . only a sustained or systemic failure
                       of the board to exercise oversight–such as an utter failure to attempt to assure a
                       reasonable information and reporting system exists–will establish the lack of good
                       faith that is a necessary condition to liability.
             b.        Demand Futility. To excuse demand, “a court must determine whether or not the

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                                     particularized factual allegations of a derivative stockholder complaint create a
                                     reasonable doubt that, as of the time the complaint is filed, the board of directors
                                     could have properly exercise its independent and disinterested business judgment
                                     in responding to a demand.”
                           c.        Evolution of Oversight Responsibility:
                                     (1)       In Graham, the court held that “absent cause for suspicion there is no duty
                                               upon the directors to install and operate a corporate system of espionage
                                               to ferret out wrongdoing which they have no reason to suspect exists.”
                                     (2)       Caremark narrowly construed the holding in Graham “as demanding for
                                               the proposition that, absent grounds to suspect deception, neither
                                               corporate boards nor senior officers can be charged with wrongdoing
                                               simply for assuming the integrity of employees and the honesty of their
                                               dealings on the company’s behalf.
                                               (a)       “Generally where a claim of directorial liability for corporate
                                                         loss is predicted upon ignorance of liability creating activities
                                                         within the corporation, as in Graham or in this case, only a
                                                         sustained or systematic failure of the board to exercise
                                                         oversight–such as an utter failure to attempt to assure a
                                                         reasonable information and reporting system exists–will
                                                         establish the lack of good faith that is a necessary condition to
                                                         liability.”
                           d.        Good Faith. A failure to act in good faith requires conduct that is qualitatively
                                     different from, and more culpable than, the conduct giving rise to a violation of
                                     fiduciary duty of care (i.e., gross negligence).
                                     (1)       The failure to act in good faith is not conduct that results, ipso facto, in
                                               the direct imposition of fiduciary liability. The failure to act in good
                                               faith may result in liability because the requirement to act in good faith
                                               “is a subsidiary element,” i.e., a condition, “of the fundamental duty of
                                               loyalty.” It follow that because a showing of bad faith conduct, in the
                                               sense described in Disney and Caremark, is essential to establish director
                                               oversight liability, the fiduciary duty violated by the conduct is the duty
                                               of loyalty.
                                               (a)       Although good faith may be describe colloquially as part of a
                                                         “triad” of fiduciary duties that includes the duties of care and
                                                         loyalty, the obligation to act in good faith does not establish an
                                                         independent fiduciary duty that stands on the same footing as
                                                         the duties of care and loyalty.44
                                               (b)       The fiduciary duty of loyalty is not limited to cases involving a
                                                         financial or other cognizable fiduciary conflict of interest. It
                                                         also encompasses where the fiduciary fails to act in good faith.
                                                         As the Court of Chancery aptly put it in Guttman, “a director
                                                         cannot act loyally towards the corporation unless she acts in the
                                                         good faith belief that her actions are in the corporation’s best
                                                         interests.”
                                     (2)       W e hold that Caremark articulates the necessary conditions predicated for




         44
             The Arkansas Supreme Court has traditionally used language indicating that “good faith” is a standalone
obligation. In practical terms, it probably does not make much difference as a violation of the obligation of good faith
will most likely also breach the duties of loyalty and due care.

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                                                                             45
                                                 director oversight liability:
                                                 (a)      the directors utterly failed to implement any reporting or
                                                          information systems or controls; or
                                                 (b)      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.
IV.        Securities Law Overview
           A.        Introduction
                     1.        Dual Regulation. There is dual regulation at the federal and the state level. Both federal
                               and state securities laws must be complied with.
                               a.         Federal Law
                                          (1)       Securities Act of 1933 (15 U.S.C. §§ 77a et seq.) The 1933 Act governs
                                                    the issuance of securities by business to raise capital.
                                          (2)       Securities Exchange Act of 1934 (15 U.S.C. §§ 87a et seq.) The 1934 Act
                                                    regulates trading in securities and other regulatory matters affecting
                                                    publicly-held corporations.
                               b.         State Law
                                          (1)       Blue Sky Laws.46 Arkansas, like most states, has its own “blue sky” law,
                                                    codified at Ark. Code Ann. §§ 23-42-101 et seq., and the Arkansas
                                                    Securities Commissioner has promulgated regulations.
           B.        W hat is a Security?
                     1.        Broad Definition. The statutory definitions of “security” under the federal acts are very
                               broad. See generally § 2(a)(1) of the 1933 Act which sets out a laundry list of both specific
                               instruments and general categories. The determination of whether a particular investment
                               interest is a security is made on a case-by-case basis.
                               a.         For example, the definition includes “notes,” “stock,” “bond,” “evidence of
                                          indebtedness,” “transferable share,” “fractional undivided interest in oil, gas, or
                                          other mineral rights,” “investment contract,” “certificate of interest or
                                          participation in any profit-sharing agreement,” “or, in general, any interest or
                                          instrument commonly known as a ‘security.”’
                     2.        Traditional Corporate Stock. W hether common or preferred, whether voting or nonvoting,
                               whether of a publicly held or a closely held corporation -- is certain to be a security under
                               federal law. Landreth Timber Co. v. Landreth, 471 U.S. 681 (1985).
                     3.        Promissory Notes. A promissory note may or may not be a security. In Reves v. Ernst &
                               Young, 494 U.S. 56 (1990), the U.S. Supreme Court adopted the so-called "family
                               resemblance" test used by the Second Circuit. This test seeks to distinguish between notes
                               that are given by businesses to raise capital for investment (a security) and those that are
                               given in connection with consumer transactions or given by businesses in exchange for
                               short-term loans to finance current operations (not a security).
                     4.        Investment Contracts. The federal statutory definition of "security" includes so-called
                               "investment contracts." This category is, in substance, a catch-all category that brings
                               within the definition of "security" a variety of investment interests, including partnership
                               interests; franchise, distributorship, and licensing arrangements; and sales of property, both
                               personal and real, coupled with management or development agreements.



           45
            In either case, imposition of liability requires a showing that the directors knew that they were not
discharging their fiduciary obligations. W here directors fail to act in the face of a known duty to act, they breach
their duty of loyalty by failing to discharge their fiduciary obligation in good faith.

           46
                So named because they were aimed at promoters who “would sell building lots in the blue sky in fee
simple.”

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              a.       Howey Test. Federal courts apply the "Howey Test" to determine whether a
                       particular investment interest is an "investment contract" subject to regulation by
                       the federal securities laws. In SEC v. W .J. Howey Co., 328 U.S. 293, 298-99
                       (1946), the United States Supreme Court announced:
                       (1)         “An investment contract for purposes of the Securities Act means a
                                  contract, transaction or scheme whereby a person (1) invests his money
                                  (2) in a common enterprise and (3) is led to expect profits (4) solely
                                  from the efforts of the promoter or a third party.”
                       (2)        Applying this test, the Supreme Court held that the offer of small plots
                                  of land in orange groves in Florida to vacationers from New England,
                                  coupled with the offer of a management contract under which an
                                  affiliate of the vendor would cultivate and tend the grove in which the
                                  plot was located, harvest and market the fruit from the entire grove, and
                                  remit a share of the profits to the various owners was the offer of an
                                  "investment contract" under the 1933 Act.
     5.     Passive Investments. Subsequent cases have established that a passive investment, whatever it
            is called, is very likely to be a security.
            a.         Limited Partnership Interests. For example, most limited partnership interests are
                       usually held to be securities, because in most limited partnerships the limited
                       partners have very little management power over the business of the partnership.
            b.         Race Horse & Property Syndications, Etc. Investments in race horse or property
                       syndications are likely to be securities. Chinchilla and earthworm raising ventures
                       have been held to be securities. Businesses using a multi-level distribution model,
                       where the role of investors is primarily to attract other investors rather than to sell
                       a product, have been found to be issuers of securities. Ownership interests in
                       LLCs may be securities, especially in manager-managed LLCs where the
                       members do not participate in the management of the LLC's business.
     6.     Under the Arkansas Securities Act. The statutory definition of “security” in the Arkansas Act
            is similar to those in the federal Acts. The important difference lies in how the Arkansas
            courts have interpreted the Arkansas Act.
            a.         The Arkansas Supreme Court looks at various factors to determine whether a
                       given interest - whether it takes the form of corporate stock or some other
                       interest– is a “security” subject to regulation under the Arkansas Act. It also
                       looks to the so-called “risk capital” test, a test that some state courts use instead of
                       the Howey test.
                       (1)        Risk Capital Test. The Arkansas courts have expressed the risk capital
                                  test in terms of five elements: (a) The investment of money or money's
                                  worth; (b) in a venture; (c) the expectation of some benefit to the
                                  investor as a result of the investment; (d) the contribution towards the
                                  risk capital of the venture; and (e) the absence of direct control over the
                                  investment or policy. Carder v. Burrow, 327 Ark. 545, 549, 940 S.W .2d
                                  429, 431 (1997).
                                  (a)        Different Results from Federal Law. Applying this test to classify
                                             various investment interests as securities or not securities, the
                                             Arkansas Supreme Court has sometimes reached conclusions
                                             opposite to the conclusions that a federal court would probably
                                             have reached applying federal law. See, e.g., Cook v. W ills, 305
                                             Ark. 442, 447, 808 S.W .2d 758, 761 (1991)(corporate stock
                                             not a security); Casali v. Schultz, 292 Ark. 602, 732 S.W .2d
                                             836 (1987)(general partnership interest a security).
C.   Exemption from 1933 Act Registration
     1.     In General. W hen businesses seek to raise capital by issuing securities, the securities laws
            require that the offering be “registered” with the appropriate governmental authority
            before the securities are marketed

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                           a.         Exempt Securities/Exempt Transactions. Because of the expense and the restrictions,
                                      businesses often seek an exemption from the registration requirements. There are
                                      two types of exemptions: exempt securities and exempt transactions. Exempt
                                      securities are listed in section 3 of the 1933 Act.
                                      (1)        Examples. Probably the most familiar example of an exempt security is
                                                 the municipal bond. “Church bonds” are another example. Exempt
                                                 securities are exempt from the registration requirements of the 1933 Act,
                                                 but they are not exempt from the antifraud laws.
                  2.       Section 4(2) Exemption. The private placement exemption is founded on Section 4(2) of
                           the 1933 Act, which says that the registration requirements of the Act “shall not apply to .
                           . . transactions by an issuer not involving any public offering.” The seminal case
                           interpreting Section 4(2) is SEC v. Ralston Purina Co., 346 U.S. 119 (1953).
                           a.         Fend for Themselves. The Court reasoned that the Section 4(2) private placement
                                      exemption must be interpreted in light of the purposes of the 1933 Act. The
                                      purpose of the registration requirement of the Act is “to protect investors by
                                      promoting full disclosure of information thought necessary to informed
                                      investment decisions.” Therefore, the Section 4(2) exemption should be limited
                                      to transactions in which the offerees do not need the protection of registration --
                                      in other words, those who are “able to fend for themselves” because they already
                                      have access to the kind of information that registration would disclose and the
                                      ability to understand that information and its significance to an investment
                                      decision. By way of illustration, the Court referred to “executive personnel who
                                      because of their position have access to the same kind of information that the act
                                      would make available in the form of a registration statement.”
                           b.         Automatic Exemption. The Section 4(2) exemption is automatic; it does not
                                      require any filing with the SEC.
                  3.       Regulation D. Section 3(b) of the 1933 Act gives the SEC authority to exempt by
                           regulation offerings of $5 million or less (“limited offerings”). The SEC has promulgated
                           two important regulations under this authority, Regulation A and Regulation D. \
                           a.         Accredited Investor.47 One of the key concepts in Regulation D is the “accredited
                                      investor.” Generally speaking, an accredited investor is a person (or entity) that
                                      because of wealth or position is conclusively deemed to be able to "fend for
                                      himself."
                                      (1)        Under Rule 506, an issuer can sell an unlimited dollar amount of
                                                 securities to an unlimited number of accredited investors and to 35 or
                                                 fewer non-accredited investors who nonetheless are sophisticated
                                                 enough (either alone or with the assistance of a “purchaser
                                                 representative") to “fend for themselves.”
                  4.       Intrastate Offering Exemption. The so-called “intrastate offering” exemption is established in
                           Section 3(a)(11) of the 1933 Act and Rule 147 promulgated thereunder.
                           a.         Single State. To qualify for this exemption, the security must be part of an issue
                                      that is offered and sold only to persons resident within a single state.
                           b.         Issuer Resident/Incorporated In State. In addition, the issuer must be a resident of
                                      (or incorporated in) that state and doing a substantial part of its business in that
                                      state.
                           c.         Nine Months Resale Restriction. Finally, the issuer must take precautions to make
                                      sure that the securities are not resold to non-residents of the state until nine or
                                      more months have passed.


         47
            Accredited investors include banks, insurance companies, other corporations with total assets in excess of
$5 million, directors or executive officers of the issuer, and individuals who have a net worth over $1 million or who
have an income of $200,000 in the previous two years (or $300,000 jointly with his or her spouse) and who
reasonably expect to reach the same income in the current year.

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              5.       Resales. Technically speaking, the registration requirements of the 1933 Act potentially
                       apply to resales of securities as well as to primary offerings by issuers. Exemptions exist
                       which remove most resales from the reach of the registration provisions, but trouble can
                       arise if a “control person” of the issuer sells large amounts of securities publicly.
     D.       Regulation of Reporting Companies by the 1934 Act
              1.       Companies Required to Register. The companies that have to register under the 1934 Act are
                       (1) those whose securities are traded on a national securities exchange (e.g., the New York
                       Stock Exchange), (2) those whose total assets are $10,000,000 or more and who have 500
                       or more shareholders, and (3) those companies that have issued securities under a 1933 Act
                       registration statement (although a small company can discontinue 1934 Act registration and
                       reporting after the first year). Also, a company can voluntarily elect to register under the
                       1934 Act and thereby become subject to its provisions.
              2.       Reporting Companies. Companies subject to the 1934 Act are often called “reporting
                       companies” because they are required to file periodic reports setting forth their financial
                       and general business condition.
     E.       Insider Trading
              1.       Definition. “Insider trading” means buying or selling securities (almost always stock) on the
                       basis of material, non-public information.
              2.       SEC’s Advocation for Blanket Rule. The SEC has always advocated for a rule that would
                       prohibit anyone in possession of inside information from buying or selling stock on the
                       basis of it.
                       a.         Supreme Court Rejection/Common-Law Rule of Deceit. The Supreme Court has, for
                                  Rule 10b-5 purposes, rejected this view. Instead, the Court has approached the
                                  problem of insider trading as a specific application of the common-law rule of
                                  deceit.
                                  (1)       Common-Law. Remember that under the common law, a person is
                                            allowed to buy or sell property on the basis of information that he has
                                            that is unknown to the other party to the transaction. The exception is
                                            where the person has a "duty to disclose" that information to the other
                                            party. One source of a duty to disclose is where there is a fiduciary
                                            relationship or other special relationship of trust and confidence between
                                            the parties. So, for example, an attorney cannot enter into a business
                                            transaction with a client without making full disclosure to the client of
                                            all material information relating to that transaction that the attorney has.
V.   Inside Information
     A.       Goodwin v. Agassiz (Mass. 1933).
              1.       Facts. Defendants purchased from plaintiff, through brokers, 700 shares of Cliff Mining
                       Company. Agassiz was president and director and McNaughton was a director and
                       general manager of the company. They had certain knowledge, material to the value of
                       the stock, that the plaintiff did not possess. Exploration in 1925 of the property of Cliff
                       Mining Company proved unsuccessful. However, an experienced geologist formulated a
                       theory as to the possible existence of copper deposits in 1926. The defendants decided to
                       test the theory but agreed that if the information became known the price of Cliff
                       Mining’s stock would soar. The plaintiff learned of the failed exploration through an
                       article and sold his stock through brokers. The plaintiff didn’t know that the purchase of
                       his stock was made for the defendants and they did not know his stock was being bought
                       for them. There was no communication between them
              2.       The directors of a commercial corporation stand in relation of trust to the corporation and
                       are bound to exercise the strictest good faith in respect to its property and business.
                       a.         The contention that directors also occupy the position of trustee toward
                                  individual stockholders in the corporation is plainly contrary to repeated decisions
                                  of this court and cannot be supported.
              3.       W hile the general principle is as stated, circumstances may exist requiring that transactions
                       between a director and a stockholder as to stock in the corporation be set aside.

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               a.           The knowledge naturally in the possession of a director as to the condition of a
                            corporation places upon him a peculiar obligation to observe every requirement
                            of fair dealing when directly buying or selling its stock.
                            (1)        Mere silence does not usually amount to a breach of duty, but parties
                                       may stand in such relation to each other that an equitable responsibility
                                       arises to communicate facts.
                            (2)        An honest director would be in a difficult position if he could neither
                                       buy nor sell on the stock exchange shares of stock of his corporation
                                       without first seeking out the other actual ultimate party to the
                                       transaction and disclosing to him everything which a court or jury might
                                       later find that he then knew affecting the real or speculative value for
                                       such shares.
                                       (a)        Business of that nature is a matter to be governed by practical
                                                  rules. Fiduciary obligations of directors ought not to be made
                                                  so onerous that men of experience and ability will be deterred
                                                  from accepting such office.
                                       (b)        On the other hand, directors cannot rightly be allowed to
                                                  indulge with impunity in practices which do violence to
                                                  prevailing standards of upright business men.
                                                  i)       Closely Scrutinized. Therefore, where a director
                                                           personally seeks a stockholder for the purpose of
                                                           buying his shares without making disclosure of
                                                           material facts within his peculiar knowledge and not
                                                           within reach of the stockholder, the transaction will
                                                           be closely scrutinized and relief may be granted in
                                                           appropriate instances.
     4.         The Geologist’s Theory. At the annual stockholders meeting, no reference was made to the
                theory. It was then at most a hope, possibly an expectation. W hether the theory was
                sound or fallacious, no one knew, and so far as appears has never been demonstrated. The
                Cliff Mining Company was not harmed by the nondisclosure. There would have been no
                advantage to it, so far as appears, from a disclosure.
     5.         The Purchase. The identity of the buyers and seller of the stock in question in fact was not
                known to the parties and perhaps could not readily have been ascertained. The defendants
                caused the shares to be bought through brokers on the stock exchange. They said nothing
                to anybody as to the reasons actuating them. The plaintiff was no novice. He was a
                member of the Boston Stock Exchange and had kept a record of sales of Cliff Mining
                Company stock. He acted upon his own judgment in selling his stock. He made no
                inquiries of the defendant or of other officers of the company.
B.   Securities and Exchange Commission v. Texas Gulf Sulphur Co. (2d. Cir. 1969).
     1.         Facts. TGS began exploratory drilling in Canada. Mollison, VP and a mining engineer,
                supervised the project. Clayton, an electrical engineer was also on-site. Stephens, TGS
                President, ordered the drilling results be kept secret to prevent a rise in land prices. TGS
                employees began buying up stock and options. Rumors of a rich strike spread and TGS
                released a misleading press release (April 12th) with regards to the size of operations and
                results to quell them. Disclosure of the large ore strike was soon made (April 16 th).
                Between the time of the two releases, TGS executives and directors ordered more stock.
                Various prices of the stock over the relevant period: Pp. 474-75.
     2.         Rule 10b-5, 17 C.F.R. 240.10b-5, on which this action is predicated, provides:
                It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality
                of interstate commerce, or of the mails or of any facility of any national securities exchange,
                            (a) To employ any device, scheme, or artifice to defraud,
                            (b) To make any untrue statement of a material fact or to omit to state a material fact
                            necessary in order to make the statements made, in the light of the circumstances under
                            which they were made, not misleading, or

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     (c) To engage in any act, practice, or course of business which operates or would operate as a
     fraud or deceit upon any person, in connection with the purchase or sale of any security.
a.   Purpose of the Rule. Rule 10b-5 is based in policy on the justifiable expectation of
     the securities marketplace that all investors trading on impersonal exchanges have
     relatively equal access to material information.
b.   Essence of the Rule. The essence of the Rule is that anyone who, trading for his
     own account in the securities of a corporation, has “access, directly or indirectly,
     to information intended to be available only for a corporate purpose and not for
     the personal benefit of anyone” may not take “advantage of such information
     knowing it is unavailable to those with whom he is dealing.” i.e., the investing
     public.
c.   Insiders, as directors or management officers are, of course, by this Rule,
     precluded from so unfairly dealing, but the Rule is also applicable to one
     possessing the information who may not be strictly termed an “insider” within
     the meaning of Sec. 16(b) of the Act.
     (1)       Thus, anyone in possession of material inside information must either
               disclose it to the investing public, or, if he is disabled from disclosing it
               in order to protect a corporate confidence, or he chooses not to do so,
               must abstain from trading in or recommending the securities concerned
               while such inside information remains undisclosed.
d.   An insider is not, of course, always foreclosed from investing in his own company
     merely because he may be more familiar with company operations than are
     outside investors.
     (1)       An insider’s duty to disclose information or his duty to abstain from
               dealing in his company’s securities arises only in those situations which
               are essentially extraordinary in nature and which are reasonably certain
               to have a substantial effect on the market price of the security if the
               extraordinary situation is disclosed.
     (2)       Nor is an insider obligated to confer upon outside investors the benefit
               of his superior financial or other expert analysis by disclosing his
               educated guesses or predictions.
e.   The basic test of materiality is whether a reasonable man would attach importance
     in determining his choice of action in the transaction in question. This, of
     course, encompasses any fact which in reasonable and objective contemplation
     might affect the value of the corporation’s stock or securities.
     (1)       Such a fact is a material fact and must be effectively disclosed to the
               investing public prior to the commencement of insider trading in the
               corporation’s securities.
               (a)        Material facts include not only information disclosing the
                          earnings and distributions of a company but also those facts
                          which affect the probable future of the company and those
                          which may affect the desire of investors to buy, sell, or hold the
                          company’s securities.
     (2)       In each case then, whether facts are material within Rule 10b-5 when
               the facts relate to a particular event and are undisclosed by those persons
               who are knowledgeable thereof will depend at any given time upon a
               balancing of both the indicated probability that the event will occur and
               the anticipated magnitude of the event in light of the totality of the
               company activity.
f.   The timing of a disclosure is a matter for the business judgment of the corporate
     officers entrusted with the management of the corporation within the affirmative
     disclosure requirements promulgated by the exchanges and by the SEC.
     (1)       W here a corporate purpose is thus served by withholding the news of a
               material fact, those persons who are thus quite properly true to their

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                                     corporate trust must not during the period of non-disclosure deal
                                     personally in the corporation’s securities or give to outsiders confidential
                                     information not generally available to all the corporations’ stockholders
                                     and to the public at large.
               g.         Our decision to expand the limited protection afforded outside investors by the
                          trial court’s narrow definition of materiality is not at all shaken by fears that the
                          elimination of insider trading benefits will deplete the ranks of capable corporate
                          managers by taking away an incentive to accept such employment.
                          (1)        Such benefits, in essence, are forms of secret corporate compensation
                                     derived at the expense of the uninformed investing public and not at the
                                     expense of the corporation which receives the sole benefit from insider
                                     incentive. Moreover, adequate incentives for corporate officers may be
                                     provided by properly administered stock options and employee purchase
                                     plans of which there are many in existence.
               h.         The core of Rule 10b-5 is the implementation of the Congressional purpose that
                          all investors should have equal access to the rewards of participation in securities
                          transactions. It was the intent of Congress that all members of the investing
                          public should be subject to identical market risks–which markets risks include, of
                          course, the risk that one’s evaluative capacity or one’s capital available to put at
                          risk may exceed another’s capacity or capital.
               i.         It seems clear from the legislative purpose Congress expressed in the Act, and the
                          legislative history of Section 10(b) that Congress when it used the phrase “in
                          connection with the purchase or sale of any security” intended only that the
                          device employed, whatever it might be, be of a sort that would cause reasonable
                          investors to rely thereon, and, in connection therewith, so relying, cause them to
                          purchase or sell a corporation’s securities.
                          (1)        There is no indication the Congress intended that the corporations or
                                     persons responsible for the issuance of a misleading statement would not
                                     violate the section unless they engaged in related securities transactions
                                     or otherwise acted with wrongful motives; indeed, the obvious purposes
                                     of the Act to protect to investing public and to secure fair dealing in the
                                     securities markets would be seriously undermined by applying such a
                                     gloss onto the legislative language.
C.   Dirks v. Securities & Exchange Commission (S. Ct. 1983).
     1.        Facts. Dirks was an officer of a N.Y. broker-dealer firm specializing in investment analysis
               of insurance company securities. Dirks caught wind of a massive fraud at Equity Funding
               of America and investigated. Senior management denied any wrongdoing while other
               employee corroborated the allegations. Neither Dirks nor his firm owned any Equity
               stock but Dirks discussed his findings with a number of clients and investors who sold their
               stock for more than $16 million. Dirks urged the Journal to publish a story about the
               fraud, but they declined citing possible liability for libel. California insurance agency soon
               investigated and uncovered the fraud. The SEC then filed a complaint against Equity.
               Then, the SEC found that Dirks had aided and abetted violations of Rule 10b-5 by
               repeating the allegations of fraud to investors who sold their stock.
     2.        In the seminal case of In re Cady, Roberts & Co., the SEC recognized that the common law
               in some jurisdictions imposes on corporate insiders, particularly officers, directors or
               controlling stockholder an affirmative duty of disclosure when dealing in securities.
               a.         The SEC found that no only did breach of this common-law duty establish the
                          elements of a Rule 10b-5 violation, but that individuals other than corporate
                          insiders could be obligated either to disclose material nonpublic information
                          before trading or to abstain from trading altogether.
     3.        In Chiarella, we accepted the two elements set out in Cady Roberts for establishing a Rule
               10b-5 violation:
               a.         The existence of a relationship affording access to inside information intended to

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               be available only for a corporate purpose, and
     b.        The unfairness of allowing a corporate insider to take advantage of that
               information by trading without disclosure.
4.   In Chiarella, the Court held that there is no general duty to disclose before trading on
     material nonpublic information, and held that a duty to disclose under §10(b) does not
     arise from the mere possession of nonpublic market information. Such a duty arises rather
     from the existence of a fiduciary relationship.
     a.        Not all breaches of fiduciary duty in connection with a securities transaction,
               however, come within the ambit of Rule 10b-5. There must also be
               manipulation or deception. In any inside-trading case this fraud derives from the
               inherent fairness involved where one takes advantage of information intended to
               be available only for a corporate purpose and not for the personal benefit of
               anyone.
               (1)       Thus, an insider will be liable under Rule 10b-5 for inside trading only
                         where he fails to disclose material nonpublic information before trading
                         on it and thus makes secret profits.
5.   W e were explicit in Chiarella in saying that there can be no duty to disclose when the
     person who traded on inside information was not the corporation’s agent, was not a
     fiduciary, or was not a person in whom the sellers of the securities had placed their trust
     and confidence.
     a.        Not to require a fiduciary relationship, the Court recognized, would depart
               radically from the established doctrine that duty arises from a specific relationship
               between two parties and would amount to recognizing a general duty between all
               participants in market transactions to forgo actions based on material, nonpublic
               information.
     b.        This requirement of a specific relationship between the shareholders and the
               individual trading on inside information has created analytical difficulties for the
               SEC and courts in policing tippees who trade on inside information
               (1)       Unlike insiders who have independent fiduciary duties to both the
                         corporation and its shareholders, the typical tippee has no such
                         relationships.
6.   The SEC’s position is that a tippee “inherits” the Cady Roberts obligation to shareholders
     whenever he receives inside information from an insider.
     a.        This view differs little from the view that the Court rejected in Chiarella. In that
               case, the Court of Appeals agreed with the SEC and affirmed Chiarella’s
               conviction, holding that “anyone–corporate insider or not–who regularly receives
               material non-public information may not use that information to trade in
               securities without incurring an affirmative duty to disclose.” Here the SEC
               maintains that anyone who knowingly receives nonpublic material information
               from an insider has a fiduciary duty to disclose before trading.
     b.        Imposing a duty to disclose or abstain solely because a person knowingly receives
               material nonpublic information from an insider and trades on it could have an
               inhibiting influence on the role of market analysts, which the SEC itself
               recognizes is necessary to the preservation of a healthy market.
7.   The conclusion that recipients of inside information do not invariably acquire a duty to
     disclose or abstain does not mean that such tippees always are free to trade on that
     information. The need for a ban on some tippee trading is clear.
     a.        Not only are insiders forbidden by their fiduciary relationship from personal using
               undisclosed information to their advantage, they also may not give such
               information to an outsider for the same improper purpose of exploiting the
               information for their personal gain.
     b.        Similarly, the transactions of those who knowingly participate with the fiduciary
               in such a breach are forbidden as transactions on behalf of the trustee himself.
     c.        Thus, the tippee’s duty to disclose or abstain is derivative from that of the

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                                      insider’s duty. As the Court noted in Chiarella, the tippee’s obligation has been
                                      viewed as arising from his role as a participant after the fact in the insider’s breach
                                      of a fiduciary duty.
                            d.        Thus, some tippees must assume an insider’s duty to the shareholder not because
                                      they receive inside information, but rather because it has been made available to
                                      them improperly.
                                      (1)       For Rule 10b-5 purposes, the insider’s disclosure is improper only
                                                where it would violate his Cady Roberts duty. Thus, a tippee assumes a
                                                fiduciary duty to the shareholders of a corporation not to trade on
                                                material nonpublic information only when the insider has breached his
                                                fiduciary duty to the shareholders by disclosing the information to the
                                                tippee and the tippee knows or should know that there has been a
                                                breach.
                                                (a)       In determining whether a tippee is under an obligation to
                                                          disclose or abstain, it is thus necessary to determine whether the
                                                          insider’s “tip” constituted a breach of the insider’s fiduciary
                                                          duty. All disclosures of confidential corporate information are
                                                          not inconsistent with the duty insiders owe to shareholders.
                                                          i)        W hether disclosure is a breach of duty depends in
                                                                    large part on the purpose of the disclosure. The test is
                                                                    whether the insider will personally benefit, directly or
                                                                    indirectly, from his disclosure. Absent some personal
                                                                    gain, there has been no breach of duty to
                                                                    stockholders. And absent a breach by the insider,
                                                                    there is no derivative breach.
        D.         The SEC & Selective Disclosure. The SEC recently concluded that selective disclosure to analysts
                   undermined public confidence in the integrity of the stock markets.
                   1.       Regulation FD. In 2000, the SEC adopted Regulation FD to create a non-insider trading-
                            based mechanism for restricting selective disclosure. If someone acting on behalf of a
                            public corporation discloses material nonpublic information to securities market
                            professional or holders of the issuer’s securities who may well trade on the basis of the
                            information, the issuer must also disclose that information to the public.
                            a.        Intentional Disclosures. Where the disclosure is intentional, the issuer must
                                      simultaneously disclose the information in a manner designed to convey it to the
                                      general public.
                            b.        Non-Intentional Disclosures. W here the disclosure was not intentional, as where a
                                      corporate officer “let something slip,” the issuer must make public disclosure
                                      “promptly” after a senior officer learns of the disclosure.
        E.         United States v. O’Hagan (S. Ct. 1997).
                   1.       Facts. O’Hagan was a partner in a Minneapolis law firm, Dorsey & W hitney, that was
                            retained by Grand Met to represent it in a potential tender offer for the common stock of
                            Pillsbury. On Oct. 4, 1998, Grand Met publicly announced its tender offer for Pillsbury
                            stock. However, back in Aug. of 1988, O’Hagan began purchasing call options of
                            Pillsbury stock.48 By the end of September, he owned 2,500 options. W hen Grant Met
                            announced its tender offer of Pillsbury, the price of Pillsbury stock rose and O’Hagan then
                            sold his Pillsbury options and common stock, making a $4.3 million profit. The SEC
                            initiated an investigation that resulted in a 57-count indictment. A jury convicted
                            O’Hagan on all counts and he was sentenced to 41-months imprisonment. A divided
                            Court of Appeals reversed, holding that liability under § 10(b) and Rule 10b-5 could not
                            be grounded on the misappropriation theory of securities fraud on which the prosecution


        48
             Each option gave him the right to purchase 100 shares of Pillsbury stock by a specified date in September
1988.

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                         relied and that Rule 14e-3(a)–which prohibits trading while in possession of material,
                         nonpublic information relating to a tender offer–exceeds the SEC’s § 14(e) rulemaking
                         authority because the rule contains no breach of fiduciary duty requirement.
                 2.      Under the “traditional” or “classical theory” of insider trading liability, § 10(b) and Rule
                         10b-5 are violated when a corporate insider trades the securities of his corporation on the
                         basis of material, nonpublic information. Trading on such information qualifies as a
                         “deceptive device” under § 10(b), the Court has affirmed, because “a relationship of trust
                         and confidence exists between the shareholders of a corporation and those insiders who
                         have obtained confidential information by reason of their position with that corporation.
                         a.        The classical theory applies not only to officers, directors, and other permanent
                                   insiders of a corporation, but also to attorneys, accountants, consultants, and
                                   others who temporarily become fiduciaries of a corporation.
                 3.      The “misappropriation theory” holds that a person commits fraud in connection with a
                         securities transaction, and thereby violates § 10(b) and Rule 10b-5 when he
                         misappropriates confidential information for securities trading purposes, in breach of a duty
                         owed to the source of the information.
                         a.        Under this theory, a fiduciary’s undisclosed, self-serving use of a principal’s
                                   information to purchase or sell securities, in breach of a duty of loyalty and
                                   confidentiality, defrauds the principal of the exclusive use of that information. In
                                   lieu of premising liability on a fiduciary relationship between company insider
                                   and purchaser or seller of the company’s stock, the misappropriation theory
                                   premises liability on a fiduciary-turned-trader’s deception of those who entrusted
                                   him with access to confidential information.
                 4.      The two theories are complementary, each addressing efforts to capitalize on nonpublic
                         information through the purchase or sale of securities.
                         a.        The classical theory targets a corporate insider’s breach of duty to shareholders
                                   with whom the insider transacts.
                         b.        The misappropriation theory outlaws trading on the basis of nonpublic
                                   information by a corporate “outside” in breach of a duty owed not to a trading
                                   party, but to the source of information.
                                   (1)       The misappropriation theory is thus designed to protect the integrity of
                                             the securities markets against abuses by outsiders to a corporation who
                                             have access to confidential information that will affect the corporation’s
                                             security price when revealed, but who owe not fiduciary or other duty
                                             to that corporation’s shareholders.49
                 5.      The Court agrees with the Government that misappropriation, as just defined, satisfies §
                         10(b)’s requirement that chargeable conduct involve a “deceptive device or contrivance”
                         use “in connection with” the purchase or sale of securities.
                         a.        Misappropriators deal in deception. A fiduciary who pretends loyalty to the
                                   principal while secretly converting the principal’s information for personal gain
                                   dupes of defrauds the principal.
                         b.        Full disclosure forecloses liability under the misappropriation theory: Because the
                                   deception essential to the misappropriation theory involves feigning fidelity to the
                                   source of information, if the fiduciary discloses to the source that he plans to trade
                                   on the nonpublic information, there is no “deceptive device” and thus no § 10(b)
                                   violation–although the fiduciary-turned-trader may remain liable under state law
                                   for breach of a duty of loyalty.
                 6.      The element that the misappropriator’s deceptive use of information be “in connection
                         with the purchase or sale of a security is also satisfied because the fiduciary’s fraud is
                         consummated, not when the fiduciary gains the confidential information, but when,


        49
            The Government could not have prosecuted O’Hagan under the classical theory, for O’Hagan was no an
“insider” of Pillsbury, the corporation in whose stock he traded.

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                        without disclosure to his principal, he uses the information to purchase or sell securities.
                        a.        The securities transaction and the breach of duty thus coincide. This is so even
                                  though the person or entity defrauded is not the other party to the trade, but is,
                                  instead, the source of the nonpublic information.
                        b.        A misappropriator who trades on the basis of material, nonpublic information, in
                                  short, gains his advantageous market position through deception; he deceives the
                                  source of the information and simultaneous harms members of the investing
                                  public.
      F.      Supreme Court’s Previous Consideration of Misappropriation Theory. The Supreme Court in Carpenter v.
              United States (1987), affirmed R. Foster W inans’ convictions on all counts, though the securities
              fraud count was affirmed only by an evenly divided court (4-4). W inans published the Wall Street
              Journal’s “Heard on the Street” column which provided investing advice and information. The
              column had a short-lived effect on the price of stocks it covered. Though it was the Journal’s
              policy to keep the contents of the column confidential before publication, W inans disclosed the
              contents of his columns to several friends who then traded the affected stocks.
      G.      Rule 10b5-2. Rule 10b5-2 provides “a non-exclusive list of three situations in which a person has a
              duty of trust or confidence for purposes of the ‘misappropriation’ theory.”
              1.        First, such a duty exists whenever someone agrees to maintain information in confidence.
              2.        Second, such a duty exists between two people who have a pattern or practice of sharing
                        confidences such that the recipient of the information knows or reasonable should know
                        that the speaker expects the recipient to maintain the information’s confidentiality.
              3.        Third, such a duty exists when someone receives or obtains material nonpublic
                        information from a spouse, parent, child, or sibling.
VI.   Short-Swing Profits
      A.      Reliance Electric Co. v. Emerson Electric Co. (S. Ct. 1972).
              1.        Section 16(b) of the Securities Act of 1934 provides, among other things, that a
                        corporation may recover for itself the profits realized by an owner of more than 10% of its
                        shares from a purchase and sale of its stock within any six-month period, provided that the
                        owner held more than 10% “both at the time of the purchase and sale.”
              2.        The history and purpose of § 16(b) have been exhaustively reviewed by federal courts on
                        several occasions since its enactment in 1934.
                        a.        Those courts have recognized that the only method Congress deemed effective to
                                  curb the evils of insider trading was a flat rule taking the profits out of a class of
                                  transactions in which the possibility of abuse was believed to be intolerably great.
                        b.        Congress did not reach every transaction in which an investor actually relies on
                                  inside information. A person avoids liability is he does not meet the statutory
                                  definition of an “insider,” or if he sells more than six months after purchase.
              3.        Among the “objective standards” contained in § 16(b) is the requirement that a 10%
                        owner be such “both at the time of the purchase and sale ... of the security involved.”
                        a.        Read literally, this language clearly contemplates that a statutory insider might sell
                                  enough shares to bring his holdings below 10%, and later–but still within six
                                  months–sell additional shares free from liability under the statute.
                                  (1)       Indeed, commentators on the securities law have recommended this
                                            exact procedure for a 10% owner who, like Emerson, wishes to dispose
                                            of his holders within six months of their purchase.
      B.      Foremost-McKesson, Inc. v. Provident Securities Company (S. Ct. 1976).
              1.        Issue. W hether a person purchasing securities that put his holdings above the 10% level is a
                        beneficial owner “at the time of the purchase” so that he must account for profits realized
                        on a sale of those securities within six months.
              2.        Section 16(b) provides that a corporation may capture for itself the profits realized on a
                        purchase and sale, or sale and purchase, of its securities within six months by a director,
                        officer, or beneficial owner.
              3.        Section 16(b)’s last sentence, however, provides that it “shall not be construed to cover any
                        transaction where such beneficial owner was not such both at the time of the purchase and

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                              sale, or the sale and purchase, of the security involved...”
                   4.         The legislative record reveals that the drafters focused directly on the fact that the original
                              draft of the bill that became § 16(b) covered a short-term purchase-sale sequence by a
                              beneficial owner only if his status existed before the purchase, and no concern was
                              expressed about the wisdom of this requirement.
                              a.         But the explicit requirement was omitted from the operative language when it
                                         was restructured to cover sale-repurchase sequences.
                              b.         In the same draft, however, the exemptive provision was added to the section.
                                         (1)       On this record, we are persuaded that the exemptive provision was
                                                   intended to preserve the requirement of beneficial ownership before the
                                                   purchase. W e hold that in a purchase-sale sequence, a beneficial owner
                                                   must account for profits only if he was a beneficial owner “before the
                                                   purchase.”
C H A PTER S IX : P R O BLEM S O F C O N TRO L
I.       Proxy Fights*
         A.         Strategic Use of Proxies*
         B.         Reimbursement of Costs*
         C.         Private Actions for Proxy Rule Violations*
         D.         Shareholder Proposals*
         E.         Shareholder Inspection Rights*
II.      Shareholder Voting Control*
III.     Control in Closely Held Corporations
         A.         Voting
                    1.        Straight Voting. In straight voting, each share may be voted for as many candidates as there
                              are slots on the board, but no share may be voted more than once for any given candidate.
                              Directors are elected by a plurality (not necessarily majority) of the votes cast.
                    2.        Cumulative Voting. Cumulative voting entitles a shareholder to cumulate or aggregate his
                              votes in favor of fewer candidates than there are slots available, including in the extreme
                              case aggregating all of his votes for just one candidate. The consequences are that a
                              minority shareholder is far more likely to be able to obtain at least one seat on the board.
                              a.         Mandatory/Permissive Cumulative Voting. Corporations formed after January 1,
                                         1987 are governed by the ‘87 Act while those formed before are governed by the
                                         ‘65 Act, under which cumulative voting is required.
                                         (1)       A corporation governed under the ‘65 Act can elect to be governed by
                                                   the ‘87 Act.
                              b.         Removal of Directors. In most states, shareholders have the right to remove a
                                         director without cause at any time during his term. Consequently, because the
                                         right of cumulative voting would be completely nullified if an election to remove
                                         were done by a straight “yes or no” vote at which the majority of votes cast
                                         determined the result, most states have a special provision to prevent this result.
                                         (1)       Under MBCA § 8.08(c), if a corporation has cumulative voting, the
                                                   director cannot be removed if the number of votes cast against his
                                                   removal would have been enough to elect him.
                    3.        Staggered Board. Only a minority of the board will stand for election in any given year.
                              The rationale given is that there will be a continuity of experience on the board. It is also
                              used as a takeover defense mechanism.
         B.         The Statutory Norm. “The business of a corporation shall be managed by its board of directors.”
                    Traditionally, powers have been allocated among the shareholders, the directors and the officers of a
                    corporation in a particular way. Even today, most statutes assume that this allocation of powers will
                    be followed.
                    1.        Shareholders. The shareholders act principally through two mechanism: (1) electing a
                              removing directors; and (2) approving or disapproving fundamental or non-ordinary changes (e.g.,
                              mergers).
                    2.        Directors. The directors “manage” the corporation’s business. That is, they formulate

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              policy, and appoint officers to carry out that policy.
     3.       Officers. The corporation’s officers administer the day-to-day affairs of the corporation,
              under the supervision of the board.
     4.       Inappropriate for Large or Closely-Held Corporations. For very large or very small
              corporations, this statutory scheme does not reflect reality.
              a.        A small corporation generally does not have its affairs managed by the board of
                        directors–the shareholders usually exercise control directly (they may happen also
                        to be directors, but they usually do not act as a body of directors, and the
                        controlling shareholders often disregard any non-shareholder directors).
              b.        A very large publicly-held company is really run by its officers, and the board of
                        directors frequently serves as little more than a “rubber-stamp” to approve
                        decisions made by officers.
C.   Shareholder Vote Pooling Agreement. An agreement in which two or more shareholders agree to vote
     together as a unit on certain or all matters.
     1.       Disagreement. W hat if the shareholders disagree? Arbitration? How do you enforce the
              decision? Proxies? To make irrevocable, the proxy must say that it is irrevocable and it
              must be coupled with an interest.
     2.       MBCA § 7.32 validates shareholder agreements no matter how far they stray from the
              statutory norm (non-public corporations).
              a.        Can eliminate the board of directors altogether.
              b.        Shareholder Agreement. The shareholder must agree. Notice to new shareholders
                        is given on the stock certificate.
D.   Ringling Bros.-Barnum & Bailey Combined Shows v. Ringling (Del. Sup. Ct. 1947).
     1.       Facts. The corporation had 1000 shares outstanding (315 by petitioner Edith, 315 by
              defendant Aubrey and 370 by defendant John. Edith alleged that Aubrey was bound to
              vote her share for an adjournment of the meeting, or in the alternative, for a certain slate
              of directors. The agreement was entered into in 1941. First, the agreement provided that
              each party “will consult and confer with the other and the parties will act jointly in
              exercising such voting rights in accordance with such agreement as they may reach with
              respect to any matter calling for the exercise of such voting rights.” Second, in the event
              that the parties disagreed, the disagreement was to be submitted to arbitration to Mr. Loos
              o W ashington, D.C. The arbitrator’s decision was to be binding. Finally, the agreement
              was to be in effect for a period of ten years unless terminated earlier by mutual agreement.
              A disagreement arose before the ‘46 meeting between Mr. Haley (acting on behalf of
              Aubrey) and Edith. Edith demanded that Mr. Koos arbitrate the dispute. He concluded
              that both parties vote to adjourn for 60 days. Mr. Haley opposed the motion to adjourn.
              The chairman concluded that the motion carried but proceeded with the election of the
              directors, regardless.
     2.       Issue. Should the agreement be interpreted as attempting to empower the arbitrator to
              carry his directions into effect?
              a.        Certainly there is no express delegation or grant of power to do so, either by
                        authorizing him to vote the shares or to compel either party to vote them in
                        accordance with his directions.
              b.        The agreement expresses no other function of the arbitrator than that of deciding
                        question in disagreement which prevent the effectuation of the purpose “to act
                        jointly.” The power to enforce a decision does not seem a necessary or usual incident of
                        such a function.
                        (1)       Mr. Loos is not a party to the agreement. It does not contemplate the
                                  transfer of any shares or interest in shares to him, or that he should
                                  undertake any duties which the parties might compel him to perform.
                                  The parties provided that they might designed any other individual to
                                  act instead of Mr. Loos. The agreement doesn’t attempt to make the
                                  arbitrator a trustee of an express trust. W hether the parties accept or
                                  reject his decision is no concern of his, so far as the agreement or

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               surrounding circumstances reveal.
     (2)       W e think the parties sought to bind each other, but to be bound only to
               each other, and not to empower the arbitrator to enforce decisions he
               might make.
               (a)        From this conclusion, it follows necessarily that no decision of the
                          arbitrator could ever be enforced if both parties to the agreement were
                          unwilling that it be enforced, for the obvious reason that there would be
                          no one to enforce it.
     (3)       The language in the agreement with respect to a decision of the
               arbitrator other than to provide that it “shall be binding upon the
               parties,” when considered in relation to its context and the situations to
               which it is applicable, means that each party promised the other to
               exercise her own voting rights in accordance with the arbitrator’s
               decision.
               (a)        The agreement is silent about any exercise of the voting rights
                          of one party by the other. There is nothing to justify implying
                          a delegation of the power in the absence of some indication
                          that the parties bargained for that means. W e do not find
                          enough in the agreement or in the circumstances to justify a
                          construction that either party was empowered to exercise
                          voting right of the other.
     (4)       Separating the Voting Right of Stock From Ownership. The defendants
               contend that there is an established doctrine “that there can be no
               agreement, or any device whatsoever, by which the voting power of
               stock of a Delaware corporation may be irrevocably separated from
               ownership of the stock, except by an agreement which complied with
               [statute].”
               (a)        The defendants’ sweeping formulation would impugn well-
                          recognized means by which a shareholder may effectively
                          confer his voting rights upon others while retaining various
                          other rights.
               (b)        Various forms of such pooling agreements, as they are
                          sometimes called, have been held valid and have been
                          distinguished from voting trusts.
               (c)        Generally speaking, a shareholder may exercise wide liberality
                          of judgment in the matter of voting, and it is not objectionable
                          that his motive may be for personal profit, or determined by
                          whims or caprice, so long as he violates no duty owed to his
                          fellow shareholders.
     (5)       Voting Agreements Okay. The ownership of voting stock imposes no
               legal duty at all. A group of shareholders, may, without impropriety,
               vote their respective shares so as to obtain advantages of concerted
               action.
               (a)        Provisions Regarding Deadlock Okay. Reasonable provisions for
                          cases of failure of the group to reach a determination because of
                          an even division in their ranks seem unobjectionable.
c.   Right to Reject Votes. The Court of Chancery may, in a review of an election,
     reject votes of a registered shareholder where his voting of them is found to be in
     violation of right of another person.
     (1)       W e have concluded that the election should not be declared invalid, but
               that effect should be given to a rejection of the votes representing Mrs.
               Haley’s shares.




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         E.         McQuade v. Stoneham (N.Y. 1934).
                    1.       Although it has been held that an agreement among stockholders whereby it is attempted
                             to divest the directors of their power to discharge an unfaithful employee of the
                             corporation is illegal as against public policy, it must be equally true that the stockholders
                             may not, by agreement among themselves, control the directors in the exercise of the
                             judgment vested in them by virtue of their office and to elect officers and fix salaries.
                             Their motives may not be questioned so long as their acts are legal. The bad faith or the
                             improper motives of the parties does not change the rule. Directors may not by
                             agreements entered into as stockholders abrogate their independent judgment.
                    2.       Agreeing to Combine to Elect Directors. Stockholders may, of course, combine to elect
                             directors. That rule is well settled.
                             a.         Limitations on Power to Unite. The power to unite is, however, limited to the
                                        election of directors and is not extended to contracts whereby limitations are
                                        placed on the power of directors to manage the business of the corporation by the
                                        selection of agents at defined salaries.
                    3.       Stoneham and McGraw were not trustees for McQuade as an individual.50 Their duty was
                             to the corporation and its stockholders, to be exercised according to their unrestricted
                             lawful judgment. They were under no legal obligation to deal righteously with McQuade
                             if it was against public policy to do so.
                    4.       The court holds that it is restrained by authority to hold that a contract is illegal and void
                             so far as it precludes the board of directors, at the risk of incurring legal liability, from
                             changing officers, salaries, or policies or retaining individuals in office, except by consent
                             of the contracting parties. 51
                    5.       Concurring Opinion. The agreement contemplated no restriction upon the powers of the
                             board of directors, and no dictation or interference by stockholders except in so far as
                             concerns the election and remuneration of officers and the adhesion by the corporation to
                             established policies.
                             a.         It seems difficult to reconcile such a decision with the statements in the opinion
                                        of Manson v. Curtis that “it is not illegal or against public policy for two or more
                                        stockholders owning the majority of the shares of stock to unite upon a course of
                                        corporate policy or action, or upon the officers whom they will elect,” and that
                                        “shareholders have the right to combine their interests and voting powers to
                                        secure such control of the corporation and the adoption of and adhesion by it to a
                                        specific policy and course of business.”
                             b.         The directors have the power and the duty to act in accordance with their own
                                        best judgment so long as they remain directors. The majority stockholders can
                                        compel no action by the directors, but at the expiration of the term of office of
                                        the directors the stockholders have the power to replace them with others whose
                                        actions coincide with the judgment or desires of the holders of a majority of the
                                        stock.
         F.         Clark v. Dodge (N.Y. 1936).
                    1.       Issue. The only question which need be discussed is whether the contract is illegal as
                             against public policy within the decision in McQuade v. Stoneham.
                    2.       Statutory Norm. The business of a corporation shall be managed by its board of directors.’
                             Gen. Corp. Law § 27.
                             a.         That is the statutory norm. Are we committed by the McQuade case to the



         50
              “A trustee is held to something stricter than the morals of the marketplace.” Meinhard v. Salmon.

         51
            The court also concludes, in the alternative, that the agreement was invalid because at the time of the
contract, McQuade was also a city magistrate. A New York City criminal statute prohibited from holding other
employment during his government service.

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                          doctrine that there may be no variation, however slight or innocuous, from that
                          norm, where salaries or policies or the retention of individuals in office are
                          concerned?
               b.         Basis of McQuade Nebulous. Apart from its practical administrative convenience,
                          the reasons upon which it is said to rest are more or less nebulous. Public policy,
                          the intention of the Legislature, detriment to the corporation, are phrases which
                          in this connection mean little. Possible harm to bona fide purchasers of stock or
                          to creditors or to stockholding minorities have more substance; but such harms
                          are absent in many instances.
               c.         No Harm in Agreements. If the enforcement of a particular contract damages
                          nobody-not even, in any perceptible degree, the public-one sees no reason for
                          holding it illegal, even though it impinges slightly upon the broad provision of §
                          27.
     3.        Directors as Sole Stockholders–Agreement Enforceable. Where the directors are the sole
               stockholders, there seems to be no objection to enforcing an agreement among them to
               vote for certain people as officers. There is no direct decision to that effect in this court,
               yet there are strong indications that such a rule has long been recognized.
     4.        Agreement Did Not Sterilize the Board. Except for the broad dicta in the McQuade opinion,
               we think there can be no doubt that the agreement here in question was legal and that the
               complaint states a cause of action. There was no attempt to sterilize the board of directors,
               as in the Manson and McQuade cases.
     5.        McQuade Confined to Its Facts. If there was any invasion of the powers of the directorate
               under that agreement, it is so slight as to be negligible; and certainly there is no damage
               suffered by or threatened to anybody. The broad statements in the McQuade opinion,
               applicable to the facts there, should be confined to those facts.
G.   Agreements Requiring Election of Directors. Agreements by which the shareholders simply commit to
     electing themselves, or their representatives , as directors, are generally considered unobjectionable,
     and are now expressly validated in many jurisdictions. They do not interfere with the obligations of
     the director to exercise their sound judgment in managing the affairs of the corporation.
     1.        Agreements Requiring Appointment of Particular Officers/Employees. The courts have had more
               difficulty with shareholder agreements requiring the appointment of particular individuals
               as officers or employees of the corporation, since such agreements do deprive the directors
               of one of their most important functions.
H.   Voting Trust. Another device that can be used for control is the voting trust, a device specifically
     authorized by the corporation laws of most states. W ith a voting trust, shareholders who which to
     act in concert turn their shares over to a trustee. The trustee then votes all the shares, in accordance
     with instructions in the document establishing the trust.
     1.        The general requirements for creating a voting trust are as follows: (1) a written agreement,
               signed by the trustees and the beneficiary; (2) property is conveyed into the trust, i.e., the
               shareholders transfer some or all of their shares to the trustee; (3) the books of the
               corporation are changed to reflect that the trustees have the right to vote the stock; and (4)
               the voting trust issues certificates to the beneficiaries.
               a.         Early Hostility. Early courts were hostile to voting trusts because they separated
                          shareholders’ voting power and economic ownership interests. Today, statutes
                          specifically authorize voting trusts in virtually all jurisdictions.
                          (1)       MBCA § 7.30 sets a maximum term for such a trust at ten years. This is
                                    in contrast with the Delaware corporation law which does not contain a
                                    sunset provision.
               b.         W hy a Voting Trust? (1) Provides cohesion and certainty to management in large
                          companies with a large number of shareholders; (2) Regulatory agencies want
                          assurance that control of the business isn’t transferred without consent; (3)
                          Closely-held family corporations; (4) Creditors may insist as a condition of
                          making loan the power along with the power to appoint trustee.
     2.        Proxy. A written grant of authority that grants the right to vote stock.

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                              a.         Generally Revocable. Generally, a proxy is revocable by the shareholder, even if
                                         the proxy itself recites that it is irrevocable.
                              b.         Exception for Proxy Coupled with Interest. All states, however, recognize one major
                                         exception to this general rule of revocability: a proxy is irrevocable if it meets two
                                         requirements: (1) it states that it is irrevocable; and (2) it is coupled with an
                                         interest.
                                         (1)       Coupled with an Interest. The recipient of the proxy must have some
                                                   property interest in the shares, or at lease some other direct economic
                                                   interest in how the vote is cast. 52
          I.        Special Statutes for Closely Held Corporations. Provisions vary widely from state to state. Generally,
                    they allow certain corporations to elect (it’s voluntary) close corporation status (whereupon the
                    corporation is said to be a statutory close corporation).
                    1.        Ex. In Delaware, close corporation status may be elected by corporations with not more
                              than 30 shareholders.
                              a.         Del. Gen. Corp. Law § 351 provides, “The certificate of incorporation of a close
                                         corporation may provide that the business of the corporation shall be managed by
                                         the stockholders of the corporation rather than by a board of directors.”
          J.        Limited Liability Company. W ith an LLC, issues of control are largely left to individual choice,
                    reflected in a document, drafted by (or for) the investors (the “members”) and called “regulations”
                    or “operating agreement” or something of the sort.
                    1.        Member Managed (like a partnership) or Manager Managed (like a corporation).
          K.        Ramos v. Estrada (Cal. App. 1992).
                    1.        Cal. Corp. Code § 178 defines a proxy to be “a written authorization signed ... by a
                              shareholder ... giving another person power to vote with respect to shares of such
                              shareholder.”
                              a.         No Proxy Statement Created. No proxies are created by this agreement. The
                                         agreement has the characteristics of a shareholders' voting agreement expressly
                                         authorized by § 706(a) for close corporations. Although the articles of
                                         incorporation do not contain the talismanic statement that “This corporation is a
                                         close corporation,” the arrangements of this corporation, and in particular this
                                         voting agreement, are strikingly similar to ones authorized by the Code for close
                                         corporations.
                    2.        Section 706(a) states, in pertinent part: “an agreement between two or more shareholders
                              of a close corporation, if in writing and signed by the parties thereto, may provide that in
                              exercising any voting rights the shares held by them shall be voted as provided by the
                              agreement, or as the parties may agree or as determined in accordance with a procedure
                              agreed upon by them....”
                              3.         Even though this corporation does not qualify as a close corporation, this
                                         agreement is valid and binding on the Estradas. §706(d) states: “This section shall
                                         not invalidate any voting or other agreement among shareholders ... which
                                         agreement ... is not otherwise illegal.”
                                         a.        The Legislative Committee comment regarding § 706(d) states that
                                                   “[t]his subdivision is intended to preserve any agreements which would
                                                   be upheld under court decisions even though they do not comply with one or
                                                   more of the requirements of this section, including voting agreements of


         52
             MBCA § 7.22(d) gives a catalog of people who will be deemed to hold a suitable “interest”: (1) a pledgee
(e.g., a holder pledges his share in return for a loan from bank, and gives bank, the pledgee, his proxy); (2) a person
who has purchased or agreed to purchase the shares; (3) a creditor of the corporation (e.g., creditor says he won’t give credit to
corporations unless the controlling shareholder gives creditor a proxy that’s irrevocable while the debt is outstanding;
and a party to a voting agreement (e.g., A, B, and C are the shareholders in a closely-held corporation; they sign a voting
agreement to vote their shares together, which impliedly gives the two shareholders in the majority on any ballot an
irrevocable proxy to vote the shares of the third).

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                                            corporations other than close corporations.”
               4.        The agreement calls for enforcement by specific performance of its terms because the stock
                         is not readily marketable. Section 709(c) expressly permits enforcement of shareholder
                         voting agreements by such equitable remedies. It states, in pertinent part: “The court may
                         determine the person entitled to the office of director or may order a new election to be
                         held or appointment to be made, may determine the validity, effectiveness and
                         construction of voting agreements ... and the right of persons to vote and may direct such
                         other relief as may be just and proper.”
IV.   Abuse of Control
      A.      Donahue v. Rodd Electrotype (Mass. 1975).
              1.       Facts. Plaintiff was a minority shareholder in a corporation who had inherited her shares
                       from her husband, an employee of the corporation. The corporation had previously
                       bought back shares from its majority stockholder at a high price. It refused to buy a similar
                       portion of P’s shares back from her at anything close to that price, thus leaving her with a
                       largely unmarketable interest.
              2.       Close Corporation. There is no single, generally accepted definition. Some commentators
                       emphasize an ‘integration of ownership and management’ in which the stockholders
                       occupy most management positions. Others focus on the number of stockholders and the
                       nature of the market for the stock. In this view, close corporations have few stockholders;
                       there is little market for corporate stock. The court accepts aspects of both definitions:
                       a.         The court deems a close corporation to be typified by: (1) a small number of
                                  stockholders; (2) no ready market for the corporate stock; and (3) substantial
                                  majority stockholder participation in management, directors and operations of the
                                  corporation.
              3.       Close Corporation Similar to Partnership. As thus defined, the close corporation bears a
                       striking resemblance to a partnership. Commentators and courts have noted that the close
                       corporation is often little more than an ‘incorporated’ or ‘chartered’ partnership. The
                       stockholders ‘clothe’ their partnership with the benefits peculiar to a corporation, limited
                       liability, perpetuity and the like.
                       a.         Relationship of Trust. Just as in a partnership, the relationship among the
                                  stockholders must be one of trust, confidence and absolute loyalty if the enterprise
                                  is to succeed. Disloyalty and self-seeking conduct on the part of any stockholder
                                  will engender bickering, corporate stalemates, and perhaps, efforts to achieve
                                  dissolution.
              4.       Although the corporate form provides the above-mentioned advantages for the
                       stockholders (limited liability, perpetuity, and so forth), it also supplies an opportunity for
                       the majority stockholders to oppress or disadvantage minority stockholders.
                       a.         The minority can, of course, initiate suit against the majority and their directors.
                                  Self-serving conduct by directors is proscribed by the director’s fiduciary
                                  obligation to the corporation. However, in practice, the plaintiff will find
                                  difficulty in challenging dividend or employment policies. Such policies are
                                  considered to be within the judgment of the directors.
                                  (1)        Thus, when these types of ‘freeze-outs’ are attempted by the majority
                                             stockholders, the minority stockholders, cut off from all corporation-
                                             related revenues, must either suffer their losses or seek a buyer for their
                                             shares. Many minority stockholders will be unwilling or unable to wait
                                             for an alteration in majority policy.
                                             (a)       At this point, the true plight of the minority stockholder in a
                                                       close corporation becomes manifest. He cannot easily reclaim
                                                       his capital. In a large public corporation, the oppressed or
                                                       dissident minority stockholder could sell his stock in order to
                                                       extricate some of his invested capital. By definition, this
                                                       market is not available for shares in the close corporation.
              5.       In a partnership, a partner who feels abused by his fellow partners may cause dissolution by

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                            his ‘express will at any time’ and recover his share of partnership assets and accumulated
                            profits. By contrast, the stockholder in the close corporation or ‘incorporated partnership’
                            may achieve dissolution and recovery of his share of the enterprise assets only by
                            compliance with the rigorous terms of the applicable chapter of the General Laws.
                            a.         The minority stockholders may be trapped in a disadvantageous situation. No
                                       outsider would knowingly assume the position of the disadvantage minority. The
                                       outsider would have the same difficulties. This is the capstone of the majority
                                       plan. Majority ‘freeze-out’ schemes which withhold dividends are designed to
                                       compel the minority to relinquish stock at inadequate prices.
                  6.        Close Corp. Stockholders Owe One Another Fid. Duty. Because of the fundamental
                            resemblance of the close corporation to the partnership, the trust and confidence which are
                            essential to this scale and manner of enterprise, and the inherent danger to minority
                            interests in the close corporation, the court holds that stockholders in the close corporation
                            owe one another substantially the same fiduciary duty in the operation of the enterprise
                            that partners owe to one another.
                  7.        Equal Opportunity in a Close Corporation. W e hold that, in any case in which the
                            controlling stockholders have exercised their power over the corporation to deny the
                            minority such equal opportunity, the minority shall be entitled to appropriate relief.
                            a.         Remedy. (1) The judgment may require Rodd to remit $36,000 with interest at
                                       the legal rate to Rodd Electrotype in exchange for forty-five shares of Rodd
                                       Electrotype treasury stock or (2) The judgment may require Rodd Electrotype to
                                       purchase all of the plaintiff’s shares for $36,000 without interest.
         B.       W ilkes v. Springside Nursing Home, Inc. (Mass. 1976).
                  1.        Facts. Four men (W ilkes, Riche, Quinn, and Pipkin) each invested $1,000 and acquired
                            10 shares of a Mass. corp. called Springdale, which was incorp. for the purpose of running
                            a nursing home out of an old hospital. It was understood by the four parties, at the time of
                            incorp., that they would each participate in management of the corp. It was also
                            understood that they would receive money in equal amounts as long as each assumed his
                            responsibility. The business became profitable. In ‘59, Pipkin sold his shares to Connor,
                            president of F.N. Agr. Bank, due to illness. In ‘65, Quinn purchased a portion of the
                            corp. property. W ilkes apparently helped inflate the price and his and Quinn’s relationship
                            deterioated. W ilkes was not given a salary when the board exercised its right to establish
                            them and not reelected as a director or officer at the ‘67 annual meeting. He was informed
                            his presence was not welcome. The master found that this exclusion was not due to
                            neglect or misconduct but rather because of bad personal relationships.
                  2.        In Donahue, we held that “stockholders in the corporation owe one another substantially
                            the same fiduciary duty in the operation of the enterprise that partners own to one
                            another.”
                            a.         As determined in previous decisions of this court, the standard of duty owed by
                                       partners to one another is one of “utmost good faith and loyalty.”
                  3.        Thus, we concluded in Donahue, with regard to “their actions relative to the operations of
                            the enterprise and the effects of that operation on the rights and investments of other
                            stockholders, [s]tockholders in close corporations must discharge their management and
                            stockholder responsibilities in conformity with this strict good faith standard. They may
                            not act out of avarice, expediency, or self-interest in derogation of their duty of loyalty to
                            the other stockholders and to the corporation.”
                            a.         Freeze-Outs. In the Donahue case we recognized that one peculiar aspect of close
                                       corporations was the opportunity afforded to majority stockholders to oppress,
                                       disadvantage or “freeze out” minority stockholders. 53


        53
            In Donahue itself, for example, the majority refused the minority an equal opportunity to sell a ratable
number of shares to the corporation at the same price available to the minority. The net result of this refusal was that
the minority could be forced to “sell out at less than fair value,” since there is by definition no ready market for

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                                     (1)       Deprivation of Corporate Offices & Employment. “Freeze outs” may be
                                               accomplished by the use of other devices. One such device which has
                                               proved to be particularly effective in accomplishing the purpose of the
                                               majority is to deprive minority stockholders of corporate offices and of
                                               employment with the corporation.
                                               (a)        Courts Hesitant to Interfere with Corp. Internal Affairs. This
                                                          freeze-out technique has been successful because courts fairly
                                                          consistently have been disinclined to interfere in those facets of
                                                          internal corporate operations, such as the selection and
                                                          retention or dismissal of officers, directors, and employees,
                                                          which essentially involve management decisions subject to the
                                                          principle of majority control.
                                               (b)        The denial or employment to the minority at the hands of the
                                                          majority is especially pernicious in some instances. A guaranty
                                                          of employment with the corporation may have been one of the
                                                          “basic reasons why a minority owner has invested capital in the
                                                          firm.”
                           b.        The Donahue decision acknowledged, as a “natural outgrowth” of the case law in
                                     this Commonwealth, a strict obligation on the part of majority stockholders in a
                                     close corporation to deal with the minority with the utmost good faith and
                                     loyalty.
                                     (1)       Concern of Donahue Standard Tempering Legitimate Action. The court is
                                               concerned that the untempered application of the strict good faith
                                               standard enunciated in the Donahue case to cases such as this one will
                                               result in the imposition of limitations on legitimate action by the
                                               controlling group in a close corporation which will unduly hamper its
                                               effectiveness in managing the corporation in the best interests of all
                                               concerned.
                                               (a)        Selfish Ownership. The majority, concededly, have certain
                                                          rights to what has been termed selfish ownership in the
                                                          corporation which should be balanced against the concept of
                                                          their fiduciary duty to the minority.
                  4.       Balancing Test. Therefore, when minority stockholders in a close corporation bring suit
                           against the majority alleging breach of the strict good faith duty owed to them by the
                           majority, the court must carefully analyze the action taken by the controlling stockholders
                           in the individual case.
                           a.        Legitimate Business Purpose. W hether the controlling group can demonstrate a
                                     legitimate business purpose for its action.
                                     (1)       In making this determination, the court must acknowledge the fact that
                                               the controlling group in a close corporation must have some room to
                                               maneuver in establishing the business policy of the corporation. It must
                                               have a large measure of discretion, for example, in declaring or
                                               withholding dividends, deciding whether to merge or consolidate,
                                               establishing the salaries of corporate officers, dismissing directors with or
                                               without cause, and hiring and firing corporate employees.
                           b.        Less Harmful Alternative? W hen an asserted business purpose is advanced, it is
                                     open to the minority to demonstrate that the same legitimate objective could
                                     have been achieved through an alternative course of action less harmful to the
                                     minority’s interest.




minority stock in a close corporation.

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C.   Ingle v. Glamore Motor Sales, Inc. (N.Y. 1989).
     1.        Facts. In ‘64, Ingle sought to purchase an equity interest in Glamore but was instead
               initially hired as a sales manager. In ‘67, Ingle and Glamore entered into a shareholders’
               agreement that provided that Ingle would purchase 22 shares of the 100 shares in the corp.
               and that Ingle would have an five-year option to purchase 18 more shares and that
               Glamore would nominate and vote Ingle as a director and secretary. The agreement also
               gave Glamore the right to purchase back the stock if Ingle ceased to be an employee for any
               reason. In ‘82, 60 more shares were issued which were purchased by Glamore and his two
               sons. A third agreement was entered into with a repurchase provision stating that if any
               stockholder shall cease to be an employee of the Corp. for any reason, Glamore would have an
               option to repurchase within 30 days. Ingle was voted out in ‘83 and fired. Glamore
               notified Ingle that he was exercising his option.
     2.        A minority shareholder in a close corporation, by that status alone, who contractually
               agrees to the repurchase of his shares upon termination of his employment for any reason,
               acquires no right from the corporation or majority shareholders against at-will discharge.
               There is nothing in law, in the agreement, or in the relationship of the parties to warrant
               such a contradictory and judicial alteration of the employment relationship or the express
               agreement.
               a.         It is necessary to appreciate and keep distinct the duty a corporation owes to a
                          minority shareholder as a shareholder from any duty it might owe him as an
                          employee.
                          (1)       Under the established common-law rule–and without any reference to
                                    the shareholders’ agreement–the corporation had the right to discharge
                                    plaintiff at will.
                                    (a)        In Murphy v. American Home Products Corp. the court concluded
                                               that there is no implied obligation of good faith and fair dealing
                                               in an employment at will, as that would be incongruous to the
                                               legally recognized jural relationship in that kind of employment
                                               relationship.
               b.         Divestiture of his status as a shareholder, by operation of the repurchase provision,
                          is a contractually agreed to consequence flowing directly from the firing, not vice
                          versa.
               c.         No duty of loyalty and good faith akin to that between partners, precluding
                          termination except for cause, arises among those operating a business in the
                          corporate form who “have only the rights, duties and obligations of stockholders”
                          and not those of partners.
     3.        Dissent. The majority is incorrect in treating the case as one of a claimed breach of a
               hiring contract by the employer rather than an unfair squeeze-out of a minority
               shareholder in a close corporation by the majority.
               a.         The majority’s decision summarily rejects, without discussion, plaintiff’s
                          underlying theory which is rooted in his equitable rights as a minority shareholder
                          and principal in a close corporation and the fiduciary duty of fair dealing owed
                          him by the majority shareholders–rights and duties which have been widely
                          recognized in statutory and decisional law in this and other jurisdictions. W ilkes
                          v. Springside Nursing Home (Mass. 1976).
               b.         The relationship of a minority shareholder to a close corporation, if fairly viewed,
                          cannot possibly be equated with an ordinary hiring and, in the absence of a
                          contract, regarded as nothing more than an employment at will.
D.   Brodie v. Jordan (Mass. 2006).
     1.        Brodie, Barbuto and Jordan each held one-third of the shares of the Malden. After Brodie
               ceased participating in the day-to-day operations, disagreements between him and Barbuto
               and Jordan arose. His requests to be bought out were denied. In ‘92, W alter was voted
               out as president and replaced by Jordan. W alter died in ‘97 and his wife inherited his
               share. She attended an annual shareholder’s meeting, through counsel, at which she

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              nominated herself for director. Jordan and Barbuto voted against her election. She also
              asked for a valuation of the company, which was denied.
     2.       “Stockholders in a close corporation own one another substantially the same fiduciary duty
              in the operation of an enterprise that partners owe one another. That is, a duty of “utmost
              good faith and loyalty.” Donahue v. Rodd Electrotype Co. Of New England.
              a.         Majority shareholders in a close corporation violate this duty when they act to
                         “freeze-out” the minority.
                         (1)        Freeze Outs. The squeezers [those who employ the freeze-out
                                    techniques] may refuse to declare dividends; they may drain off the
                                    corporation's earnings in the form of exorbitant salaries and bonuses to
                                    the majority shareholder-officers and perhaps to their relatives, or in the
                                    form of high rent by the corporation for property leased from majority
                                    shareholders; they may deprive minority shareholders of corporate
                                    offices and of employment by the company; they may cause the
                                    corporation to sell its assets at an inadequate price to the majority
                                    shareholders.
                                    (a)       W hat these examples have in common is that, in each, the
                                              majority frustrates the minority's reasonable expectations of
                                              benefit from their ownership of shares.
              b.         Shareholder’s Reasonable Expectations. W e have previously analyzed freeze-outs in
                         terms of shareholders' “reasonable expectations” both explicitly and implicitly. See
                         Bodio v. Ellis Mass. 1987) (thwarting minority shareholder's “rightful expectation”
                         as to control of close corporation was breach of fiduciary duty); W ilkes v.
                         Springside Nursing Home, Inc. (Mass. 1976) (denying minority shareholders
                         employment in corporation may “effectively frustrate [their] purposes in entering
                         on the corporate venture”).
                         (1)        A number of other jurisdictions, either by judicial decision or by statute,
                                    also look to shareholders' “reasonable expectations” in determining
                                    whether to grant relief to an aggrieved minority shareholder in a close
                                    corporation.
     3.       Remedy for Freezed Out Minority Shareholder. The proper remedy for a freeze-out is to
              restore the minority shareholder as nearly as possible to the position she would have been
              in had there been no wrongdoing.
              a.         If, for example, a minority shareholder had a reasonable expectation of
                         employment by the corporation and was terminated wrongfully, the remedy may
                         be reinstatement, back pay, or both.
              b.         Similarly, if a minority shareholder has a reasonable expectation of sharing in
                         company profits and has been denied this opportunity, she may be entitled to
                         participate in the favorable results of operations to the extent that those results
                         have been wrongly appropriated by the majority.
E.   Smith v. Atlantic Properties, Inc. (Mass. App. 1981).
     1.       Facts. W olfson purchased property in ‘51 for $350,000 ($50,000 down and a note, payable
              in 33 months, for the remainder). He offered a 1/4th interest in the property to Smith,
              Zimble, and Burke, who each paid $12,500. Smith, an attorney, organized Atlantic to
              operate the property. Each of the four investors received 25 shares. The articles of
              incorporation and by-laws included an 80% provision and had the effect of giving any one
              of the investors a veto in corporate decisions. Atlantic, after selling some assets, retained
              about 28 acres. Atlantic showed a profit during subsequent years and the mortgage was
              paid. Disagreements arose between W olfson and the other stockholders as a group.
              W olfson desired repairs to structures on the property, the other stockholders desired
              dividends. He exercise his veto power in spite of potential IRS penalties–which were
              soon assessed in ‘62, ‘63, and ‘64. Further penalties were assessed in ‘65, ‘66, ‘67, and ‘68.
     2.       Donahue Rule. The court in Donahue relied on the resemblance of a close corporation to a
              partnership and held that stockholders in the close corporation owe one another

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                            substantially the same fiduciary duty in the operation of the enterprise that partners owe to
                            one another. That standard, the court said, was the utmost duty of good faith and loyalty.
                            The court went on to say that such stockholders may not act out of avarice, expediency, or
                            self-interest in derogation of their duty of loyalty to the other stockholders and to the
                            corporation.
                  3.        Majority Shareholders May Seek Protection. In the Donahue case, the court recognized that
                            cases may arise in which, in a close corporation, majority stockholders may ask protection
                            from a minority stockholder.
                            a.         Such an instance arises in the present case because Dr. Wolfson has been able to
                                       exercise a veto concerning corporate action on dividends by the 80% provision
                                       (in Atlantic's articles or organization and by-laws) already quoted. The 80%
                                       provision may have substantially the effect of reversing the usual roles of the
                                       majority and the minority shareholders. The minority, under that provision,
                                       becomes an ad hoc controlling interest.
                  4.        W hatever may have been the reason for Dr. W olfson's refusal to declare dividends (and
                            even if in any particular year he may have gained slight, if any, tax advantage from
                            withholding dividends) we think that he recklessly ran serious and unjustified risks of
                            precisely the penalty taxes eventually assessed, risks which were inconsistent with any
                            reasonable interpretation of a duty of “utmost good faith and loyalty.
         F.       Nixon v. Blackwell (Del. 1993). 54
                  1.        The tools of good corporate practice are designed to give a purchasing minority
                            stockholder the opportunity to bargain for protection before parting with consideration. It
                            would do violence to normal corporate practice and our corporation law to fashion an ad
                            hoc ruling which would result in a court-imposed stockholder buy-out for which the
                            parties had not contracted.
                  2.        It would be inappropriate judicial legislation for this Court to fashion a special
                            judicially-created rule for minority investors when the entity does not fall within those
                            statutes, or when there are no negotiated special provisions in the certificate of
                            incorporation, by-laws, or stockholder agreements.
         G.       Jordan v. Duff and Phelps, Inc. (7th Cir. 1988).
                  1.        Facts. Jordan began work at Duff in ‘77. By ‘83 he had purchased 188 of 20,100 shares
                            outstanding. The shares were purchased at book value and he was required to sign an
                            agreement before purchase. The agreement provided that upon certain events, the
                            corporation would buy back the stock. A board resolution, however, provided an
                            exception allowing the stock to be kept for five years after termination. Jordan, seeking a
                            move because of family strife, inquired about transferring and was denied. Jordan
                            subsequently took a job in Houston. He finished the year out at Duff, however, to have
                            his stock valued at the end of the year. A merger between Duff and SP was soon
                            announced however, after Jordan had received a check for his stock. His stock would
                            have been valued much higher under the merger. He refused to cash the check and asked
                            for his stock back. This was denied and he filed suit. The merger, nevertheless, fell
                            through after the Fed disapproved. Jordan amended his complaint to ask for rescission
                            rather than damages.
                  2.        Close corporations buying their own stock, like knowledgeable insiders of closely held
                            firms buying from outsiders, have a fiduciary duty to disclose material facts. The “special
                            facts” doctrine developed by several courts at the turn of the century is based on the


         54
              The equal opportunity rule is at odds with the premise that equity investments in the corporation are
permanent and are not subject to easy withdrawal, as in a partnership. That is, parties often choose the corporate form
because it assures the stability of corporate resources. Shareholders can withdraw their investment only by selling to
another investor. Based on this, some recent courts have refused to infer partnership-type duties in close corporations
of the theory that parties could have contracted for them and, absent an agreement, corporate principles apply. Nixon
v. Blackwell is representative of this trend.

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                       principle that insiders in closely held firms may not buy stock from outsiders in
                       person-to-person transactions without informing them of new events that substantially
                       affect the value of the stock.
                       a.        Because the fiduciary duty is a standby or off-the-rack guess about what parties
                                 would agree to if they dickered about the subject explicitly, parties may contract
                                 with greater specificity for other arrangements. It is a violation of duty to steal
                                 from the corporate treasury; it is not a violation to write oneself a check that the
                                 board has approved as a bonus.
                                 (1)       No Agreement, Express or Implied, Regarding No Duty to Disclose. The
                                           stock was designed to bind Duff & Phelps's employees loyalty to the
                                           firm. The buy-sell agreement tied ownership to employment. The
                                           Agreement did not ensure that employees disregard the value of the
                                           stock when deciding what to do, and neither did the usual practice at
                                           Duff & Phelps. So the possibility that a firm could negotiate around the
                                           fiduciary duty does not assist Duff & Phelps; it did not obtain such an
                                           agreement, express or implied.
                                 (2)       Employment at will is still a contractual relation, one in which a
                                           particular duration (“at will”) is implied in the absence of a contrary
                                           expression. The silence of the parties may make it necessary to imply
                                           other terms-those we are confident the parties would have bargained for
                                           if they had signed a written agreement. One term implied in every
                                           written contract and therefore, we suppose, every unwritten one, is that
                                           neither party will try to take opportunistic advantage of the other. “The
                                           fundamental function of contract law (and recognized as such at least
                                           since Hobbes's day) is to deter people from behaving opportunistically
                                           toward their contracting parties, in order to encourage the optimal
                                           timing of economic activity and to make costly self-protective measures
                                           unnecessary.”
              3.       Dissent. The mere existence of a fiduciary relationship between a corporation and its
                       shareholders does not require disclosure of material information to the shareholders. A
                       further inquiry is necessary, and here must focus on the particulars of Jordan’s relationship
                       with Duff and Phelps.
                       a.        Jordan’s deal with Duff and Phelps required him to surrender his stock at book
                                 value if he left the company. It didn’t matter whether he quit or was fired,
                                 retired, or died; the agreement is explicit on these matters. The majority
                                 hypothesizes about “implicit parts of the relations between Duff & Phelps and its
                                 employees. But those relations are totally defined by:
                                 (1)       The absence of an employment contract, which made Jordan an
                                           employee at will
                                 (2)       The shareholder agreement, which has no “implicit parts” that bear on
                                           Duff & Phelps’ duty to Jordan, and explicitly tie his rights as a
                                           shareholder to his status as an employee
                                 (3)       A provision in the stock purchase agreement between Jordan and Duff
                                           & Phelps that “nothing herein contained shall confer on the Employee
                                           any right to be continued in the employment of the Corporation.”
V.   Control, Duration, and Statutory Dissolution
     A.       Dissolution
              1.       Voluntary. In a corporation, a minority shareholder cannot dissolve the corporation. This
                       requires a board proposal and majority shareholder approval. See MBCA § 14.02. 55
                       Articles of dissolution are then filed with the Secretary of State.
              2.       Administrative. The corporation is dissolved for failure to pay its franchise taxes. The


     55
          Two-thirds is required in some jurisdictions.

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                           corporation can, however, pay its back taxes and be reinstated (resurrected). See Ark.
                           Code Ann. § 4-27-1420 et seq.
                  3.       Judicial. Modern corporate statutes provide a minority shareholder another
                           option–involuntary dissolution. The minority shareholder can ask a court to dissolve a
                           corporation, and she would receive a final disposition after the corporation’s assets are
                           liquidated and its affairs are wound up. A court in its discretion56 may order involuntary
                           dissolution if the shareholder shows one of the statutory grounds:
                           a.          Board Deadlock. The directors cannot agree and the shareholders have been
                                       unable to break the impasse on the board–and the corporation’s business is
                                       suffering as a result (irreparable injury to the corporation threatened or suffered).
                           b.          Misconduct. Those in control have acted in a way that is “illegal, oppressive, or
                                       fraudulent.” See MBCA § 14.30(2)(iv).
                                       (1)        Oppressive. Most litigation is over the meaning of oppression.
                                                  (a)        Unfairness.
                           c.          Shareholder Deadlock. The shareholders are deadlocked–that is, the shareholders
                                       have been unable to elect new directors for a specified period, such as two
                                       consecutive meetings. See MBCA § 14.30(2)(iii)
                                                  (a)        Arkansas courts have tied oppression to reasonable expectations
                                                             of the minority shareholder. Smith v. Leonard, 317 Ark. 182,
                                                             876 S.W .2d 266 (1994).57
         B.       Alaska Plastics, Inc. V. Coppock (Alaska 1980).
                  1.       No Market For Close Corp. Shares. In a corporation with publicly traded stock, dissatisfied
                           shareholders can sell their stock on the market, recover their assets, and invest elsewhere.
                           In a close corporation there is not likely to be a ready market for the corporation's shares.
                           a.          The corporation itself, or one of the other individual shareholders of the
                                       corporation, who are likely to provide the only market, may not be interested in
                                       buying out another shareholder. If they are interested, majority shareholders who
                                       control operate policy are in a unique position to “squeeze out” a minority
                                       shareholder at an unreasonably low price.
                  2.       From a dissatisfied shareholder's point of view, the most successful remedy is likely to be a
                           requirement that the corporation buy his or her shares at their fair value. Ordinarily, there
                           are four ways in which this can occur:
                           a.          Articles of Incorporation. First, there may be a provision in the articles of
                                       incorporation or by-laws that provide for the purchase of shares by the
                                       corporation, contingent upon the occurrence of some event, such as the death of
                                       a shareholder or transfer of shares.
                           b.          Involuntary Dissolution. Second, the shareholder may petition the court for



         56
             Therefore, shareholders are not entitled to dissolution even if they prove a ground to do so. Courts are
reluctant to dissolve a corporation: (1) dissolution is the ultimate form of corporate punishment, and (2) courts fear
that corporations, if dissolved, will be sold piecemeal and become worthless.

         57
            Court considers "oppressive actions to refer to conduct that substantially defeats the 'reasonable
expectations' held by minority shareholders in committing their capital to the particular enterprise. A shareholder
who reasonably expected that ownership would lead him or her to a job, a share of corporate earnings, a place in
corporate management, or some other form of security, would be oppressed in a very real sense when others in the
corporation seek to defeat those expectations and there exists no effective means of salvaging the investment."
         A court considering a claim of oppression "must investigate what the majority shareholders knew, or should
have known, to be the petitioner's expectations in entering the particular enterprise. Majority conduct should not be
deemed oppressive simply because the petitioner's subjective hopes and desires in joining the venture are not fulfilled.
Disappointment alone should not necessarily be equated with oppression."


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                                     involuntary dissolution of the corporation.
                           c.        Statutory Right of Appraisal. Third, upon some significant change in corporate
                                     structure, such as a merger, the shareholder may demand a statutory right of
                                     appraisal.
                           d.        Equitable Remedy for Breach of Fid. Duty. Finally, in some circumstances, a
                                     purchase may be justified as an equitable remedy upon a finding of a breach of a
                                     fiduciary duty between directors and shareholders and the corporation or other
                                     shareholders.
                  3.       Dissolution/Liquidation. As to the second method, Alaska's corporation code provides a
                           shareholder may bring an action to liquidate the assets of a corporation upon a showing
                           that “the acts of the directors or those in control of the corporation are illegal, oppressive
                           or fraudulent....” A shareholder may also seek liquidation when “corporate assets are being
                           misapplied or wasted.” Upon a liquidation of assets all creditors and the cost of liquidation
                           must be paid and the remainder distributed among all the shareholders “according to their
                           respective rights and interests.”
                           a.        Extreme Remedy. Liquidation is an extreme remedy. In a sense, forced
                                     dissolution allows minority shareholder to exercise retaliatory oppression against
                                     the majority. Absent compelling circumstances, courts often are reluctant to order
                                     involuntary dissolution. As a result, courts have recognized alternative remedies
                                     based upon their inherent equitable powers.
                                     (1)        Alternative Remedies. Among those alternative remedies:
                                                (a)       An order requiring the corporation or a majority of its
                                                          stockholders to purchase the stock of the minority shareholders
                                                          at a price to be determined according to a specified formula or
                                                          at a price determined by the court to be a fair and reasonable
                                                          price.
                  4.       Statutory Appraisal. Available under the Alaska Business Corporation Act in two
                           circumstances where there is some fundamental corporate change: (1) the remedy is
                           available upon the merger or consolidation with another corporation; or (2) upon a sale of
                           substantially all of the corporation's assets.
                           a.        De Facto Merger. In some circumstances courts have found that a corporate
                                     transaction so fundamentally changes the nature of the business that there is a “de
                                     facto” merger which triggers the same statutory appraisal remedy.
                  5.       Breach of a Fiduciary Duty Triggers Equitable Remedy. The Massachusetts Supreme Judicial
                           Court, in Donahue v. Rodd Electrotype Co., concluded that shareholders in closely held
                           corporations owe one another a fiduciary duty. 58
                           a.        The California Supreme Court concluded that a controlling group of
                                     shareholders owes a similar duty to minority shareholders. In Jones v. H. F.
                                     Ahmanson & Co. (Cal. 1969), the court held that a controlling block of stock
                                     could not be used to give the majority benefits that were not shared with the
                                     minority.
                           b.        W e believe that Donahue and Ahmanson correctly state the law applicable to the
                                     relationship between shareholders in closely held corporations, or between those
                                     holding a controlling block of stock, and minority shareholders. W e do not
                                     believe, though, that the existence and breach of a fiduciary duty among
                                     corporate shareholders supports the appraisal remedy ordered by the trial court in
                                     this case.


         58
            “Because of the fundamental resemblance of the close corporation to the partnership, the trust and
confidence which are essential to this scale and manner of enterprise, and the inherent danger to minority interests in
the close corporation, we hold that stockholders in the close corporation owe one another substantially the same
fiduciary duty in the operation of the enterprise that partners owe to one another. In our previous decisions, we have
defined the standard of duty owed by partners to one another as the ‘utmost good faith and loyalty.’ ” Donahue.

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     6.       Trial Court’s Remedy Inappropriate. W e are not aware of any authority which would allow a
              court to order specific performance on the basis of an unaccepted offer, particularly on
              terms totally different from those offered. Such a rule would place a court in the impossible
              position of making and enforcing contracts between unwilling parties.
              a.          Appropriate Remedy–Equal Opportunity. Donahue and Ahmanson suggest the
                          appropriate form of a remedy, however. In Donahue the court stated that where a
                          controlling shareholder took advantage of a special benefit, the fiduciary duty
                          owed to the other shareholders required that the corporation offer such a benefit
                          equally: “The rule of equal opportunity in stock purchases by close corporation
                          provide equal access to these benefits for all stockholders.”
     7.       Derivative Suit Claim/Business Judgment Rule. Judges are not business experts, a fact which
              has become expressed in the so-called “business judgment rule.” The essence of that
              doctrine is that courts are reluctant to substitute their judgment for that of the board of
              directors unless the board’s decisions are unreasonable.
              a.          Unfair Distribution of Corp. Funds W ill Trump Bus. Judg. Rule. If a stockholder is
                          being unjustly deprived of dividends that should be his, a court of equity will not
                          permit management to cloak itself in the immunity of the business judgment rule.
                          Thus, there is authority for concluding that an unfair distribution of corporate
                          funds would be a proper subject for a derivative suit.
C.   Meiselman v. Meiselman (N.C. 1983).
     1.       North Carolina statute allowed a court to order dissolution where such relief was
              “reasonably necessary for the protection of the rights and interests of the complaining
              shareholder.” As an alternative, the court could order a buy-out of the complaining
              shareholder’s shares.
     2.       Reasonable Expectations. The Supreme Court held that, at least in cases involving close
              corporations, the complaining shareholder need not establish oppressive or fraudulent
              conduct by the controlling shareholder or shareholders. Instead, “rights and interest,”
              under the statute include “reasonable expectations,” which include expectations that the
              minority shareholder will participate in the management of the business or be employed by
              the company but limited to expectations embodied in understandings, express or implied,
              among the participants.
D.   Note on Limited Liability Companies
     1.       Under the Delaware Limited Liability Co. Act § 18-604:
              [U]pon resignation any resigning member is entitled to receive any distribution to which such member
              is entitled under a limited liability company agreement and, if not otherwise provided in a limited
              liability company agreement, such member is entitled to receive, within a reasonable time after
              resignation, the fair value of such member's limited liability company interest as of the date of
              resignation based upon such member's right to share in distributions from the limited liability
              company.
     2.       Thus, while in a corporation the default rule generally will be one of no right of
              dissolution or buyout, under the LLC default rule members are granted that right.
E.   Haley v. Talcott (Del. Ch. 2004).
     1.       Facts. Haley and Talcott were members of Greg Real Estate, LLC, which owned the land
              that a second company, Delaware Seafood (a.k.a. Redfin Grill), occupied. Haley and
              Talcott chose to create and operate the Redfin Grill as an entity solely owned by Talcott.
              However, due to a series of contracts between the two, the relationship was more similar
              to a partnership than a typical employer/employee relationship. The business grew into a
              profitable one. The two parties exercised an option to purchase the land on which the
              business was situated and both signed personal guaranties for the mortgage. A rift evolved
              between the two due to Haley’s expectance to receive a share in the Redfin Grill. Letters
              were exchange, revolving around Haley’s alleged resignation. A stalemate ensued due to
              Haley’s mere 50% interest in the LLC. While the agreement contained a detailed exit
              mechanism, it did not express any details about releasing the party from the personal
              guaranty or whether the party could resort to judicial dissolution in lieu of the exit

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                            mechanism. Therefore, Haley sought judicial dissolution of the LLC.
                  2.        Section 18-802 provides in its entirety:
                            On application by or for a member or manager the Court of Chancery may decree dissolution of a
                            limited liability company whenever it is not reasonably practicable to carry on the business in
                            conformity with a limited liability company.
                            a.         Section 18-802 of the Delaware LLC Act plays a role for LLCs similar to the role
                                       that § 273 of the Delaware General Corporation Law plays for joint venture
                                       corporations with only two stockholders. 59
                                       (1)        Section 273 essentially sets forth three pre-requisites for a judicial order
                                                  of dissolution: 1) the corporation must have two 50% stockholders; 2)
                                                  those stockholders must be engaged in a joint venture; and 3) they must
                                                  be unable to agree upon whether to discontinue the business or how to
                                                  dispose of its assets.
                  3.        The Delaware LLC Act is grounded on principles of freedom of contract. For that reason,
                            the presence of a reasonable exit mechanism bears on the propriety of ordering dissolution
                            under § 18-802.
                            a.         W hen the agreement itself provides a fair opportunity for the dissenting member
                                       who disfavors the inertial status quo to exit and receive the fair market value of
                                       her interest, it is at least arguable that the limited liability company may still
                                       proceed to operate practicably under its contractual charter because the charter
                                       itself provides an equitable way to break the impasse.
                                       (1)        In In re Delaware Bay Surgical Services, the court declined to dissolve a
                                                  corporation under § 273 in part because a mechanism existed for the
                                                  repurchase of the complaining members 50% interest. But this matter
                                                  differs from Surgical Services:
                                                  (a)        The court in Surgical Services found that both parties clearly
                                                             intended, upon entering the contract, that if the parties ended
                                                             their contractual relationship, the respondent would be the one
                                                             permitted to keep the company.
                                                  (b)        By contrast, no such obvious priority of interest exists here.
                                                             Haley and Talcott created the LLC together and while the
                                                             detailed exit provision provided in the formative LLC
                                                             agreement allows either party to leave voluntarily, it provides
                                                             no insight on who should retain the LLC if both parties would
                                                             prefer to buy the other out, and neither party desires to leave.
                                                  (c)        In this case, forcing Haley to exercise the contractual exit
                                                             mechanism would not permit the LLC to proceed in a
                                                             practicable way that accords with the LLC Agreement, but
                                                             would instead permit Talcott to penalize Haley without expres
                                                             contractual authorization.




         59
              The relevant portion of § 273(a) reads: If the stockholders of a corporation of this State, having only 2
stockholders each of which own 50% of the stock therein, shall be engaged in the prosecution of a joint venture and if
such stockholders shall be unable to agree upon the desirability of discontinuing such joint venture and disposing of
the assets used in such venture, either stockholder may, unless otherwise provided in the certificate of incorporation of
the corporation or in a written agreement between the stockholders, file with the Court of Chancery a petition stating
that it desires to discontinue such joint venture and to dispose of the assets used in such venture in accordance with a
plan to be agreed upon by both stockholders or that, if no such plan shall be agreed upon by both stockholders, the
corporation be dissolved.

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                                                      60
         F.       Pedro v. Pedro (Minn. App. 1992).
                  1.        Closely Held Corp. Shareholders Analogous to Partners. The relationship among shareholders
                            in closely held corporations is analogous to that of partners. Shareholders in closely held
                            corporations owe one another a fiduciary duty. In a fiduciary relationship “the law imposes
                            upon them highest standards of integrity and good faith in their dealings with each other.”
                            Owing a fiduciary duty includes dealing “openly, honestly and fairly with other
                            shareholders.”
                  2.        Inasmuch as appellants’ breaches of fiduciary duty forced the buyout, they cannot benefit
                            from wrongful treatment of their fellow shareholder and must disgorge any such gain.
                            a.        Breach of Fiduciary Duty. Appellants claim no breach of fiduciary duty can exist
                                      because there has been no diminution in the value of the corporation or the stock
                                      value of respondent's shares. In support of this assertion, appellants cite several
                                      cases where actions by an officer or director did reduce the value of the
                                      corporation, constituting a breach of fiduciary duty.
                                      (1)        An action depleting a corporation's value is not the exclusive method of
                                                 breaching one's fiduciary duties. Moreover, loss in value of a
                                                 shareholder's stock is not the only measure of damages.
                  3.        Damages Calculation. Moreover, the measure of damages for the buyout was proper.
                            a.        If the fair value of the shares is greater than the purchase price for the buyout as
                                      calculated from the formula in the SRA, the difference is the measure of
                                      respondent's damage resulting from having been forced to sell his shares in the
                                      company.
                  4.        Lifetime Employment. Minnesota statute provides, “In determining whether to order
                            equitable relief, dissolution, or a buy-out, the court shall take into consideration the duty
                            which all shareholders in a closely held corporation owe one another to act in an honest,
                            fair and reasonable manner in the operation of the corporation and the reasonable
                            expectations of the shareholders as they exist at the inception and develop during the
                            course of the shareholders' relationship with the corporation and with each other.”
                            a.        Employment Part of Reasonable Expectations. This section allows courts to look to
                                      respondent's reasonable expectations when awarding damages. In addition to an
                                      ownership interest, the reasonable expectations of such a shareholder are a job,
                                      salary, a significant place in management, and economic security for his family.
                            b.        Double Recovery? Even appellants concede respondent has two separate interests,
                                      as owner and employee. Thus, allowing recovery for each interest is appropriate
                                      and will not be considered a double recovery.
         G.       Stuparich v. Harbor Furniture Mfg., Inc. (Cal. App. 2000).
                  1.        Issue. The issue is whether plaintiffs raised a triable issue of material fact as to whether
                            dissolution is “reasonably necessary” to protect their rights or interests.
                  2.        On this undisputed record, we cannot say that the trial court erred in finding as a matter of
                            law, that the drastic remedy of liquidation is not reasonably necessary for the protection of
                            the rights or interests of the complaining shareholder or shareholders.
VI.      Transfer of Control
         A.       Frandsen v. Jensen-Sundquist Agency, Inc. (7th Cir. 1986).
                  1.        Merger Not a Sale. A sale of stock was never contemplated. The transaction originally
                            contemplated was a merger of Jensen-Sundquist into First W isconsin. In a merger, as the
                            word implies, the acquired firm disappears as a distinct legal entity. In effect, the
                            shareholders of the merged firm yield up all of the assets of the firm, receiving either cash
                            or securities in exchange, and the firm dissolves. In this case, the shareholders would have


          60
              The result in this case is curious because the court finds a breach of fiduciary duty to make up the
difference between the SRA buyout price and the fair market value of the shares. The Minnesota statute, however,
explicitly states that the court may order a buy-out of the shares of either party at “fair value” is “those in control have
acted fraudulently, illegally, or in a manner unfairly prejudicial toward one or more shareholders.”

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               received cash. Their shares would have disappeared but not by sale, for in a merger the
               shares of the acquired firm are not bought, they are extinguished.
               a.         The distinction between a sale or shares and a merger is such a familiar one in the
                          business world that it is unbelievable that so experienced a businessman as
                          Frandsen would have overlooked it.
               b.         A sale of the majority bloc’s shares is not the same thing as a sale of either all or
                          some of the holding company’s assets. The sale of assets does not result in
                          substituting a new majority bloc, and that is the possibility at which the protective
                          provisions are aimed.
B.   Zetlin v. Hanson Holdings, Inc. (N.Y. 1979).
     1.        Premium Price for Majority Shares. Absent looting of corporate assets, conversion of a
               corporate opportunity, fraud or other acts of bad faith, a controlling shareholder is free to
               sell, and a purchaser is free to buy, that controlling interest at a premium price.
               a.         Premium Price is for Privilege of Controlling Corp. Certainly, minority shareholders
                          are entitled to protection against such abused by controlling shareholders. They
                          are not entitled, however, to inhibit the legitimate interests of the other
                          stockholders. It is for this reason that control shares usually command a premium
                          price. The premium is the added amount an investor is willing to pay for the
                          privilege of directly influencing the corporation’s affairs.
C.   Perlman v. Feldmann (2d. Cir. 1955).
     1.        Facts. Feldmann owned 32% of the shares of Newport Steel and sold his shares for $20 per
               share–a two-thirds premium over the then-market price of $12. A minority shareholder
               brought a derivative suit claiming Feldmann had sold a corporate asset, namely Newport’s
               steel supplies, during the Korean W ar’s steel shortage, when steel prices were controlled
               and access to steel commanded a premium. Feldmann had invented a way to skirt the
               price controls (known in the industry as the “Feldmann Plan”) by having buyers make
               interest-free advances to obtain supply commitments. The buyer (W ilport), a syndicate of
               steel end-users, wanted Newport’s steel supplies free of the Feldmann plan. The court
               held that Feldmann had breached a fiduciary duty to the corporation because his sale of
               control sacrificed the favorable cash flow generated by the Feldmann Plan.
     2.        Both as director and as dominant stockholder, Feldmann stood in a fiduciary relationship
               to the corporation and to the minority stockholders as beneficiaries thereof.
     3.        It is true that this is not the ordinary case of breach of fiduciary duty. W e have here no
               fraud, no misuse of confidential information, no outright looting of a helpless corporation.
               a.         But on the other hand, we do not find compliance with that high standard which
                          we have just stated and which we and other courts have come to expect and
                          demand of corporate fiduciaries. The actions of defendants in siphoning off for
                          personal gain corporate advantages to be derived from a favorable market
                          situation do not betoken the necessary undivided loyalty owed by the fiduciary to
                          his principal.
               b.         W e do not mean to suggest that a majority stockholder cannot dispose of his
                          controlling bloc to outsiders without having to account to his corporation for
                          profits or even never do this with impunity the buyer is an interested customer,
                          actual or potential, for the corporation’s product. But when the sale necessarily
                          results in a sacrifice of this element of corporate good will and consequent
                          unusual profit to the fiduciary who has caused the sacrifice, he should account for
                          his gains.
               c.         So in a time of market shortage, where a call on a corporation’s product
                          commands an unusually large premium, in one form or another, we think it
                          sound law that a fiduciary may not appropriate to himself the value of this
                          premium.
     4.        Dissent. Concededly, a majority or dominant shareholder is ordinarily privileged to sell his
               stock at the best price obtainable from the purchaser. In so doing he acts on his own
               behalf, not as an agent of the corporation. If he knows or has reason to believe that the

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             purchaser intends to exercise to the detriment of the corporation the power of
             management acquired by the purchase, such knowledge and reasonable suspicion will
             terminate the dominant shareholder’s privilege to sell and will create a duty not to transfer
             the power of management to the purchaser.
D.   Essex Universal Corp. v. Yates (2d. Cir. 1962).
     1.      Illegal to Sell Office W ithout Sufficient Stock. It is established beyond question under New
             York law that it is illegal to sell corporate officer or management control by itself (that is,
             accompanied by no stock or insufficient stock to carry voting control). The same rule
             apparently applies in all jurisdictions where the question has arisen.
             a.         Rationale. The rationale of the rule is indisputable: persons enjoying management
                        control hold it on behalf of the corporation’s stockholders, and therefore may not
                        regard it as their own personal property to dispose of as they wish.
     2.      There is no question of the right of a controlling shareholder under New York law
             normally to derive a premium from the sale of a controlling block of stock. In other
             words, there was no impropriety per se in the fact that Yates was to receive more per share
             than the generally prevailing market price for Republic stock.
     3.      Issue. W hether it is legal to give and receive payment for the immediate transfer of
             management control to one who has achieved majority share control but would not
             otherwise be able to convert that share control into operating control for some time.
             a.         The easy and immediate transfer of corporate control to new interests is ordinarily
                        beneficial to the economy and it seems inevitable that such transactions would be
                        discouraged if the purchaser of a majority stock interest were require to wait
                        some period before his purchase of control could become effective. Conversely,
                        it would greatly hamper the efforts of any existing majority group to dispose of its
                        interest if it could not assure the purchaser of immediate control over corporation
                        operations.
             b.         If Essex was contracting to acquire what in reality would be equivalent to
                        ownership of a majority of stock, i.e., if it would as a practical certainty have been
                        guaranteed of the stock voting power to choose a majority of the directors of
                        Republic in due course, there is no reason why the contract should not similarly
                        be legal. W hether Essex was thus to acquire the equivalent of majority stock
                        control would, if the issue is properly raised by the defendants, be a factual issue
                        to be determined by the district court on remand.
                        (1)         Because 28.3 percent of the voting stock of a public held corporation is
                                    usually tantamount to majority control, I would place the burden of
                                    proof on this issue on Yates as the party attacking the legality of the
                                    transaction.
     4.      Concurrence #1 (J. Clark). Prefer to avoid too precise instructions to the district court in
             the hope that if the action again comes before us the record will be generally more
             instructive on this important issue than it is now (a case-by-case approach).
     5.      Concurrence #2 (J. Friendly). I have no doubt that many contracts, drawn by competent
             counsel and responsible counsel, for the purchase of blocks of stock from interests thought
             to “control” a corporation although owning less than a majority, have contained
             provisions like paragraph 6 of the contract sub judice.
             a.         However, developments over the past decades seems to me to show that such a
                        clause violates basic principle of corporate democracy. To be sure, stockholders
                        who have allowed a set of directors to be placed in office, whether by their vote
                        or their failure to vote, must recognize that death, incapacity or other hazard may
                        prevent a director from serving a full term, and that they will have no voice as to
                        his immediate successor.
                        (1)         But the stockholders are entitled to expect that, in that event, the
                                    remaining directors will fill the vacancy in the exercise of their fiduciary
                                    responsibility. A mass seriatim resignation directed by a selling
                                    stockholder, and the filling of vacancies by his henchman at the dictation

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                                                 of a purchaser and without any consideration of the character of the
                                                 latter’s nominees, are beyond what the stockholders contemplated or
                                                 should have expected to contemplate.
         E.      Classified Board. A classified board is one for which different classes of stock elect different sets of
                 directors. Contrast this with a staggered board, as was the one set out in the facts of Essex.
         F.      DeBaun v. First W estern Bank and Trust Company (Cal App. 1975).
                 1.         Early Law. Early case law held that a controlling shareholder owed no duty to minority
                            shareholders or to the controlled corporation in the sale of his stock.
                            a.         Now Controlling Shareholder Must Exercise Good Faith & Fairness. Decisional law
                                       has since recognized the fact of financial life that corporate control by ownership
                                       of a majority of shares may be misused. Thus the applicable proposition now is
                                       that in any transaction where the control of the corporation is material, the
                                       controlling majority shareholder must exercise good faith and fairness from the
                                       viewpoint of the corporation and those interested therein.
                 2.         Duty of Good Faith Encompasses Recognizing Potential Looter. That duty of good faith and
                            fairness encompasses an obligation of the controlling shareholder in possession of fact such
                            as to awaken suspicion and put a prudent man on his guard (that a potential buyer of his
                            shares may loot the corporation of its assets to pay for the shares purchased) to conduct a
                            reasonable adequate investigation (of the buyer).
C H A PTER S EVEN : M ER G ER S , A CQ U ISITIO N S , A N D T AK EO VER S
I.       Mergers and Acquisitions61
         A.      The DeFacto Merger Doctrine
                 1.         Statutory Merger. A statutory merger is a combination accomplished by using a procedure
                            described in the state corporation laws (most of which are essentially the same in this
                            respect). Under a statutory merger the terms of merger are spelled out in a document
                            called a merger agreement, drafted by the parties, which prescribes, among other things,
                            the treatment of the shareholders or each corporation. Considerable flexibility is available.
                            a.         Approval Required. If the statutory merger procedure is used, approval by votes of
                                       the boards of directors and shareholders of each of the two corporations is
                                       required.
                            b.         Appraisal Right for Non-Approving Shareholders (Dissenter’s Rights). In addition,
                                       shareholders of each corporation who voted against the merger would have been
                                       entitled to demand that they be paid in cash the fair value of their shares
                                       (determined by agreement or, failing agreement, by a judicial proceeding). This
                                       right to be paid off is called the “appraisal right.”
                 2.         Practical Mergers. These acquisitions do not use the statutory procedure.
                            a.         Short Form Merger. Corp. A would offer its shares to Corp. B shareholders in
                                       return for their shares of Corp. B. Corp. A would seek to acquire enough shares
                                       to gain control of Corp. B (and the offer could be made contingent on that
                                       outcome). No votes of the shareholders and directors of Corp. B would be
                                       required since the transaction would be between Corp. A and the individual
                                       stockholders of Corp. B. Neither would there be any appraisal rights. Once it
                                       gained sufficient control (typically 90%), Corp. A could use a special procedure, a
                                       short form merger, to merge Corp. B into Corp. A.
                                       (1)       Corp. A might also acquire the shares of Corp. B for cash. It might also
                                                 use a subsidiary to accomplish the acquisition. The common element
                                                 would be a sale by the individual Corp. B shareholders for their shares,
                                                 for share of Corp. A, or for cash.
                            b.         Assets Acquisition. Corp. A buys all of the assets of Corp. B for stock (or for cash).
                                       Here, Corp. A would deal with Corp. B rather than with its shareholders.



         61
              See also Handout on Mergers and Acquisitions: Diagrams.

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                                      (1)       One advantage of assets acquisition is that the acquiring corporation does
                                                not succeed to unforeseen liabilities of the acquire corporation as it
                                                would under a statutory merger. (Known liabilities will be satisfied by
                                                the seller or assumed by the buyer and taken into account in the
                                                purchase price).
                                                (a)        There is authority, however for holding an acquiring
                                                           corporation in an assets acquisition liable for product liabilities
                                                           of the acquired corporation that did not arise until years after
                                                           the asset transfer. See, e.g., Knapp v. North American Rockwell
                                                           Corp. (3d. Cir. 1974).
                                      (2)       Corp B will be left with nothing but shares of Corp. A. Ordinarily, it
                                                would then liquidate and distribute the share to its shareholders. Corp.
                                                B would cease to exist.
                   3.       Farris v. Glen Alden Corporation (Pa. 1958). 62
                            a.        Facts. Glen Alden acquired the assets of List in a stock-for-assets exchange
                                      approved by both companies’ boards and the List shareholders, but not the Glen
                                      Alden shareholders. The transaction doubles the assets of Glen Alden, increased
                                      its debt sevenfold, and left its shareholders in a minority position. To
                            b.        W hen use of the corporate form of business organization first became widespread,
                                      it was relatively easy for courts to define a “merger” or a “sale of assets” and to
                                      label a particular transaction as one or the other.
                                      (1)       But prompted by the desire to avoid the impact of adverse, and to
                                                obtain the benefits of favorable, government regulations, particularly
                                                federal tax laws, new accounting and legal techniques were developed by
                                                lawyers and accountants which interwove the elements characteristic of
                                                each, thereby creating hybrid forms of corporate amalgamation. Thus, it
                                                is no longer helpful to consider an individual transaction in the abstract
                                                and solely by reference to the various elements therein determine
                                                whether it is a “merger” or a “sale.”
                                      (2)       Instead, to determine properly the nature of a corporate transaction, we
                                                must refer not only to all the provisions of the agreement, but also to the
                                                consequences of the transaction and to the purposes of the provisions of
                                                corporate law said to be applicable.
                            c.        Appraisal Rights. Section 908(A) of the Penn. Bus. Corp. Law provides: “If any
                                      shareholder of a domestic corporation which becomes a party to a plan or merger
                                      or consolidation shall object to such plan of merger or consolidation, such
                                      shareholder shall be entitled to ... [the fair value of his shares upon surrender of
                                      the share certificate or certificates representing his shares].”
                            d.        Fundamental Change? Does the combination outlined in the present
                                      “reorganization” agreement so fundamentally change the corporate character of
                                      Glen Alden and the interest of the plaintiff as a shareholder therein, that to refuse
                                      him the rights and remedies of a dissenting shareholder would in reality force him
                                      to give up his stock in one corporation and against his will accept shares in
                                      another?
                                      (1)       If so, the combination is a merger within the meaning of the corporation


         62
              Glen Alden was incorporated in Pennsylvania and List in Delaware. Delaware law at the time provided
that a sale of substantially all of the assets of List required the approval of a majority of the List shareholders, but the
List shareholders did not have appraisal rights. Under Pennsylvania law, if Glen Alden had sold it assets to List,
approval by a majority of the Glen Alden shareholders would have been required and dissenting shareholders would
have had appraisal rights. Under present Delaware law, appraisal is not available in a merger if the shares relinquished
are “(i) listed in a national securities exchange or (ii) held of record by more than 2,000 stockholders,” and if the
shares received have similar characteristics (e.g., voting and dividend rights). Del. Gen. Corp. Law § 262(b)(1).

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                                               law.
                            e.       The amendments do not provide that a transaction between two corporations
                                     which has the effect of a merger but which includes a transfer of assets for
                                     consideration is to be exempt from the protective provisions of the statute. They
                                     provide only that the shareholders of a corporation which acquires the property
                                     or purchases the assets of another corporation, without more, are not entitled to the
                                     right to dissent from the transaction.
                  4.      Hariton v. Arco Electronics (Del. 1963). 63
                          a.         Equal Dignities. The sale-of-assets statute and the merger statute are independent
                                     of each other. They are, so to speak, of equal dignity, and the framers of a
                                     reorganization plan may resort to either type of corporate mechanics to achieve
                                     the desired end. This is not an anomalous result in our corporation law.
         B.       Freeze-Out Mergers
                  1.      Tender Offers. A tender offer is a public offer made by a bidder to a target’s shareholders, in
                          which the bidder offers a substantial premium above market price for most or all of the
                          target’s shares.
                          a.         Oversubscribed. More shareholder tender their stock than needed. The wanted
                                     shares have to be purchased pro-rata.
                  2.      Authorized, Issued, & Outstanding. Shares are (1) authorized by the articles of incorporation;
                          (2) issued, meaning they have at some time been sold by the corporation to an investor; or
                          (3) outstanding, meaning that the stock is currently owned by someone other than the
                          corporation.
                          a.         Authorized, Issued But Not Outstanding. “Treasury stock.”
                  3.      W einberger v. UOP, Inc. (Del. Sup. 1983).
                          a.         The plaintiff in a suit challenging a cash-out merger must allege specific acts of
                                     fraud, misrepresentation, or other items of misconduct to demonstrate the
                                     unfairness of the merger terms to the minority.
                          b.         The ultimate burden of proof is on the majority shareholder to show by a
                                     preponderance of the evidence that the transaction is fair. Nevertheless, it is first
                                     the burden of the plaintiff attacking the merger to demonstrate some basis for
                                     invoking the fairness obligation.
                                     (1)       However, where corporate action has been approved by an informed
                                               vote of a majority of the minority shareholders, we conclude that the
                                               burden entirely shifts to the plaintiff to show that the transaction was
                                               unfair to the minority.
                                     (2)       But in all this, the burden clearly remains on those relying on the vote to
                                               show that they completely disclosed all material facts relevant to the
                                               transaction.
                          c.         In considering the nature of the remedy available under our law to minority
                                     shareholders in a cash-out merger, we believe that it is, and hereafter should be,
                                     an appraisal under 8 Del.C. § 262 as hereinafter construed.
                          d.         Complete Candor. In assessing this situation, the Court of Chancery was required
                                     to: examine what information defendants had and to measure it against what they
                                     gave to the minority stockholders, in a context in which “complete candor” is
                                     required. In other words, the limited function of the Court was to determine
                                     whether defendants had disclosed all information in their possession germane to
                                     the transaction in issue. And by “germane” we mean, for present purposes,
                                     information such as a reasonable shareholder would consider important in decided
                                     whether to sell or retain stock.


          63
              Most courts have rejected the de facto merger doctrine and have refused to imply merger-type protection
for shareholders when the statute does not provide it. In fact, in many states where courts have used the de facto merger
analysis, the legislature has later abolished the doctrine by statute.

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                                      (1)      Completeness, not adequacy, is both the norm and the mandate under
                                               present circumstances.
                                      (2)      This is merely stating in another way the long-existing principle of
                                               Delaware law that these Signal designated directors on UOP’s board still
                                               owed UOP and it shareholders and uncompromising duty of loyalty.
                            e.        There is no “safe harbor” for such divided loyalties in Delaware. W hen directors
                                      of a Delaware corporation are on both sides of a transaction, they are required to
                                      demonstrate their utmost good faith and the most scrupulous inherent fairness of
                                      the bargain.
                            f.        The concept of fairness has two basic aspects: fair dealing and fair price. 64
                                      (1)      Fair Dealing. The former embraces questions of when the transaction
                                               was time, how it was initiated, structured, negotiated, disclosed to the
                                               directors, and how the approvals of the directors and the stockholders
                                               were obtained.
                                               (a)        Part of fair dealing is the obvious duty of candor required by
                                                          Lynch I. Moreover, one possessing superior knowledge may
                                                          not mislead any stockholder by use of corporate information to
                                                          which the latter is not privy.
                                                          i)          Delaware has long imposed this duty even upon
                                                                      person who are not corporate officers or directors, but
                                                                      who nonetheless are privy to matters of interest or
                                                                      significance to their company.
                                      (2)      Fair Price. The latter aspect of fairness relates to the economic and
                                               financial considerations of the proposed merger, including all relevant
                                               factors: assets, market value, earnings, future prospects, and any other
                                               elements that affect the intrinsic or inherent value of a company’s stock.
                                               (a)        Delaware Block/W eighted Average Method. Elements of value,
                                                          i.e., assets, market price, earnings, etc., were assigned a
                                                          particular weight and the resulting amounts added to determine
                                                          the value per share. This procedure has been used for decades.
                                                          i)          However, to the extent that it excludes other
                                                                      generally accepted techniques used in the financial
                                                                      community and the court, it is now clearly outmoded.
                                                                      It is time we recognize this in appraisal and other
                                                                      stock valuation proceedings and bring out law current
                                                                      on the subject.
                                               (b)        More Liberal Approach. W e believe that a more liberal approach
                                                          must include proof of value by any techniques or methods
                                                          which are generally considered acceptable in the financial
                                                          community and otherwise admissible in court, subject only to
                                                          our interpretation of 8 Del.C. § 262(h). 65
                                                          i)          Fair price obviously requires consideration of all



         64
            Not Bifurcated. The test for fairness is not a bifurcated on as between fair dealing and price. All aspects of
the issue must be examined as a whole since the question is one of entire fairness. However, in a non-fraudulent
transaction we recognize that price may be the preponderant consideration outweighing other features of the merger.
Here, the court addresses the two basic aspects of fairness separately because it finds error as to both.

          65
             The Court of Chancery “shall appraise the shares, determining their fair value exclusive of any element of
value arising from the accomplishment or expectation of the merger, together with a fair rate of interest, if any, to be
paid upon the amount determined to be the fair value. In determining such fair value, the Court shall take into
account all relevant factors. (emphasis added).

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                                            relevant factors involving the value of a company.
                       (c)        No Limitation On Other Relief. W hile a plaintiff’s monetary
                                  remedy ordinarily should be confined to the more liberalized
                                  appraisal proceeding herein established, we do not intend any
                                  limitation on the historic powers of the Chancellor to grant
                                  such other relief as the facts of a particular case may dictate.
                                  i)        The appraisal remedy we approve may not be
                                            adequate in certain cases, particularly where fraud,
                                            misrepresentation, self-dealing, deliberate waste of
                                            corporate assets, or gross or palpable overreaching are
                                            involved.
     g.       No Business Purpose. In view of the fairness test which has long been applicable to
              parent-subsidiary mergers, the expanded appraisal remedy now available to
              shareholders, and the broad discretion of the Chancellor to fashion such relief as
              the facts of a given case may dictate, we do not believe that any additional
              meaningful protection is afforded minority shareholders by the business purpose
              requirement. Accordingly, such requirement shall no longer be of any force or
              effect.
4.   Coggins v. New England Patriots Football Club, Inc. (Mass. 1986).
     a.       In Singer v. Magnavox Co. (Del. 1977), the Delaware court established the so-
              called “business-purpose” test, holding that controlling stockholders violates their
              fiduciary duties when they “cause a merger to be made for the sole purpose of
              eliminating a minority on a cash-out basis.”
              (1)       In 1983, Delaware jettisoned the business-purpose test, satisfied that the
                        “fairness” test, long applicable to parent-subsidiary mergers, the
                        expanded appraisal remedy now available to stockholders, and the broad
                        discretion of the Chancellor to fashion such relief as the facts of a given
                        case may dictate, provided sufficient protection to the frozen-out
                        minority. W einberger v. UOP, Inc. (Del. 1983).
                        (a)       Business Purpose Test Still Applicable in Mass. Unlike the
                                  Delaware court, however, we believe that the “business-
                                  purpose” test is an additional useful means under our statutes
                                  and case law for examining a transaction in which a controlling
                                  stockholder eliminates the minority interest in a corporation.
                                  This concept of fair dealing is not limited to close corporations
                                  but applies to judicial review of cash freeze-out mergers.
     b.       A controlling stockholder who is also a director standing on both sides of the
              transaction bears the burden of showing that the transaction does not violate
              fiduciary obligations. Judicial inquiry into a freeze-out merger in technical
              compliance with the statute may be appropriate, and the dissenting stockholders
              are not limited to the statutory remedy of judicial appraisal where violations of
              fiduciary duty are found.
              (1)       Judicial scrutiny should begin with recognition of the basic principle that
                        the duty of a corporate director must be to further the legitimate goals of
                        the corporation. The result of a freeze-out merger is the elimination of
                        public ownership in the corporation. The controlling faction increases
                        its equity from a majority to 100%, using corporate processes and
                        corporate assets.
              (2)       The corporate directors who benefit from this transfer of ownership
                        must demonstrate how the legitimate goals of the corporation are
                        furthered. A director of a corporation violates his fiduciary duty when
                        he uses the corporation for his or his family’s personal benefit in a
                        manner detrimental to the corporation.
                        (a)       W hile we have recognized the right to “selfish ownership” in a

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                                                      corporation, such a right must be balanced against the concept
                                                      of the majority stockholder’s fiduciary obligation to the
                                                      minority shareholders.
                                 (3)       Because the danger of abuse of fiduciary duty is especially great in a
                                           freeze-out merger, the court must be satisfied that the freeze-out was for
                                           the advancement of a legitimate corporate purpose.
                                 (4)       If satisfied that elimination of public ownership is in furtherance of a
                                           business purpose, the court should then proceed to determine if the
                                           transaction was fair by examining the totality of the circumstances.
                         c.      The normally appropriate remedy for an impermissible freeze-out merger is
                                 rescission.
                                 (1)       Because Massachusetts statutes do not bar a cash freeze-out, however,
                                           numerous third parties relied in good faith on the outcome of the
                                           merger.
                                 (2)       The passage of time has made the 1976 position of the parties difficult, if
                                           not impossible, to restore.
                                 (3)       In these circumstances, the interests of the corporation and of the
                                           plaintiffs will be furthered best by limiting the plaintiffs’ remedy to an
                                           assessment of damages.
                         d.      Rescissory damages must be determined based on the present value of the
                                 Patriots, that is, what the stockholders would have if the merger were rescinded.
        C.       De Facto Non-Merger*
        D.       LLC Mergers
                 1.      VGS, Inc. v. Castiel (Del. Ch. 2000).
                         a.      Castiel formed VGS, LLC for the purpose of pursuing a FCC license to build and
                                 operate a satellite system. The LLC had only one member, VGS Holdings, Inc.
                                 Ellipso, Inc. joined as a second member, followed by Sahagen, LLC as a third
                                 member.66 The units were distributed as follows: 660 units to Holdings, 260
                                 units to Sahagen and 120 units to Ellipso. Castiel had the power to appoint,
                                 remove, and replace 2 of the 3 members of the Board of Managers. Castiel
                                 named himself and Tom Quinn. Sahagen named himself as the third member of
                                 the Board. Disagreements between Castiel and Sahagen soon arose about how to
                                 manage the LLC. Sahagen convinced Quinn to oust Castiel and together they
                                 acted by written consent to merge the LCC into VGS, Inc. The LCC ceased to
                                 exist and its assets and liabilities passed to VGS. The incorporators did not name
                                 Castiel to the board of the corporation. 67
                         b.      Section 18-404(d) of the LCC Act states in pertinent part:
                                           Unless otherwise provided in a limited liability company agreement, on any
                                           matter that is to be voted on by manager, the managers may take such action
                                           without a meeting, without prior notice and without a vote if a consent or
                                           consents in writing, setting forth the action so taken, shall be signed by the
                                           managers having not less than the minimum number of votes that would be
                                           necessary to authorize such action at a meeting.
                                 (1)       Therefore, the LLC Act, read literally, does not require notice to Castiel



        66
            Castiel controlled both Holdings and Ellipso. Sahagen, LLC was controlled by Peter Sahagen, an
aggressive venture capitalist.

         67
            On the same day as the merger, Sahagen executed a promissory note to the corporation in exchange for
two million shares of stock. VGS also issued 1,269,200 shares of common stock to Holdings, 230,800 shares of
common stock to Ellipso, and 500,000 shares of common stock to Sahagen Satellite. Thus, Holdings and Ellipso went
from having a 75% interest in the LLC to having only a 37.5% interest in VGS.

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                                           before Sahagen and Quinn could act by written consent. The LLC
                                           Agreement does not purport to modify the statute in this regard.
                                 (2)       Purpose of W ritten Consent. Section 18-404(d) has yet to be interpreted
                                           by this court or the Supreme Court. Nonetheless, it seems clear that the
                                           purpose of permitting action by written consent without notice is to
                                           enable LLC managers to take quick, efficient action in situations where a
                                           minority of managers could not block or adversely affect the course set
                                           by the majority even if they were notified of the proposed action and
                                           objected to it.
                                           (a)       Not Intended to Clandestinely Deprive. The General Assembly
                                                     never intended to enable two managers to deprive,
                                                     clandestinely and surreptitiously, a third manager representing
                                                     the majority interest in the LLC of an opportunity to protect
                                                     that interest by taking action that the third manager’s member
                                                     would surely have opposed if he had knowledge of it.
                                           (b)       Action by W ritten Notice Only By Constant Majority. Application
                                                     of equity requires construction of the statute to allow action
                                                     without notice only by a constant or fixed majority. It cannot
                                                     apply to an illusory, will-of-the wisp majority which would
                                                     implode should notice be given.
                        c.       Duty of Loyalty. Sahagen and Quinn each owed a duty of loyalty to the LLC, its
                                 investors and Castiel, their fellow manager.
                                 (1)       Agreement Doesn’t Rely on Equity Interest Voting. It may seem somewhat
                                           incongruous, but this Agreement allows the action to merge, dissolve or
                                           change to corporate status to be taken by simple majority vote of the
                                           board of managers rather than rely upon the default position of the
                                           statute which requires a majority vote of the equity interest.
                                           (a)       However, Sahagen and Quinn Knew of Castiel’s Control Plan.
                                                     Instead, the drafters made the critical assumption, known to all
                                                     the players here, that the holder of the majority equity interest
                                                     has the right to appoint and remove two managers, ostensibly
                                                     guaranteeing control over a three-member board.
                                           (b)       W hen Sahagen and Quinn, fully recognizing that this was
                                                     Castiel’s protection against actions adverse to his majority
                                                     interest, acted in secret, without notice, they failed to discharge
                                                     their duty of loyalty to him in good faith.
                        d.       Breach of Duty of Loyalty Abrogates Protection of Bus. Judgment Rule. It should be
                                 clear that the actions of Sahagen and Quinn, in their capacity as managers
                                 constituted a breach of their duty of loyalty and that those actions do not,
                                 therefore, entitle them to the benefit or protection of the business judgment rule.
II.   Takeovers
      A.      Introduction
              1.       Cheff v. Mathes (Del. Ch. 1964).
                       a.       Purpose of Entrenchment. In an analogous field, courts have sustained the use of
                                proxy funds to inform stockholders of management’s views upon the policy
                                questions inherent in an election to a board of directors, but have not sanctioned
                                the use of corporate funds to advance the selfish desires of the directors to
                                perpetuate themselves in office.
                       b.       Maintain Proper Business Practices. Similarly, if the action of the board were
                                motivated by a sincere belief that the buying out of the dissident stockholder was
                                necessary to maintain what the board believed to be proper business practices, the
                                board will not be held liable for such decision, even though hindsight indicates
                                the decision was not the wisest course.
              2.       The court in Cheff essentially applies the business judgment rule.

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                           a.      Reasonable Investigation/Plausible Business Purpose. Courts initially dealt with the
                                   takeover dilemma by a judicial slight of hand. To ascertain whether an
                                   entrenchment motive lurked behind a takeover defense, courts adopted a process
                                   oriented standard. The courts accepted defensive action if the incumbent board
                                   could point to a “reasonable investigation” (preferably by outside directors) into a
                                   plausible business purpose for the defense–thus showing the absence of an
                                   entrenchment motive. Once this was done, the challenger bore the difficult
                                   burden of proving the board’s dominant motive was entrenchment.
                  3.     Greenmail. During the ‘80s, the purchase by a corporation of a potential acquirer’s stock,
                         at a premium over the market, came to be called “greenmail.”
                         a.        IRS Response. In 1987, the IRS enacted § 5881 which imposes a penalty tax of
                                   50 percent on the gain from greenmail, which is defined as gain from the sale of
                                   stock that was held for less than two years and sold to the corporation pursuant to
                                   an offer that “was not made on the same terms to all shareholders.”
         B.       Development
                  1.     Two-Tiered Front-Loaded Cash Tender Offer. Ex. P could offer to buy 51 percent of the
                         stock at $65 (the front end), and announce that will thereafter merge S Corp. into his own
                         firm in a transaction that pays $55 cash per share for the remaining 49 percent of the stock
                         (the back end). 68
                  2.     Unocal Corp. v. Mesa Petroleum Co. (Del. 1985).
                         a.        Issue. The validity of a corporation’s self-tender for its own shares which
                                   excludes from participation a stockholder making a hostile tender offer for the
                                   company’s stock.
                         b.        It is now well-established that in the acquisition of its shares a Delaware
                                   corporation may deal selectively with its stockholders, provided the directors have
                                   not acted out of a sole or primary purpose to entrench themselves in office. Cheff
                                   v. Mathes.
                                   (1)       The only difference is that heretofore the approved transaction was the
                                             payment of “greenmail” to a raider or dissident posing a threat to the
                                             corporate enterprise. All other stockholders were denied such favored
                                             treatment, given Mesa’s past history of greenmail, its claims here are
                                             rather ironic.
                         c.        Two-Part Analysis. W hen a board addressed a pending takeover bid it has an
                                   obligation to determine whether the offer is in the best interests of the
                                   corporation and its shareholders.
                                   (1)       Threat to Corporate Policy. There are certain caveats to a proper exercise
                                             of this function. Because of the omnipresent specter that a board may be
                                             acting primarily in its own interests, rather than those of the corporation
                                             and its shareholders, there is an enhanced duty which calls for judicial
                                             examination at the threshold before the protections of the business
                                             judgment rule may be conferred.
                                             (a)       W e must bear in mind the inherent danger in the purchase of
                                                       shares with corporate funds to remove a threat to corporate
                                                       policy when a threat to control is involved. The directors are
                                                       of necessity confronted with a conflict of interest, and an
                                                       objective decision is difficult.
                                             (b)       In the fact of this inherent conflict, directors must show that
                                                       they had reasonable grounds for believing that a danger to
                                                       corporate policy and effectiveness existed because of another


          68
             Hence the term “cash-out merger.” The tender offer is “front-end loaded” because the front end offers a
higher price ($65) than the back end ($55). A two-tiered offer can be “coercive” even if the front end is any-and-all
offer rather than an offer for 51 percent of the stock.

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                                   person’s stock ownership.
                                   i)         However, they satisfy that burden by good faith and
                                              reasonable investigation.
              (2)       Reasonable in Relation to Threat Posed. If a defensive measure is to come
                        within the ambit of the business judgment rule, it must be reasonable in
                        relation to the threat posed. This entails an analysis by the directors of
                        the nature of the takeover bid and its effect on the corporate enterprise.
                        (a)        Examples of such concerns may include: inadequacy of the
                                   price offered, nature and timing of the offer, questions of
                                   illegality, the impact on “constituencies” other than
                                   shareholders (i.e., creditors, customers, employees, and perhaps
                                   even the community generally), the risk of nonconsummation,
                                   and the quality of securities being offered in the exchange.
                        (b)        W hile not a controlling factor, it also seems that a board may
                                   reasonably consider the basic stockholder interests at stake,
                                   including those short term speculators, whose actions may have
                                   fueled the coercive aspect of the offer at the expense of the
                                   long-term investor.
     d.       Fairness. The concept of fairness, while stated in the merger context, is also
              relevant in the area of tender offer law.
3.   Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc. (Del. 1985.
     a.       Business Judgment Rule. If the business judgment rule applies, there is a
              presumption that in making a business decision the directors of a corporation
              acted on an informed basis, in good faith and in the honest belief that the action
              taken was in the best interests of the company.
              (1)       However when a board implements anti-takeover measures there arises
                        the omnipresent specter that a board may be acting primarily in its own
                        interests, rather than those of the corporation and its shareholders.
                        (a)        This potential for conflict places on the directors the burden of
                                   proving that they had reasonable grounds for believing there
                                   was danger to corporate policy and effectiveness, a burden
                                   satisfied by a showing of good faith and reasonable
                                   investigation. In addition, the directors must analyze the
                                   nature of the takeover and its effect on the corporation in order
                                   to ensure balance–that the responsive action taken is reasonable
                                   in relation to the threat posed.
                                   i)         The Rights Plan. Under the circumstances, it cannot
                                              be said that the Rights Plan as employed was
                                              unreasonable, considering the threat posed. Indeed,
                                              the Plan was a factor in causing Pantry Pride to raise
                                              its bids from a low of $42 a share to an eventual high
                                              of $58. At the time of its adoption the Rights Plan
                                              afforded a measure of protection consistent with the
                                              directors’ fiduciary duty in facing a takeover threat
                                              perceived as detrimental to corporate interests.
                                   ii)        Stock Exchange. The directors’ general broad powers
                                              to manage the business and affairs of the corporation
                                              are augmented by the specific authority conferred
                                              under Delaware statute, permitting the company to
                                              deal in its own stock. However, when exercising that
                                              power in an effort to forestall a hostile takeover, the
                                              board’s actions are strictly held to the fiduciary
                                              standards outline in Unocal.
                                              a)         These standards require the directors to

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                                                determine the bests interests of the
                                                corporation and its stockholders, and impose
                                                an enhanced duty to abjure any action that is
                                                motivated by consideration other than a
                                                good faith concern for such interests.
b.   W hen Pantry Pride increased its offers, it became apparent to all that the break-
     up of the company was inevitable. The significantly altered the board’s
     responsibilities under the Unocal standards. It no longer faced threats to corporate
     policy and effectiveness, or to the stockholders’ interests, from a grossly
     inadequate bid.
     (1)        The directors’ role changed from defenders of the corporate bastion to
                auctioneers charged with getting the best price for the stockholder at a
                sale of the company.
                (a)         Other Corporate Constituencies. Revlon argued that it acted in
                            good faith in protecting the noteholders because Unocal permits
                            consideration of other corporate constituencies. Although such
                            considerations may be permissible, there are fundamental
                            limitations upon that prerogative.
                            i)        Considerations Inappropriate W here Active Bidding
                                      Engaged. A board may have regard for various
                                      constituencies in discharging its responsibilities,
                                      provided there are rationally related benefits accruing
                                      to the stockholders. However, such concern for non-
                                      stockholder interests in inappropriate when an auction
                                      among active bidders is in progress, and the object is
                                      no longer to protect or maintain the corporate
                                      enterprise but to sell it to the highest bidder.
c.   Lock-Ups. A lock-up is not per se illegal under Delaware law. Such option can
     entice other bidder to enter a contest for control of the corporation, creating an
     auction for the company and maximizing shareholders’ profit.
     (1)        However, while those lock-ups which draw bidders into the battle
                benefit shareholders, similar measures which end an active auction and
                foreclose further bidding operate to the shareholders’ detriment.
     (2)        The no-shop provision, like the lock-up provision, while not per se
                illegal, is impermissible under the Unocal standards when a board’s
                primary duty becomes that of an auctioneer responsible for selling the
                company to the highest bidder.
d.   Favoritism for a white knight to the total exclusion of a hostile bidder might be
     justifiable when the latter’s offer adversely affects shareholder interest, but when
     bidders make relatively similar offers, or dissolution of the company become
     inevitable, the directors cannot fulfill their enhanced Unocal duties by playing
     favorites with the contending factions.
     (1)        Market forces must be allowed to operate freely to bring the target’s
                shareholders the best price available for their equity.




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