katz_corporations_2005 by nuhman10


 Katz – Fall 2005

   Brian Ryckman

  A. Generally – Agency is the label the law applies to a relationship which…

         (1) by MUTUAL CONSENT (formal or informal, express or implied),

         (2) one person or entity (called the “agent), undertakes to ACT ON BEHALF of another person or entity
             (called the “principal”),

         (3) subject to the PRINCIPAL’S CONTROL.

     1. Restatement Definition – Agency is the fiduciary 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 (§ 1)

  B. Creation of the Agency Relationship – The creation of an agency relationship involves two steps: (1)
     manifestation by the principal, and (2) consent by the agent.

     1. Manifestation AND Consent Required – The principal must in some manner INDICATE that the agent is
        to act for him, and the agent must ACT OR AGREE to act on his behalf and subject to his control.

         i) Knowledge – Manifestation by or attributable to the principal must somehow reach the agent;
            otherwise the agent has not to consent to. When the agent then manifests consent, an agency exists –
            even though the principal may initially be unaware of the consent.

            Ex: A professor asks his research assistant whether she knows anyone who is good at cite checking. The assistant answers
            that M is great at that stuff. The professor then replies “If you see her, ask her if she will cite check this chapter within the
            next couple of days.” Later the assistant sees M and communicates the message. M then telephones the professor and says
            “Yes.” An agency relationship exists. Even thought principal did not communicate the manifestation directly, the
            manifestation reached the agent and the agent directly communicated consent.

     2. Objective Standard – To decide whether an act constituted consent (by either principal or agent), the
        courts ask whether the would-be party has done or said something that the other party would have
        reasonably interpreted as consent.

            Ex: Rachel, owner of Blackacre, writes to Sam: “Please act as my broker to sell Blackacre.” Sam puts a “For Sale” sign on
            Blackacre. By beginning the requested task, Sam has given necessary manifestation of consent; agency relationship exists.

         i) Subjective Intent NOT Necessary – It is not necessary that the parties intend to create the legal
            relationship or to subject themselves to the liabilities which the law imposes upon them as a result of it.
            On the other hand, there is not necessarily an agency relationship because the parties to a transaction
            say that there is, or contract that the relationship shall exist, or believe it does exist

            Ex: P and A enter into an agreement which is stated to be a "contract of sale." It provides that A shall purchase specified
            goods from P; that the risk of loss of such goods after purchase is upon P, if A uses care in their custody; that A is to sell
            them at prices to be fixed by P from time to time and is to keep the proceeds as a separate account, remitting monthly 90 per
            cent; that unsold goods may be returned to P; and that P will pay A one-half of A's selling expenses. A is P's agent.

            Ex: B, wishing to borrow money, goes to A, the local representative of an insurance company employed by it to lend money
            and collect interest, and signs a document which states that A is B's agent for the purpose of borrowing money from the
            company, for which B is to pay A one per cent of the money borrowed. Both B and A understand that A is primarily to
            protect the interests of the company. A is not B's agent, and payment of interest by B to A is payment to insurance company.
       ii) Agency Labels in Contracts – Sometimes when parties form a relationship they expressly claim or
           disclaim the agency label. Courts do consider such statements when trying to determine what
           relationship actually existed. However, the parties‟ self-selected label is never dispositive.

            Ex: Franchise agreements often include a statement to the effect that “this agreement does not create an agency relationship”

   3. Control by Principal is Required – To create an agency relationship, the reciprocal consents of the
      principal and agent must include an understanding that the principal is in control of the relationship.

       i) Total Control Not Required – The control need not be total or continuous or extend to the way the
          agent physically performs, but there must be some control by principal.

            Ex: a hospital patient caught hepatitis from contaminated blood and sought to sue the blood supplier for breach of warranty.
            The patent claimed that he was in privity with the blood manufacturer b/c the hospital was acting as his agent when it
            obtained the blood. Held: the court rejected the patient‟s claim, noting that there was no indication that the hospital was in
            any way subject to the patient‟s control.

C. Freedom of Contract in Agency Context – Although agency is not a contractual relationship, the parties to an
   agency can make contracts regarding their agency relationship.

   Ex: Parties can agree that the principal will pay the agent for the agent‟s services, or, the parties can by agreement set a definite term
   to the relationship or limit the principal’s right to control the agent with regard to matters connected with agency.

  A. Power to Bind Principal – The most important consequence of an agency relationship is the agent‟s power to
     bind the principal to third parties and to bind third parties to principal. An agent can bind a principal through:
     (1) actual authority; (2) apparent authority; (3) estoppel; (4) inherent power, and (5) ratification.

     1. Power v. Right to Bind – An agent has the right to bind the principal only to the extent that the principal
        has authorized the agent to do so. Thus, it is possible for the agent to have the power to bind the principal
        while lacking the right. In such circumstances, the agent wrongs the principal and the agent is liable to the
        principal for the wrongful conduct. However, the principal is nonetheless bound to the third party.

  B. ACTUAL Authority – If the principal‟s authorization creates “actual authority” in the agent, the agent has the
     power to bind the principal through any act or omission within the agent‟s actual authority.

     1. Creation – The creation of actual authority involves an…

              (1) OBJECTIVE MANIFESTATION (words or conduct) by the principal followed by

              (2) the agent’s REASONABLE INTERPRETATION of that manifestation which leads the agent to
                  believe that it is authorized to act for the principal

         i) Silence or Inaction – The principal‟s inaction can constitute a manifestation when silence, reasonably
            interpreted, indicates consent.

         ii) Extent of Actual Authority: Reasonable Belief from Principal’s Manifestations – For an agent to
             have actual authority, the agent must believe the authority exists, that belief must be based on some
             manifestation of principal, and that belief must be reasonable.

             a. Restatement re: Extent – An agent is authorized to do, and to do only, what it is reasonable for
                him to infer that the principal desires him to do in the light of the principal's manifestations and the
                facts as he knows or should know them at the time he acts (§ 33)

         iii) Third Party Knowledge Irrelevant – An agent can have actual authority even though the third party to
              the transaction neither knew nor has reason to know the extent of the agent‟s authority.

             Ex: A power company authorizes a coal broker to buy coal for it. The broker contracts to buy the coal in its own name.
             When the coal seller later prepares to deliver the coal to the broker, the seller discovers that the broker has gone out of
             business. Then the seller discovers that the broker was making the purchase on the power company‟s behalf and had actual
             authority to do so. By asserting actual authority, the seller can hold the undisclosed principal (power company) to the
             contract. Because there was actual authority, it is irrelevant at the time of the contract whether the seller was ignorant of the
             underlying agency relationship.

     2. IMPLIED Actual Authority – In addition to the authority expressly indicated by the principal‟s words and
        other conduct, an agent may also have implied authority. Unless otherwise agreed, implied actual authority
        includes authority to do acts which are…

         (1) INCIDENTAL to it,

         (2) usually ACCOMPANY IT, or

         (3) are REASONABLY NECESSARY to accomplish it (§ 35)
           a. Rationale – It is seldom that the words of a principal are sufficiently specific to include or exclude
              all the acts which he expects the agent to do or not to do. Almost all directions are ambiguous and all
              include by implication authorization to do what is necessary in order to accomplish the end.

C. APPARENT Authority – Apparent authority is the power to affect the legal relations of another person by
   transactions with third persons, professedly as agent for the other, arising from and in accordance with the
   other's manifestations to such third persons (Restatement § 8)

   1. Generally – Apparent authority is a doctrine that exists to protect third parties who are misled by the
      appearance of legitimate authority for an agent to act.

       i) Harmful Intent of Agent Irrelevant – An apparent agent‟s intent is therefore immaterial A person
          with apparent authority can bind the principal to a contract even if the person does not intend to benefit
          the principal and even if the person is lying about being authorized.

       ii) Extends Beyond Scope of Agent’s Authority – Apparent authority can also extend an actual agent‟s
           power to bind the principal beyond the scope of the agent‟s actual authority.

           Ex: A broker is sent to an art auction to represent an art collector. The broker is given the express actual authority to make
           bids up to $25K. However, at the auction, the broker bids $50K for a piece of artwork. Liability for the bid is covered under
           the apparent authority of the agent although not authorized under actual authority

   2. Creation – Creation of apparent authority involves an objective manifestation from one party which
      somehow reaches a third party and which causes that THIRD PARTY to REASONABLY BELIEVE that
      another party is indeed authorized to act for the first party.

       i) Restatement – Apparent authority to do an act is created by written or spoken words or any other
          conduct of the principal which, reasonably interpreted, causes the third person to believe that the
          principal consents to have the act done on his behalf by the person purporting to act for him (§ 27)

           a. Reliance Sometimes Required – Some jurisdictions require detrimental reliance by the third party
              before apparent authority can be used to bind the principal to the third party.

       ii) Evidence of Manifestation Required – The third party must be able to point to at least some
           manifestation attributable to the apparent principal. This requirement means that, with one exception,
           the statements of the apparent agent cannot give rise to apparent authority.

           Ex: A salesman, nattily dressed and appearing for all the world to be precisely whom he claims to be, rings your doorbell and
           introduces himself as an representative of Acme Burial Insurance Company. He shows you an impressive, glossy brochure
           and a printed contract form. You sign o the dotted line and give the man $100 down payment. You later discover that the
           fellow had not connection whatsoever with Acme and that he had created the phony brochures and contract forms as props.
           Unfortunately, you have no recourse against Acme. Although your belief that the salesman was acting for Acme may have
           been reasonable, you cannot point to any manifestation by or attributable to Acme, the apparent principal.

           a. Exception – If the apparent agent has the actual authority to act for the principal and accurately
              describes the extent of its authority, then this description is attributable to the principal and is
              sufficient evidence of manifestation.

               Ex: You operate a horse ranch. One day a woman approaches you and informs you that shy buys horses on behalf of
               Acme Rodeo Company and that she has the authority to pay up to $2,500 per horse. At that time, here statements are
               accurate. Two weeks later, she returns and purports to commit Acme to purchase a horse for $2,200. Unbeknownst to
               you, however, three days prior Acme had expressly restricted her authority to purchases of $1,700 or less. You should
               be able to hold Acme to the contract through an apparent authority claim.
           b. Apparent Authority by Position – An agent is sometimes placed in a position in an industry or
              setting in which holders of the position customarily have authority of a specific scope. Absent
              notice to third parties to the contrary, placing the agent in such a position constitutes a
              manifestation that principal assents to be bound by actions by the agent that fall within that scope.

                Ex: Ralph is hired in a dry cleaning store to work at the counter and he is expressly authorized to accept clothes for
                cleaning, give receipts, return cleaned clothes to customers, and accept payment from customers. Although the owner
                expressly forbid Ralph from promising to have any garment cleaned in less than two days, Ralph does so anyway. The
                doctrine of apparent authority may hold the dry cleaning store to Ralph‟s promise b/c his position as a counter clerk
                reasonable constitutes manifestation to make such a promise.

       iii) Rare w/ Undisclosed Principals – Apparent authority is very rare in the undisclosed principal context.
            The third party must be able to point to some manifestation attributable to the principal that supports an
            inference that the agent has actual authority for some principal but which does not disclose the identity
            of the actual principal.

D. ESTOPPEL – Unlike apparent authority, estoppel can apply even though the claimant can show no
   manifestation attributable to the asserted principal. Rather, estoppel liability can arise from the asserted
   principal‟s mere negligent failure to protect against misapprehension.

   1. Restatement Rule – A person who is not otherwise liable as a party to a transaction purported to be done on
      his account, is nevertheless subject to liability to persons who have changed their positions because of their
      belief that the transaction was entered into by or for him, if…

           (a) He intentionally or carelessly CAUSED such belief, or

           (b) Knowing of such belief and that others might change their positions because of it, he did NOT take
               REASONABLE STEPS to notify them of the facts. (§ 8B)

           Ex: P arrives in a small city and claims to be the personal representative of a millionaire developer (M) and she is there to
           make a recommendation on whether the town‟s riverfront property should be developed. On the strength of this claim, she is
           wined, dined, put up in an expensive hotel, etc. This makes it in the papers and M reads it. Knowing that P has no
           connection to him, he chuckles at the story. Later, P throws a huge party but disappears before paying the bills. The city
           seeks payment from M. Here, there is no apparent authority to bind the payments. However, estoppel claim can be made for
           the charges made after the story was run in the paper and M found out about it but failed to notify the city of the mistake.

E. INHERENT Authority – There are situations in which the principal is made liable because of an act done or a
   transaction entered into by an agent even though there is no tort, contract or restitutional theory upon which
   the liability can be rested.

   1. Restatement – Inherent agency power is a term used…to indicate the power of an agent which is derived
      not 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 (§ 8A)

       Ex: Paul purchases Eli‟s Dry Cleaning, does not change the business‟ name and hires Eli to manage the dry cleaning store.
       Although dry cleaning stores customarily order cleaning solvent in large quantities, P instructs E never to buy more than $50
       worth of solvent at a time. Disregarding these instructions, E places a phone order for solvent costing $450. The seller of the
       solvent believes that E still owns the store. E has acted without actual authority; his principal‟s manifestations expressly prohibit
       the order he made. E has also acted without apparent authority. Nonetheless, agency law will bind P on the order

       Ex: An agent, acting within her authority, negotiates a K with a third party under which the agent‟s principal will sell widgets to
       the third party. During the negotiations the agent falsely describes the widgets. The principal has not authorized the agent to
       make misstatements, and, arguably at least, nothing in the principal‟s manifestation to the third party created an appearance of
       such authority. Nonetheless, agency law will attribute the misstatement to the principal.
F. 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.

   1. Restatement Definition - Ratification is the affirmance by a person of a prior act which did not bind him
      but which was done or professedly done on his account, whereby the act, as to some or all persons, is given
      effect as if originally authorized by him. (§ 82)

       i) Affirmance as Ratification – A purported principal affirms by either…

           (1) MAKING A MANIFESTATION that, viewed objectively, indicates a choice to treat the
               unauthorized act as if it had been authorized; or

           (2) ENGAGING IN CONDUCT that is justifiable only if the purported principal has made such a

       ii) Inaction as Ratification – A purported principal can also affirm through inaction by…

          (1) FAILING TO REPUDIATE the act…

          (2) Under such circumstances that, according to the ordinary experience and habits of men, one would
              NORMALLY BE EXPECTED TO SPEAK if he did not consent.

       iii) Notice Not Required – Affirmance occurs when the manifestation occurs, and this manifestation need
            not reach the third party to become effective.

       iv) Ratification is usually All or Nothing – Ratification occurs on an “all or nothing” basis. If a purported
           principal attempts to ratify only part of a single transaction, then either the entire transaction is ratified
           or there is no ratification at all.

  A. Respondeat Superior – Respondeat superior is a venerable doctrine which imposes strict, vicarious liability on
     a principal when:

         (1) an agent‟s tort has caused physical injury to a person or property,

         (2) the tortfeaser agent meets the criteria to be considered a “servant” of the principal, and

         (3) the tortious conduct occurred within the servant‟s “scope of employment.”

     1. Broad Application – When triggered respondeat superior automatically renders the principal liable for the
        agent‟s misconduct regardless of whether the master (i) authorized the misconduct; (ii) forbade the
        misconduct; or (iii) even used all reasonable means to prevent the misconduct.

     2. Servant Status – Under Restatement § 220(1), an agent is a servant if the principal controls or has the right
        to control the agent‟s “physical conduct in the performance of [agency] services.” The opposite of a servant
        is an independent contractor.

     3. Scope of Employment – 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. Under Restatement § 228(1), conduct 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
                UNEXPECTABLE by the master.

         i) Broad Application – An act can be within the scope of employment even though (i) the master has
            expressly forbid the act; (ii) the act is tortious; and (iii) the act constitutes a crime.

            Ex: A bar owner instructs a bouncer never to use a certain chokehold in restraining obstreperous customers. One night the
            bouncer overreacts to an especially troublesome person and uses the hold. The patron subsequently files a civil suit against
            the bar owner and seeks to press criminal charges. Nonetheless, the bouncer acted within the scope of employment; the
            relevant conduct fits within the general guidelines of § 228(1)

         ii) Commuting – In general, a servant‟s trips to and from work are not within the scope of employment.
             However, if at the master’s request the servant undertakes an errand while going to or from work, the
             entire trip may become part of the scope of employment.

  A. Fiduciary Duty of Agent – Except when the principal has knowingly agreed to the contrary or when
     extraordinary circumstances exist, the agent is obliged to prefer the principal‟s interests over its own and to act
     “solely for the benefit of the principal in all matters connected with the agency

     1. Restatement Definition – Unless otherwise agreed, an agent is subject to a duty to his principal to act
        solely for the benefit of the principal in all matters connected with his agency (§ 387)

         i) Vague Standard – The need to rely on a vague concept such as the duty of loyalty stems from the
            difficulty of specifying precisely what it is that the employer expects of the employee.

         ii) Broad Application to Various Activities – An agent‟s duty of loyalty includes a number of specific
             duties of selflessness, all service to protect the principal‟s economic interest. Some of these include…

             a. No Unapproved Benefits – Unless otherwise agreed (i.e. compensation packages), an agent may not
                benefit from its efforts on behalf of the principal

                 Reading v. Regem – A Royal Army Medical Officer, while serving in Egypt, was paid (bribed) to escort lorries through
                 the city of Cairo while wearing his full uniform. The Royal Army eventually took possession all the ill-gotten profits
                 claiming that the Crown was entitled to the money because (1) the funds were unlawfully obtained and (2) it was
                 plaintiff‟s employer at the time of their earning. Held: 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 had control, the facilities
                 which he employs, 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, then he is accountable for it to his master

             b. Keep Confidential Information – An agent has a duty to safeguard the principal‟s confidential
                information and not to use that information for the agent‟s own benefit or the benefit of others

             c. No Competition – Unless otherwise agreed, the agent has a duty not to compete with the principal
                in any manner within the scope of the agency relationship.

             d. No Acting for Others with Conflicting Interests – Unless otherwise agreed, an agent may not act
                for anyone whose interests might conflict with the interests of the principal

             e. No Dealing with the Principal – When the principal uses an agent to arrange a transaction, the
                agent may not become the other party to the transaction unless the principal consents.

             f. Good Conduct – The agent‟s conduct reflects on the principal, so the agent must not act in a way
                that brings disrepute on the principal.

             g. Duty to Follow Instructions – An agent has a duty to obey instructions from the principal unless
                the instructions call for the agent to do something improper.

             h. Duty of Care – An agent has a duty to act with “due care.”

  B. Principal’s Remedies for Agent’s Breach of Duty – If an agent‟s breach of duty to a principal causes damage
     to the principal, the principal can recover those damages from the agent. If the agent‟s breach of duty renders
     the principal liable to a third party, the agent must indemnify and hold harmless the principal from that liability.
C. Contracts between Agent and Third Parties – Agents often make contracts on behalf of principals, and
   agency law provides rules for determining whether the agent is liable for such contracts. The analysis turns on
   whether the agent‟s principal is disclosed.

   1. Disclosed Principal – If the principal is disclosed, then the agent is not liable on the contract. With a
      disclosed principal, the third party enters into the contract knowing that the agent is merely a representative
      and the principal is the obligor.

       Ex: A patron at a gambling casino approaches the roulette wheel and asks the employee working “Is this game honest?” The
       employee responds “As honest as the day is long.” The patron places several bets, losing each one. Subsequently, the patron
       discovers that the wheel is rigged and claims breach of warranty against both the employee and the casino. The claim against the
       employee will fail. The patron‟s bets were transactions between the patron and the casino, and the employee‟s principal was
       disclosed. The employee is therefore not liable on the contract – even though the employee‟s statement gave rise to the breach of
       warranty claim.

   2. Partially Disclosed Principal – If the principal is partially disclosed, then the agent is almost always liable
      on the contract. The rationale is again one of expectations. Without knowing the identity of the principal,
      the third party is presumably relying on the trustworthiness and creditworthiness of the agent.

       Ex: An attorney contracts an art dealer and contracts to buy a famous Picasso print. The attorney explains that she is acting for a
       client but declines to identify the client b/c the client dislikes notoriety. The attorney is liable on the contract.

   3. Undisclosed Principal – If the principal is undisclosed, the agent is liable a fortiori. As far that the third
      party knows, the contract is with the agent and no other.

       Ex: A power company authorizes a coal broker to buy coal for it. The broker contracts to buy the coal in its own name, without
       disclosing its status as agent for the power company. The broker is liable on the contract.

  A. Ending the Agency Relationship – An agency relationship may end in numerous ways, including…

     1. Through the EXPRESS WILL of Either the Principal or the Agent – Both the principal and the agent
        have the power to end the relationship at any time. Whether the particular party has the right to do this (i.e.
        without legal ramifications) is another matter

     2. Through the EXPIRATION of a Specified Term – If the relationship is specified to only last a particular
        period of time, the relationship automatically terminates at the end of the period unless the parties agree to
        an extension or a renewal

     3. Through the ACCOMPLISHMENT of the Agency’s Purpose – If the manifestations that crate an agency
        indicate a specific objective, achieving that objective ends the agency

     4. By OCCURRENCE of an Event or Condition – Sometimes the manifestation that create an agency
        indicate that particular event or condition will end the agency. If so, once that event occurs the agency

     5. OTHER Terminating Events – Including… (i) by the destruction of or end of the principal‟s legal interest
        in the property; (ii) by the death, bankruptcy or mental incapacity of the agent or principal; (iii) or by the
        expiration of a reasonable time period.

  B. Effects of Termination

     1. Effect on Agent’s Authority and Power to Bind Principal

        i) Death or Incapacity: No Notice Required – If the principal has died or lacks capacity, the agent‟s
           apparent authority terminates immediately, even without notice to third parties.

        ii) All Other Reasons: Notice Required – In all other situations, agent‟s apparent authority terminates to
            any particular third party only when…(i) the third party learns that the agency has ended, or (ii) in light
            of other information, the third party can no longer reasonably believe that the agent is authorized to act.

            Ex: M is a rancher. S is a horse breeder. On Monday, M introduces R to S as “my agent for buying horses.” On Tuesday, M
            fires R for insubordination but fails to tell S. The next day, R purports to buy a horse from S for M. R‟s action binds M,
            although the firing ended R‟s actual authority. Because neither death nor incapacity caused the agency relationship to end,
            R‟s apparent authority remained intact.

            Ex: J is a long-time customer of Hunter Brokerage Company and has always done his investing through D, one of the agents.
            One afternoon, unbeknownst to J, Hunter fires D. That night, D calls J with a “hot tip” and urges J to make a quick
            investment of $5,000. D explains that the opportunity may disappear overnight and persuades J to bring the money to D‟s
            home. D has never before tried to rush J‟s decision and J has sent all past funds to the offices of Hunter. J probably cannot
            hold H accountable for D‟s actions. The termination of the agency relationship had ended D‟s actual authority to bind hunter
            and D probably lacks apparent authority as well. Given D‟s two deviations from the standard practice, J could no longer
            reasonably believe that D was authorized to act for Hunter.
2. Agent’s Right to Compete with the Principal – Once an agency relationship ends, any barrier to
   competition does as well. However, the right to compete comes with three limitations…

   i) Prohibition against Using Confidential Information – The agent‟s duty not to disclose or exploit the
      principal‟s confidential information clearly continues after the agency relationship ends.

       a. Customer Lists – A former employee may not solicit the former employer‟s customers, whose
          availability as patrons cannot readily be ascertained b/c they “have been secured by years of business
          effort and advertising, and the expenditure of time and money,

           Town & Country House & Home Service, Inc. v. Newbery – Employees in a cleaning service quit positions, formed a
           corporation, and tried to take the business from their former employer. To do this, they contacted people from their
           former employer‟s list of customers. The employer sued for an injunction and damages on theory of unjust competition.
           Held: Here, the plaintiff‟s customers were the only ones that the defendant‟s solicited. This list took significant time and
           effort by plaintiff to develop. It would be different if these customers had been equally available to appellants and
           respondent, but, these customers had been screed by respondent at considerable effort and expense, without which their
           receptivity and willingness to do business with this kind of service organization could not be known. Injunction granted.

   ii) Duty of Proper Termination – The agent has a duty not to begin actual competition while still an
       agent. Furthermore, the agent may not actively deceive the principal as to the agent‟s reasons for
       terminating the agency relationship.

       Ex: May works as the headmaster of a private school. Frustrated by policies set by the board of trustees, she decides to start
       her own school. Before resigning, she discusses her plans with several of the private school‟s major donors and obtains
       commitments from the for startup funding. She also copies the private school‟s mailing list of the families of current
       students. Her actions breach her duty of loyalty. She has the right to compete with the private school for donations, but only
       after she terminates her agency relationship. She never has the right to purloin her principal‟s mailing list.

   iii) Noncompetition Obligations by Contract – Parties can always arrange their own non-compete
        contracts which create lasting obligations after the agency ends.

  A. Generally – A partnership exists when two or more people have agreed (“association” implies a consensual
     agreement), expressly or tacitly, to share in the profits and the control (as “co-owners”) of a “business.”

     1. Uniform Partnership Act Definition – The UPA defines a partnership as “an association of two or more
        persons to carry on as co-owners a business for profit.”

     2. Creation – A partnership may arise without formality and no meetings need be held, no documents signed,
        no certificates filed, no fees paid. People become partners when they agree to “carry on as co-owners a
        business for profit.” Failure of the associates to label themselves as “partners” or to think of themselves as
        belonging to a partnership is irrelevant as well.

         i) Dispositive Question – If they share in the profits and control of a business they are partners and are
            subject to the rights and liabilities that flow from that status, like it or not

             Ex: A manager who is entitled by contract to a bonus consisting of a share of profits is not, by virtue of that fact alone, a
             partner. Where two people own real estate as joint tenants, the share in profits and are co-owners, but they are not partners
             unless the management of the property requires enough activity to constitute a “business.”

  B. Underlying Intent Required – For a partnership to exist, there must be a business relationship whose
     participants intend the kind of arrangement that the law calls a partnership. The participants must agree to that
     arrangement, either expressly or by their conduct.

     1. Formal Label Intent Irrelevant – It is not necessary, however, that the participants intend or agree to the
        legal label of partnership. A partnership can exist even thought the participants have no idea that the legal
        label applies to them, or even if the participants have expressly disclaimed the legal label altogether.

         Ex: Caesar lends money to Julio, who personally owns a company that produces and markets cheese. The loan agreement
         provides that, until the money is repaid, Caesar (i) will receive a share of the company‟s profits in lieu of interest, (ii) may have
         the marketing right for 50% of the company‟s output, and (iii) may have his own accountant check the company‟s finances
         weekly and approve any payments to be made by the company in excess of $100. The loan agreement also expressly states that
         Caesar and Julio are not partners in the cheese company but rather are creditor and debtor. Nonetheless, a court may find that a
         partnership exists.

  C. Profit Sharing – For participants to be partners they must have the right to share in the business’s profits. It
     is not necessary that the business actually have profits, and profit sharing is not irrefutable evidence of partner
     status, but the right to share whatever profits exist is a necessary precondition to being a partner.

     1. Profit Sharing Not Sufficient Alone – UPA §7(3) – The sharing of gross returns does not of itself establish
        a partnership, whether or not the persons sharing them have a joint or common right or interest in any
        property from which the returns are derived

         Martin v. Peyton (1927) – P was a creditor of a firm, and claimed that the D‟s, who had made investments in the firm, were
         partners and liable for its debts. D‟s claimed that they were creditors, not partners. During negotiations, it was proposed that the
         three become partners but this was flatly refused. In the end, to insure the investors against lost, KN&K were to turn over to them
         a large number of their own securities which may have been valuable but which were of so speculative a nature that they could
         not be used as collateral for bank loans. Held: The court determined that nothing of the agreement, the indenture, or the option
         created a partnership. Sharing in returns does not in of itself create a partnership.

         i) Revenues v. Profits – If two parties are merely sharing revenues (i.e. gross income), then a partnership
            does not exist. Rather, it is necessary for the parties to share profits (i.e. revenues – expenses).
       ii) Loss Sharing Not Required – Neither the UPA nor the RUPA explicitly mention loss sharing as a
           prerequisite to partnership. Rather, the statutes treat loss sharing as a consequence of partnership status.
           However, an express agreement to share losses is strong evidence of a partnership.

   2. Profit Sharing is Prima Facie Evidence of Partnership – Though not sufficient alone, the sharing of
      profits has a pivotal role in most disputes concerning the existence of a partnership. Thus UPA § 7(4)
      provides that the receipt by a person of a share of the profits of a business is prima facie evidence that he is
      a partner in the business

           a. Exceptions – But NO such inference shall be drawn if such profits were received in payment…

               (a) As a debt by installments or otherwise,

               (b) As wages of an employee or rent to a landlord,

               (c) As an annuity to a widow or representative of a deceased partner,

               (d) As interest on a loan, though the amount of payment vary with the profits of the business,

               (e) As the consideration for the sale of a good-will of a business or other property by installments
                   or otherwise

D. Co-Ownership (and Co-Management) – Co-ownership is a key characteristic of a partnership but neither the
   UPA nor RUPA define what this term entails. Generally, however, the more an alleged partner participates in
   management decisions or exercises control over the business, the more likely is a finding of partnership.

       i) Property Ownership – UPA §7(2) states that joint tenancy, tenancy in common, tenancy by the
          entireties, joint property, common property, or part ownership does not of itself establish a partnership,
          whether such co-owners do or do not share any profits made by the use of the property

E. Personal Liability for Partnership Debts – All partners are automatically personally liable for all debts and
   other obligations of the partnership, and it is irrelevant whether a particular partner participates or approves the
   conduct that creates the obligation.

   1. Distribution of Losses – Absent a contrary agreement, partners share losses as the do profits – equally.
      However, if the profits are apportioned by certain percentages, the losses are to be distributed the same.

   2. Joint and Several Liability – Under UPA § 15, partners are jointly and severally liable for partnership
      debts arising from partner misconduct and merely jointly liable for all other partnership debts.

F. Benefits of Partnerships – Why risk the potential, personal, joint and several liability of partnerships?

   1. Tax Advanatages – Corporations are taxable entities and therefore face double taxation when distributing
      profits. The corporation must first pay corporate income tax on its corporate profits before distributing them
      as dividends. The shareholders later have to pay income taxes on any dividends. A partnership, in contrast,
      is a “pass through entity” and pays no tax. Thus, the profits of the partnership are only taxed at the
      individual level and the losses allow the partners to obtain tax deductions in their own income taxes.

   2. Control – Partnerships also give the parties more control over the activities of the entity. Unlike in
      corporations, there is not board of directors or shareholders to help influence or direct the actions and
      decisions of the partnership.

  A. Generally – Partners owe each other a fiduciary duty of loyalty. However, the definition and scope of such a
     duty of loyalty is vague.

          Meinhard v. Salmon (1928) – P (Meinhard) and D (Salmon) created a joint venture under which P would loan money to D to
          secure a lease for property and then to run the Hotel Bristol. P paid ½ of the moneys requisite to reconstruct, alter, manage and
          operate the property, and D was to pay 50% as well, although D had the “sole power to manage, lease, underlet and operate” the
          property. The two were subject to split both the profits and losses from the venture. Later, however, a new lease for the property
          was formed (for much more property, actually) and P was not told until it was signed and delivered. At this time, P demanded
          that it be held in trust as an asset of the venture, making offer to share the personal obligations incident to the guaranty. This was
          refused and the action was brought. Held: Joint adventurers, like copartners, owe to one another, while the enterprise continues,
          the duty of the finest loyalty. The fact that D had exclusive power charged him with the duty of disclosure, since only though
          disclosure could the opportunity be equalized. The trouble with D‟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.

          Dissent – This was not a general partnership; this was a limited partnership in its scope and purpose. Thus, because the deal
          involved time and scope outside of that which was agreed to by the partners originally, there was neither duty to disclose nor a
          duty to include the other partner in the eventual profits of the dealing.

  B. Restricting Personal Profiting – In general, a partner may not profit at the expense – either direct or indirect –
     of the partnership. In particular, without consent of the fellow partners, a partner is PROHIBITED from…

          (1) Competing with the partnership,

          (2) Taking business opportunities from which the partnership might have benefited or that the partnership
              might have needed,

          (3) Using partnership property for personal gain, and

          (4) Engaging in conflict of interest transactions.

     1. UPA § 21(1) – Every partner must account to the partnership for any benefit, and hold as trustee for it any
        profits derived by him without the consent of the other partners from any transaction connected with the
        formation, conduct, or liquidation of the partnership or from any use by him of its property

         Non-competition – Ex: Michael is a partner in a company that provides business consulting services throughout the US. While
         on a skiing vacation, M meets Dorothy, who seeks some business advice M agrees and pockets a large fee. The fee belongs to the
         partnership, and it is irrelevant that M did work on his own time. M did the type of work the partnership does and for M to retain
         the fee would be to set himself as a competitor to the partnership.

         Taking Business Opportunities – Ex: Alice, a partner in a biotech partnership, knows that the partnership is looking to rent new
         office and laboratory space. She happens to know of a building, in the ideal location, suitable to house the firm‟s special
         equipment. She learns that the owner is willing either to lease or sell. Alice decides that the building would make a fine personal
         investment, so she buys it for herself. She leases the building to a company that does not compete with the partnership, and after
         she resells the building at a profit. She must account to the biotechnology partnership for whatever profit she made on the
         building. Although Alice did not engage in directly competitive activity, the building could have been a fruitful opportunity for
         the partnership. Under § 21, Alice must therefore “hold as trustee…any profits derived…from this transaction connected with
         the…conduct…of the partnership.”

         Partnership property – Ex: Alex is a partner in a landscaping company that works exclusively on commercial projects. On
         weekends, without the permission of his copartners, Alex uses the company equipment to do landscaping at private homes. He
         must disgorge his profits from the partnership. They result from his use of partnership property.

         Conflict of Interest – Ex: Alice is a partner in a biotech partnership that is looking to rend a new laboratory space. Alice
         happens to own a building, in an ideal location, suitable to house the firm‟s special equipment. If Alice leases or sells the
         building to the partnership, she will be on “both sides of the deal” and thus she has a conflict of interest.

  A. Partnership Property – Partnerships have the ability to own property and typically do so either by accepting
     contributions or by purchase. Funds for purchase can from contributions, from business operations (including
     the sale of other partnership property), or from loans.

     1. What is Partnership Property – UPA § 8 provides three major categories of partnership property…

             (1) Property ORIGINALLY BROUGHT into the partnership stock or subsequently acquired by
                 purchase or otherwise, on account of the partnership,

             (2) Property ACQUIRED WITH PARTNERSHIP FUNDS is partnership property, and

             (3) Any ESTATE IN REAL PROPERTY acquired in the partnership name

     2. Extent of Property Rights of a Partner

         i) UPA § 24 – The property rights of a partner are (1) his rights in specific partnership property, (2) his
            interest in the partnership, and (3) his right to participate in the management.

             a. Right of Equal Use or Possession – The right in specific partnership property is the possessory
                right of equal use or possession by partners for partnership purposes. This possessory right is
                incident to the partnership and does not exist absent the partnership.

             b. Partner’s Interest in the Partnership – The real interest of a partner, as opposed to that incidental
                possessory right, 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.”

                i. No Specific Interest in Partnership Property – A copartner owns no personal specific interest
                   in any specific property or asset of the partnership. The partnership owns the property or 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.

                    Putnam v. Shoaf – Dispute concerning the sale of a partnership interest. Mrs. Putnam (P) acquired from her
                    husband interest in the Frog Jump Gin Company partnership. Eventually, however, P wanted to sell her interest.
                    John and Maurine Shoaf (D‟s) agreed to take over the position in the partnership and to assume personal liability for
                    all partnership accounts. After taking over, D‟s hired a new bookkeeper who found out that the previous
                    bookkeeper was embezzling money from the partnership. Litigation was pursued against both the bookkeeper and
                    the banks that had honored the forged checks. P was allowed to intervene claiming an interest in any fund paid by
                    the banks (which was in excess of $68K). One-half was paid to the other partners and the other half is the cause of
                    this action. Held: All P had to convey was her interest in the partnership. Accordingly, she had no specific interest
                    in the admittedly unknown [future awarded interest] to separately convey or retain...there can be no doubt that the
                    intent of P was to convey such interest
B. Raising Additional Capital

   1. Collective Action Problem – Business firms often need additional funds to finance their activities and are
      generally confronted with the question regarding how to do so. In such a situation, equity investors,
      together, would be better off if each provided a pro rata share of the amount needed. However, each
      investor, acting out of self-interest, may decline to invest and all may lose in the end.

   2. Possible Solutions – To avoid a collective action problem resulting in the partnership‟s failure to raise
      additional capital, there are the following possible solutions…

      i) Request from Partners – Each individual partner will evaluate the costs v. benefits of providing
         additional funding. Each partner, in theory, should contribute the extra money. However, the free-rider
         problem will be prevalent and the money will not raised (i.e. prisoner‟s dilemma)

      ii) Pro Rata Dilution – Provision permits the managing partner to issue a call for additional funds and
          provides that if any partner does not provide the funds called for, his share is reduced according to the
          existing formula.

      iii) Penalty Dilution – Sell points in the firm at a lower price. However, the worry with this strategy is that
           it can be abused to edge out other partners (at a lower price); investors would be very leery about
           investing in such a partnership.

      iv) Partnership Loans –

      v) Selling New Partnership Shares – Managing partner can sell shares to anyone at whatever price can be
         obtained. This is comparable to a corporation selling new shares of common stock.

  A. General Right to Partnership Management – UPA § 18(e) provides that in the absence of an agreement
     otherwise, “[a]ll partners have equal rights in the management and conduct of the partnership business”

     1. May NOT Transfer Interest in Management – Absent a contrary agreement, although it is possible for a
        partner to transfer economic rights in the partnership (i.e. rights to share of the profits), a partner cannot
        transfer his right to participate in the management of the partnership.

  B. Right to Partnership Information – The UPA provides that every partner shall at all times have access to and
     may inspect and copy any of the partnership books. Furthermore, all other partners shall render on demand true
     and full information of all things affecting the partnership to any other partner.

  C. Voting Control – While each member of the partnership has the right to participate in partnership decisions,
     differences are resolved by majority vote, with each partner being entitled to one vote.

     1. Ordinary Matters Decide by Majority – UPA §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.
         Ex: R, S and C form a partnership to raise chickens and eventually have a disagreement about where to buy their chicken feed. R
         wants to buy from Eli‟s Feed and Stock. Both S and C want to buy from Rebecca‟s Ranching Necessity. On this ordinary matter,
         S and C will prevail. Each partner has one vote and a majority vote controls.

         i) Where No Majority or Even Split, Keep Status Quo – Where there are only two partners (or an even
            split) and a majority is impossible, courts tend to rule in favor of the status quo.
             Ex: Compare the following two cases. In both, the status quo was respected and upheld by the courts.

             National Biscuit Company v. Stroud (1959) – Two partners entered into a general partnership to sell groceries without
             restrictions on each partner‟s control. After several months, one of partners (S) advised plaintiff that he personally would not
             be responsible for any additional bread sold by plaintiff to the partnership. At request of the other partner (F), plaintiff sold
             and delivered more bread worth $171.04. Held: 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 “equal rights
             in the management and conduct of the partnership business.” Thus, F‟s purchases of bread for the partnership bound the
             partnership and co-partners.

             Summers v. Dooley (1971) – Summers (P,App) entered a partnership agreement w/ Dooley (D,Res) for the purpose of
             operating a trash collection business. The business was operated by the two men and when either was unable to work, the
             non-working partner provided replacement at his own expense. Dooley became unable to work and at his own expense hired
             an employee to take his place. Summers approached Dooley regarding the hiring of an additional employee, to which
             Dooley rejected. Nevertheless, an additional employee was hired. Dooley, upon finding this out, objected stating that he did
             not feel additional labor was necessary and refused to pay for the new employee out of the partnership funds. Summers sued.
             Held: Court rules that, here, because one of the partners continually voiced objection to the hiring of a third man and did not
             sit idly by and acquiesce in the actions of the 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.

         ii) Third Person’s Knowledge Irrelevant – In cases of an even division of the partners as to whether or
             not an act within scope of the business should be done, of which disagreement a third person has
             knowledge, no restriction can be placed upon the power to act (see Nat’l Biscuit supra)

     2. LIMITATION: Unanimous Approval Required – UPA § 18(h) states that “no act in contravention of
        any agreement between the partners may be done rightfully without the consent of ALL the partners.”

         i) Admitting New Partners – UPA § 18(g) provides that “[n]o person can become a member of a
            partnership without the consent of all the partners.”
       ii) Amending the Partnership Agreement – Contrary to an express agreement otherwise, any alterations
           or amendments made to the partnership agreement require unanimous consent of the partners.

       iii) Other Activities Requiring Unanimous Approval – Other various activities that required unanimous
            approval by the partners are enumerated in UPA § 9(3) including…

           (1) Assign the partnership property in trust for creditors or on the assignee's promise to pay the debts of
               the partnership,

           (2) Dispose of the good-will of the business,

           (3) Changing the ordinary business of the partnership (i.e. purpose or function)

           (4) Do any other act which would make it impossible to carry on the ordinary business of a partnership,

           (5) Confess a judgment,

           (6) Submit a partnership claim or liability to arbitration or reference

       iv) Rationale – This protects rights which are part of the bargain reflected in the partnership agreement. If a
           majority were to violate this kind of rule, any dissenting partners would be entitled to various remedies
           available under law (including damages, if provable) for violation of the partnership agreement.

   3. Freedom of Contract to Change Voting Procedures – Of course, the partners are free to draft their
      partnership agreement in such a way as to provide for different voting schemes. UPA are default rules.

       Ex: The partnership might require a two-thirds vote on some or all matters, or where capital contributions are uneven, there is
       some obvious appeal to a rule that allocates voting power in accordance with capital contribution.

D. Right to Bind The Partnership in Contract – Partners may by agreement define the authority of each partner
   to bind the partnership. However, the UPA does provide default rules in the absence of such definition.

   1. Binding the Partnership (§9) – Every partner is an agent of the partnership for the purpose of its business,
      and the act of every partner for apparently carrying on in the USUAL way the business of the partnership of
      which he is a member binds the partnership,…

       i) Knowledge of Third Party Irrelevant – Even if a third party has no knowledge of the existence of the
          partnership, if the transaction deals with the usual business of the partnership, then all partners are bound

   2. Exceptions: UNLESS …

       i) Third Party Has Knowledge of No Authority – If the partner acting has NO AUTHORITY to act for
          the partnership in the particular matter, and the person (3rd Party) with whom he is dealing has
          KNOWLEDGE of the fact that he has no authority, then the acts of the partner do not bind partnership


       ii) Not Done For Business Purpose in Usual Way – If an act of a partner is NOT apparently for the
           carrying on of the business of the partnership in the usual way, the act does not bind the partnership
           unless authorized by the rest of the partners.
E. Right to be Indemnified (§18(b)) – The UPA obligates the partnership to indemnify every partner in respect of
   payments made and personal liabilities reasonably incurred in the ordinary and proper conduct of the
   partnership‟s business, or for the preservation of its business or property.

F. Right to Be Involved In Business – Each partner has the right to be involved in the business of the partnership

   1. No Extra Compensation – Absent a contrary agreement, a partner‟s work in partnership business brings
      him no right to extra compensation and thus the partners split any partnership profits equally.

   2. Exception: Winding Up – UPA 18(f) provides the exception that “a surviving partner is entitled to
      reasonable compensation for his services in winding up the partnership affairs”

  A. Generally – Dissolution is defined by § 29 of the UPA as the “change in the relation of the partners caused by
     any partner ceasing to be associated in the carrying on as distinguished from the winding up of the business.”

     1. Partnership Not Terminated During Dissolution – UPA § 30 provides that “[o]n dissolution the
        partnership is not terminated, but continues until the winding up of partnership affairs is completed.”

     2. Causes of Dissolution – §§ 31 and 32 of the UPA provide for the various causes of dissolution…

         i) Voluntary Dissolution (UPA § 31)

             a. By Unanimous Agreement – The partners may decide to dissolve their partnership for various
                reasons and this decision must be unanimous unless the partnership agreement specifies otherwise

             b. Duration – If the partnership agreement provides for a limited duration, at the end of such time.

             c. Acts of Partners – Including: withdrawal of a partner, expulsion of a partner, death of a partner,
                bankruptcy of a partner, addition of a partner, and the assignment of a partner’s interest for the
                benefit of creditors.

             d. Operation of Law – “By any event which makes it unlawful for the business of the partnership to
                be carried on and for the members to carry it on in the partnership”. This means that if by either
                legislative enactment or a court decision the business that he partnership was carrying on is no
                longer legal then the partnership is dissolved by operation of law.

         ii) By Court Decree (UPA § 32) – Including if…

                            a. a partner has been declared a lunatic 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,

                            d. a partner willfully 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.

         iii) On Application by a Partner (UPA § 801(5)) – If a judge finds that…

             a. the economic purpose of the partnership is likely to be unreasonably frustrated;

             b. 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
            c.   it is not otherwise reasonably practicable to carry on the partnership business in conformity with the
                 partnership agreement
                 Owen v. Cohen (1941) – P and D entered into oral partnership agreement to operate a bowling alley. P advanced
                 almost $7K to the partnership with understanding that amount so contributed was considered a loan to the partnership
                 and was to be repaid out of the prospective profits. Subsequently, the relationship soured and trial court dissolved the
                 partnership and ordering the assets sold. D appeals. Held: Court was warranted in finding that there were antagonistic
                 feelings which made the parties incapable of carrying on the business to their mutual advantage. P successfully made
                 out a cause for judicial dissolution under UPA § 32(1)(c). D argues because the loan was to be repaid from the profits
                 of the business, the court‟s order directing the discharge of partnership obligation in a manner violative of the express
                 understanding of the parties is unjustifiable. However, because it was D‟s actions which provoked the dissolution of the
                 partnership, to now award the sum owned is consistent with the principles of equity jurisprudence .

   3. Notice of Dissolution to Third Parties – Whether a partner‟s post-dissolution acts bind the partnership to a
      third party often depends on whether the third party knows or has notice of the dissolution. Thus, a
      partnership can limit its liability for unauthorized acts by promptly “spreading the word” both about the
      dissolution and about any limitations on the winding up authority of particular partners.

B. Winding Up – Winding up is the process of liquidating the partnership assets.

   Ex: that is, selling the real and personal property the partnership owned, collecting any outstanding accounts, paying any outstanding
   debts, and closing out any loose ends of the business – canceling orders not yet delivered, canceling any lease or rental agreements,
   terminating any relationships that the partnership may have had with persons who were not partners, etc.

   1. Liquidating the Property – Often, when a partnership decides to dissolve, the partnership assets will be
      sold at auction to pay for the debts of the corporation. At such auction, there is no fiduciary duty preventing
      former partners from bidding on the assets themselves, and in some cases, it can be to partnership‟s benefit

       Prentiss v. Sheffel (1973) – Two partners claimed that the third had been derelict in his duties (i.e. failed to contribute
       proportionate share of losses), and thus the partnership was ordered dissolved. At liquidation of the assets, two partners were the
       highest bidders and were awarded sale of the partnership assets. D claims he was wrongfully excluded from management of the
       partnership that the other two should not be allowed to purchase the assets. Held: There was no indication that the exclusion was
       done for wrongful purpose of obtaining the partnership assets in bad faith rather than being merely the result of the inability of
       the partners to harmoniously function in a partnership relationship. The defendant has failed to demonstrate how he was injured
       by the participation of the other partners in the judicial sale – defendant was not forced to sell his interest to the plaintiffs. He had
       the same right to purchase the partnership assts as they did by submitting the highest bid at the judicial sale

   2. Continuing the Business – The dissolution of a partnership does not automatically mean the termination of
      the business. Rather, winding up in some situations (death, withdrawal, etc.) will simply be an internal
      process of buying out the interest of the partner and making the appropriate bookkeeping changes for the
      reorganization and continued operation of the business.

       i) Disagreement – If there is disagreement about whether the partnership should continue in its business,
          in the absence of an agreement otherwise (see Pav (dissent) infra), UPA § 38 provides default rules…

            a. Rightful Dissolution – (1) When dissolution is caused in any way, except in contravention of the
               partnership agreement, each partner…may have the partnership property applied to discharge its
               liabilities [i.e. any partner may force liquidation], and the surplus applied to pay in cash the net
               amount owing to the respective partners.

                     1. Exception – But if dissolution is caused by expulsion of a partner, he shall receive in cash
                        only the net amount due him from the partnership. However, the partnership still exists.

            b. Wrongful Dissolution – (2)(b) The partners who have not caused the dissolution wrongfully, if
               they all desire to continue the business … may do so…provided they … 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…and in like manner indemnify him against all present or future
           partnership liabilities

           Pav-Saver Corporation v. Vasso Corporation (1986) – Pav-Saver Corp. (inventor = Dale) is the owner of a trademark
           and patents for concrete paving machines. P entered into a partnership agreement with two other parties (Vasso,
           Meersman) for manufacture and sale of Pav-Saver machines. Agreement contained a provision that the trademark was to
           be only used “during the term of the Agreement.” Furthermore, it also said that “this joint venture shall be permanent,
           and the same shall not be terminated or dissolved by either party except upon mutual approval of both parties” (w/out
           penalty of 4x‟s gross royalties). Subsequently, however, Meersman terminated the partnership by ousting Dale and
           assuming the role of day-to-day manager. Trial court ruled that PSC had wrongfully terminated that partnership and
           Vasso was entitled to continue the partnership business and to possess the partnership assets. Held: Despite the parties‟
           contractual direction that the patents would be returned upon the mutually approved expiration of the partnership, the
           right to possess the partnership property and continue in business upon a wrongful termination is recognized by statute.
           DISSENT – Claims that “while the rights and duties of the partners in relation to the partnership are governed by the
           UPA, the uniform act also provides that such rules are subject to any agreement between the parties.”

3. Continued Liability: Existing Debts and Debts Incurred During Winding Up – Even after a partner‟s
   invocation of rightful dissolution, that partner still remains liable for (1) any previously existing debt, and
   (2) debt incurred by any act appropriate for winding up partnership affairs or completing transactions
   unfinished at dissolution.

   i) Exception: Express Assumption of Debt – Where a partner agrees to assume the existing debt of a
      dissolved partnership, the partners whose obligations have been assumed shall be discharged from any
      liability to any creditor of the partnership who, knowing of the agreement, consents to a material
      alteration in the nature or time of payment of such obligations

4. Sharing of Profits or Losses

   i) Generally – UPA § 18(a) provides that: “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”

   ii) Repayment Hierarchy (UPA § 40(b)) – After all the outstanding accounts have been collected, all the
       assets have been turned into cash, and all the outstanding bills and claims against the partnership have
       been paid and settled, then any cash remaining has to be divided among the partners.

       a. Loans – If any of the partners have loaned money to the partnership, those loans are repaid with
          whatever interest was agreed upon.

       b. Initial Investment – Next, the partners will be given back their initial investments

       c. Profits – Finally, if there is still comes cash left, it will be divided among the partners as profits, and
          the distribution will be the same proportions as the distribution of profits in the past and in
          accordance with what is set out in the partnership agreements

   iii) All Partners Presumed to Share Equally in Profits and Losses – In the absence of an agreement to
        the contrary the law presumes that partners intend to participate equally in the profits and losses
        irrespective of any inequality in the amounts each contributed to the capital employed in the venture,
        with the losses being shared by them in the same proportions as they share the profits

   iv) Contribution of Capital v. Labor Irrelevant – Where one partner contributes money as against the
       other‟s skill and labor, neither party is liable to the other for contribution for any loss sustained. Thus,
upon the loss of money, the party who contributed it is not entitled to recover any part of it from the
party who contributed the services.

a. Rationale – Where one party contributes money and the other contributes services, then in the event
   of the loss each would lose his own capital – the one his money and the other his labor

   Kovacik v. Reed (1957) – Kovacik had a chance to remodel some kitchens and asked Reed to become his
   superintendent and estimator. Kovacik explained that if Reed would superintend he would share the profits on a 50-50
   basis. Kovacik did not ask Reed to share any losses that might result, and Reed did not offer to do so nor did Reed
   contribute any funds. Subsequently, the venture lost money and Kovacik demanded that Reed contribute. However,
   Reed claimed that he never agreed to be liable for losses and refused to pay. Kovacik sued for accounting. Held: Reed
   was not liable for any contribution to Kovacik. Each lost their own capital contribution: K‟s money and R‟s labor.

  A. Generally – A limited partnership is an entity, organized under state law, allowing one or more managing
     owners (general partners) to run an enterprise built on money and other property contributed by those owners
     and one or more passive owners (limited partners).

     1. Creation – Creating a limited partnership involves special formalities: namely, the filing of a certificate of
        limited partnership with the public official or office prescribed in the state limited partnership act.

     2. Personal Liability – Like the partners of an ordinary general partnership, the general partners of an
        ordinary limited partnership pare personally liable for all the partnership debts. Limited partners are not
        personally liable except in extraordinary circumstances.

     3. Management – Except as otherwise provided in the partnership agreement, both the right to manage and
        the power to bind a limited partnership are reserved for the general partners. The limited partners are
        essentially passive investors.

     4. Profit and Loss Sharing – Partners in a limited partnership share profits and losses essentially in
        proportion to their respective capital contributions.

     5. Dissolution – Except as otherwise provided in the partnership agreement, the dissociation of a limited
        partner does not dissolve the partnership and the disassociation of a general partner merely threatens the
        partnership with dissolution.

  B. Losing “Limited” Status and Liability – If a limited partner participates in the control of the business of the
     limited partnership, that conduct causes a third party to reasonably believe that the limited partner is a general
     partner, and with that belief the third party transacts business with the limited partnership, then the limited
     partner is liable to the third party as if a general partner.

     Holzman v. De Escamilla (1948) – Partnership was formed between De Escamilla (as general partner) and Russell and Andrews (as
     limited partners) to run a farm. However, subsequently, the farm went into bankruptcy and action was brought for the purpose of
     determining whether Russell and Andrews had become liable as general partners to the creditors of the partnership. R and A claimed
     no, court disagreed. Held: 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. Here, R and A were (1) consulted before any
     decision was made concerning which crops to plant/harvest; (2) visited farms twice a week for such consultation; (3) fired De
     Escamilla; and (4) withdrew money 20 times via checks signed by both partners (the account required two of three to sign). Court says
     that this clearly shows they took part in the control of the business of the partnership and thus became liable as general partners

  A. Corporation Defined – A corporation is an artificial and independent entity (i.e. separate from its owners),
     created under state law, for the organization of economic entities.

     1. Limited Liability – The shareholders‟ liability is normally limited to the amount they have invested. If the
        corporation runs up large debts after the shareholders have made their initial capital contribution, the
        shareholders are normally not responsible for those debts.

     2. Management – Corporations follow the principle of centralized management. The shareholders only
        participate by electing the board of directors. The board of directors then appoints “officers” (i.e. high-
        level executives). The corporation is managed under the supervision of the board, with day-to-day control
        resting with the officers.

         i) Shareholder Voting – Common shareholders have the right to vote (at annual or special meetings) for
            the election of directors and certain “fundamental matters.” Under most state statutes, the fundamental
            matters that require a common shareholder vote include:

             (1) mergers involving the corporation,

             (2) any amendment to the certificate of incorporation,

             (3) the sale of substantially all of the corporation‟s assets, and

             (4) liquidation.

         ii) Shareholders have No Agency Relationship to Corporation – Shareholders are neither agents nor
             principals of the corporation and they can neither act on behalf of the corporation nor give orders to
             officers or other employees at the corporation

     3. Indefinite Duration – There is no limit on the duration of a corporation. It is possible to specify such a
        limit in the corporate documents but this is rarely done. The fact that the ownership (i.e. the shares) changes
        hands, whether by sale, inheritance, gift, etc., does not in any way affect corporation‟s continued existence.

     4. Transferability of Interest – Ownership interest in a corporation are very readily transferable. Ownership
        is embodied in shares of stock, and unless the shareholders agree otherwise, any shareholder may, at any
        time, sell or give his shares to anyone else without consent by the other shareholders.

     5. Assets Separated from Shareholders – Assets of the corporation are held by the corporation.
        Shareholders cannot remove from the corporation their pro rata share of the assets. This protects the
        stability of the corporation as well as the creditors

     6. Taxation – Corporations are taxed as a separate entity. If the corporation has profits or losses, it files its
        own tax return, and pays its own taxes independently of the tax position of its shareholders. Thus,
        shareholders are often subject to double-taxation when the corporation issues dividends as such money is
        taxed both on the corporate level and the individual level.
B. Process of Incorporation – In every state, one of more people may form a corporation by simply filing a
   document with the Secretary of State or some similar stat official. This filing, and subsequent review, is called

   1. Certificate of Incorporation – The central step in the incorporation process is the filing with a state official
      (Sec of State) a document called the articles of incorporation or charter. This is usually a brief document
      which includes: name, duration, corporation‟s power and purpose, specify classes of stock and their
      respective rights, and specify a registered office of incorporation (or name an agent of service of process if
      the corporation‟s offices are outside the state).

   2. Defective Incorporation – Problems arise when a promoter has attempted to incorporate, but b/c of some
      technical defect the incorporation has not yet successfully occurred. The modern view, as embodied in
      most state statutes, expressly imposes personal liability as the penalty for purporting to do business as a
      corporation that is not in fact incorporated.

C. Types of Corporations

   1. Public Corporation – Large firms with many shareholders and w/ active trading of shares. An important
      aspect of a public corporation is its facilitation of passive investments, and thus, the aggregation of
      individual savings, which in turn permits large-scale investment and large-scale operation

   2. Closely Held Corporation – The principal distinguishing feature of the closely held corporation is a small
      number of shareholders.

       i) Shareholders are Managers – The people owning a substantial portion of the total shares will occupy
          the top managerial positions or will be involved in a meaningful way in the selection and monitoring of
          the people who do occupy those positions was well as in the formulation of corporate strategies and
          policies (i.e. there is no separation between ownership and control of a closely held corporation)

       ii) Transferability of Shares – In a closely held corporation, limitations may be imposed on transfer, by
           agreement among the shareholders. In the absence of such agreement, shares are freely transferable but
           often difficult to do. Since it will be unfeasible to sell shares to outsiders, the shareholders may enter
           into an “ancillary” agreement among themselves to provide some mechanism by which they may
           liquidate their shares.

   3. Limited Liability Company (LLC) – The limited liability company is a relatively new, hybrid form of
      business entity that combines the liability shield of a corporation with the federal tax classification of a
      partnership. A creature of state law, each LLC is organized under an LLC statute that creates the company,
      gives it a legal existence separate from its owners, shields those members from partner-like vicarious
      liability, governs the company‟s operations, and controls how and when the company comes to an end.

  A. Generally – A properly-formed corporation will normally shield the stockholders from being personally liable
     for the corporation‟s debts, so their losses will be limited to their investment. However, this shield is not
     complete: In a few very extreme cases, courts sometimes “pierce the corporation veil” and hold some or all of
     the shareholders PERSONALLY LIABLE for the corporation’s debts. This is said to be done only whenever it
     is necessary to “prevent fraud or to achieve equity.”

     1. Determining Which Shareholders Are Liable – Only those shareholders whose actions are related to the
        piercing factors, particularly those who “dominated” the business and abused creditor expectations, may be
        held personally liable for the corporation‟s obligations.

  B. Likely Piercing Factors – Courts are MORE LIKELY to PIERCE in the following situations…

     1. Closely Held Corporations – Courts generally pierce corporate veil ONLY in closely held corporations.
        No reported case of piercing has ever involved the shareholders of a publicly traded corporation. Mainly,
        this is because shareholders in a closely held corporation usually manage the business, choosing the risks
        the business takes and the asset coverage for those risks.

     2. Involuntary Creditors – Court are often less willing to pierce the corporate veil for creditors whose
        dealings with the corporation are voluntary (e.g. suppliers, employees, customers, & lenders) because in the
        background of such dealings is a presumed assumption of risk as the parties had the opportunity to bargain
        for a personal guarantee but decided not to.

         i) No Assumption of Risk With Involuntary Creditors – Involuntary creditors (e.g. tort victims), on the
            other hand, cannot easily protect themselves contractually nor do they knowingly assume the risk of
            dealing with a corporation with limited liability.

     3. Enterprise Liability Doctrine – Courts sometimes use the enterprise liability doctrine to disregard
        multiple incorporations of the same business under common ownership. Courts have accepted a theory of
        enterprise liability when a business artificially separates assets from risks to avoid claims by involuntary
        creditors. This is particular so when for the creditor‟s perspective, the business appeared to be a shell.

         i) Liability Imposed on Enterprise but Not Individuals – This doctrine pools together business assets
            to satisfy the liabilities of any part of the enterprise, but assets of the individual owners are not exposed.

            Walkovszky v. Carlton – Carlton had set up 10 wholly owned cab corporations in which he was the controlling and
            dominant shareholder. Each corporation owned two cabs and employed its own taxi drivers. As required by statute, each cab
            corporation carried insurance in the amount of $10,000 but no more. A taxi driver of one of the corporations ran over
            Walkovsky, who sued all of the other cab corporations and Carlton himself. Held: The corporate form may not be
            disregarded merely because the assets of the corporation are insufficient to assure plaintiff the recovery sought. Thus,
            Carlton is not personally liable since there was no evidence that he conducted the business in his individual capacity or
            siphoned profits. However, the assets of all 10 companies collectively can be attacked under the enterprise liability doctrine
            because the corporations, held out to the public as a single enterprise, were artificially separated into different corporations.

         ii) Parent-Subsidiary Piercing: Generally No Liability – Generally, a parent corporation is not liable for
             the debts of its subsidiary.

         iii) Exception: “Shell” or Single Economic Entity” – However, when a subsidiary corporation is so
              controlled as to be the alter ego or mere instrumentality of its parent, the corporate form may be
              disregarded in the interests of justice. To do this, courts have required a showing that the parent
              dominated the subsidiary so that they acted as a single economic entity.
       a. Factors in Determining whether “Single Economic Entity” – Common directors or officers;
          common business departments; file consolidated financial statements and tax returns; parent finances
          subsidiary; grossly inadequate capital; parent pays salaries; parent provides all business; parent uses
          subsidiary‟s property; daily operations are not kept separate

           In re Silicone Gel Breast Implants Product Liability Litigation (1995) – MEC was an independent, privately-held
           corporation manufacturing a variety of medical and plastic surgery devices including breast implants. Bristol-Meyers
           Squibb purchased MEC. Eventually, however, Bristol shut down MEC‟s production of breast implants. P‟s suing
           Bristol for damages sustained because of MEC‟s breast implants. Held: Bristol ruled liable because it controlled MEC‟s
           board, annual budgets, financial arrangements, employment policies, regulatory compliance, manufacturing quality
           control, and public relations. In addition, Bristol had failed to provide insurance to cover the subsidiary‟s potential
           exposure and had permitted the use of its name in the subsidiary‟s ads and packaging.

       b. Corporations Acting as Limited Partner – Corporations, as a separate entity, can also assume the
          role of general partner in a limited partnership. So long as the corporation‟s officers are not acting in
          an individual capacity, they will not be held individually liable even if they also assume the duel role
          as a limited partner as well.

           Frigidaire Sales Co. v. Union Properties Inc. (1997) – P (Frigidaire Sales) entered into a K with Commercial
           Investors, a limited partnership. D‟s were individual limited partners in Commercial and were also officers, directors,
           and shareholders of Union Properties, the only general partner for Commercial. Commercial eventually breached the K
           with P and P brought suit. P claims that D‟s should be held generally liable for the limited partnership‟s obligations
           because they exercised the day-to-day control and management of Commercial. D‟s argue that Commercial was
           controlled by Union, a separate legal entity and not by them in their individual capacities. Held: Court affirmed lower
           court decision for no liability noting that (1) P was never led to believe that D‟s were acting in any capacity other than in
           their corporate capacities; and (2) D‟s scrupulously separated their actions on behalf of the corporation from their
           personal actions, thus, P never mistakenly assumed that D‟s were general partners with general liability

4. Failure to Observe Corporate Formalities – Courts often look to see whether the participants have
   observed corporate formalities, such as holding shareholders‟ and directors‟ meetings, issuance of stock,
   election of directors and officers, passing resolutions authorizing payments, and keeping corporate minutes.
   In deciding to pierce, courts sometimes cite to the failure to observe corporate formalities and the theory that
   shareholders have used the corporation as their “alter ego” or “conduit” for their own personal affairs.

   i) Rationale – Rarely do the unobserved corporate formalities relate to the creditor‟s claim when
      attempting to pierce. However, looking at such evidence has been justified by the idea that a lack of
      formalities suggests shareholders systematically disregard corporate obligations in general. Moreover,
      such disregard may have confused or misled a creditor about what or whom they were dealing with.

5. Undercapitalization – Courts are often willing to pierce the corporate veil when a corporation is formed or
   operated without capital adequate to meet expected business obligations or a purposeful failure to insure.

   i) Siphoning Profits – When a shareholder drains out all of the profits and/or capital while the company
      operates, whether in the form of salaries, dividends, loans to himself, etc., the court is likely to consider
      this as a form of inadequate capitalization and strongly in favor of piercing the corporate veil.

       Sea-Land Services, Inc. v. Pepper Source – P, an ocean carrier, carries freight for Pepper Source. Pepper Source never
       pays the $87,000 freight bill because it has no funds at the time the bill becomes due. Pepper source is owned by Marchese,
       who also owns five other entities. P sues Marchese and the five entities, seeking to hold Marchese liable for Pepper Source‟s
       debt, and to satisfy any judgment with the assets of the other 5 corporations. Held: Marchese may be held personally liable
       (remanded). All the corporations were run out of a single office and it was common for one company to siphon money from
       the others interest free and thereby leaving a company insolvent and unable to satisfy its liabilities. Furthermore, Marchese
       also siphoned money from the companies to pay personal debts. However, it was not established that injustice would result
       because merely because a judgment would be unsatisfied. Corporate veils are pierced only when some wrong occurred
       beyond a creditor’s inability to collect. There was no such allegation here, and the case was remanded to determine whether
       there was the requisite “injustice” or “fraud” involved here.
       ii) Zero Capital – When the shareholder invests no money whatsoever in the corporation, courts are
           especially likely to pierce the veil, and may require less of a showing on the other factors than if
           capitalization was inadequate but not zero.

           Kinney Shoe Corp. v. Polan – P leases a building to Industrial Realty Co., a corporation owned by D. Other than this lease,
           Industrial has no assets, no income, and no bank account. Nor does Industrial ever issue any stock certificates, because it has
           no paid-in capital. D, the sole shareholder of Industrial, makes no capital contribution, keeps no minutes, and elects no
           officers. D, who has put all his assets in a different corporation, Polan Industries, had Industrial sub-lease the building to
           Polan, and then prevents Polan from asking any payments to Industrial. Consequently, Industrial makes no lease payments to
           P. P sues D, on a veil-piercing theory. Held: D is held liable for the lease to Industrial. Grossly inadequate capitalization
           combined with disregard of corporate formalities, causing basic unfairness, are sufficient to pierce the corporate. A
           stockholder‟s liability is limited to the amount he has invested in the corporation, but Polan invested nothing in Industrial.
           This corporation was no more than a shell – a transparent shell. When nothing is invested in the corporation, the
           corporation provides no protection to its owner.

   6. Commingling Personal and Corporate Assets or Affairs – Piercing is also justified when shareholders
      fail to keep corporate and personal assets separate. As with the emphasis on corporate formalities, the theory
      is that corporate creditors have a valid expectation that business assets will be available to meet their claims.
      Thus, if the corporate funds/assets are being used to pay personal debts, there is an inference that the
      officers are disregarding creditor interests.

   7. Deception – Courts almost always pierce when there is a finding of misrepresentation by the participants
      such that a creditor is deceived into believing that the corporation is solvent or the at the creditor is
      otherwise protected.

C. Justifications for Limited Liability – There are three major justifications underlying the limited liability
   associated with corporations. However, each is subject to critique.

   1. Assumption of Risk – When a creditor decides to become involved with a corporation, that creditor is on
      notice (via the corporation‟s filing of documents) that the corporation is only subject to limited liability.
      Thus, by making such choice, the creditor presumably assumes the risk of dealing with this limitation.

       i) Critique – This theory, however, is often inapplicable to many situations where there was either no
          choice made by the creditor (i.e. involuntary “tort” creditors) or where there was no expectation of
          personal liability by the creditor but the veil is nevertheless pierced.

   2. Encourage Enterprise – Under this theory, limited liability for shareholders is necessary to encourage
      potential investors to invest their money in enterprise. Without such limited liability, risk averse people
      would be deterred from investing, shares would be less freely alienable, and the majority of investing in
      enterprise would be driven solely by large institutions (e.g. banks)

       i) Critique – By investing in a diversified portfolio, the risk associated with a particular investment
          decreases considerably. Furthermore, investors in closed corporations are neither passive investors nor
          ever intend to have their shares freely alienable.

   3. Need for Formalities – Although mainly artificial in nature, corporate formalities provide objective criteria
      to judge the existence of a corporation. Thus, because limited liability is merely a line-drawing exercise
      anyway, corporate formalities serve as the best possible benchmarking standard.

       i) Critique – Corporate formalities are completely artificial in nature and should not serve as justifying
          certain entities to escape liability while others (e.g. partnerships) do not.

  A. Generally – The board of directors manages and oversees the corporation‟s business and affairs. Judicial
     review of directors‟ performance of their decision-making and oversight functions is governed by the duty of
     care, which in turn is defined by the business judgment rule.

  B. Duty of Care – Virtually all states impose, either by statute or case law, a duty of due care on all officers and
     directors. The director or officer must exercise that degree of skill, diligence, and care that reasonably prudent
     person would exercise in similar circumstances.

     1. MBCA § 8.30 – The Model Business Corporation Act states the typical law in most states: “A director shall
        discharge his duties as a director…

         (1) in GOOD FAITH;

         (2) with the care an ORDINARY PRUDENT PERSON in a like position would exercise under similar
         circumstances; and

         (3) in a manner he REASONABLY BELIEVES to be in the BEST INTEREST of the corporation.”

     2. Violation Results in Personal Liability – A director who violates his duty of care, and who thereby injures
        the corporation, may be held personally liable for the corporation‟s damages. This is even true if the
        director is paid little or nothing for his director‟s services, and otherwise had little or nothing to gain.

     3. Violations Not Common – The actual business decisions made by a director or officer will not be second-
        guessed by the court as long as they are rational, made in good faith, and based on reasonable information.
        Thus, liability for breach of the duty of due care generally arises where the director or officer has failed to
        comply with reasonable procedures for making decisions. Even where the director‟s procedures were
        inadequate, most courts hold that there is only liability for “gross negligence” or “recklessness”

         i) TOTAL FAILURE to Act as Director – Most successful claims against directors have come in cases
            where the director simply fails to do the basic things that directors generally do. Thus a director might
            be found GROSSLY NEGLIGENT (and therefore liable) if he does some or all of the following:

             (1) fails to attend meetings;

             (2) fails to learn anything of substance about the company’s business;

             (3) fails to read reports, financial statements, etc. given to him by the corporation;

             (4) fails to obtain help (e.g. advice of counsel) when he sees or ought to see signals that things are going
             seriously wrong with the business; or

             (5) otherwise neglects to go through the standard motions of diligent behavior.
C. Business Judgment Rule – The business judgment rule is a rebuttable presumption that directors in
   performing their functions are honest and well-meaning, and that the decisions are informed and rationally
   undertaken. In short, the business judgment rule presumes that directors do not breach their duty of care.

   1. MBCA § 8.31 – A director shall not be liable to the corporation or its shareholders for any decision to take
      or not to take action, or any failure to take any action, as a director, unless the party asserting liability in a
      proceeding establishes that… the challenged conduct consisted or was the result of…a decision…

       (A) which the director did not reasonably believe to be in the best interests of the corporation, or

       (B) as to which the director was not informed to an extent the director reasonably believed appropriate in
           the circumstances; or

   2. Purpose of the Rule – The presumption of the business judgment rule operates at two levels: (1) it shields
      directors from personal liability, and (2) it insulates board decisions from judicial review.

       i) Justification – The business judgment rule has been supported by the idea that it encourages educated
          risk-taking, it avoids judicial meddling, and it encourages qualified people to become directors and take
          business risk without being judged in hindsight.

       ii) Overcoming the Presumption – When a board decision is challenged, courts place the burden on the
           challenger to overcome the business judgment presumption by proving either: (1) fraud, illegality, or
           conflict of interest (i.e. lack of good faith), (2) lack of a rational business purpose, or (3) gross
           negligence in discharging duties to supervise and to become informed.

   3. Decisions Lacking Good Faith – A director loses the presumption that he was acting in good faith if the
      challenger shows fraud, conflict of interest, or illegality.

       i) Fraud – A director who acts fraudulently is liable, and any action tainted by the fraud can be
          invalidated, regardless of fairness.

          Ex: Directors who mislead shareholders in connection with shareholder voting; directors who knowingly disseminate false or
          misleading information to public trading markets; directors who knowingly or recklessly misrepresent a material fact to the
          board on which the other directors rely to the corporation‟s detriment.

       ii) Conflict of Interest – If a director is personally interested in a corporate action because he stands to
           receive a personal or financial benefit, the business judgment rule presumption shields neither the
           director from liability nor the board‟s approval from review.

          Ex: X is an officer and director of Printing Corp. He votes to have Printing Corp. purchase most of its paper from Paper
          Corp. Paper Corp. charges the avg. of 5% more for the same paper as is available from Discount Corp. It turns out that X is
          a secret substantial shareholder in Paper Corp. who will benefit financially from this large volume of business from Printing
          Corp. Thus, X is “interested” in the transaction and thus will not receive the protection of the business judgment rule.

       iii) Illegality – If directors approve illegal behavior or remain intentionally ignorant of it, the prevailing
            view is that the business judgment presumption is lost.

          Ex: Bribery of state officials; bribery of foreign officials; dismantling and removal of corporate plants and equipment to
          discipline unruly employees in violation of labor laws; a business plan that created a strong incentive for employees to
          commit Medicare/Medicaid fraud in attracting medical referrals.
4. Decisions Lacking Rational Business Purpose – The protection of the business judgment rule also can be
   overcome if the action of the directors lacked a “rational” business purpose. The focus is on the merits of
   the board action or inaction and the absence of a rational business purpose suggests bad faith. However, if it
   can be said that the corporation received some fair benefit, the matter is entrusted to the director‟s judgment.

   i) “Rational” Purpose – The director must have rationally believed that his business judgment was in the
      corporation‟s best interest. Thus, so long as the business judgment was not “improvident beyond
      explanation,” “removed from the realm of reason,” or totally beyond the bounds of reason, it will be
      sustained even though most people might have not held such a belief.

       Kamin v. American Express Company – The D‟s are the directors or American Express Co. They have caused the
       corporation to distribute the shares it holds in a separate company, DLJ, to shareholders as a special dividend. P, an Amex
       shareholder, brings a derivative suit against the D‟s alleging that they should have had American Express sell these DLJ
       shares on the open market instead of distributing them as a dividend. He points out that this technique would have resulted in
       substantial tax savings to the shareholders. Held: P makes no claim that the D‟s engaged in fraud or self-dealing. P is
       merely claiming that a different decision by the board would have been more advantageous. But a complaint alleging merely
       that some other decision would have been wiser does not state a cause of action, because of the business judgment rule.
       More than imprudence or mistaken judgment must be shown. Here, the evidence shows that the directors considered the
       tax advantages in selling the stock rather than distributing it, but were worried that this path would hurt the corporations‟
       reported earnings. Thus, their decision did not lack a rational business purpose and was reached in good faith.

   ii) Salary & Severance As Rational Judgment – If an independent and informed board, acting in good
       faith, determines that the services of a particular individual warrant large amount of money, whether in
       the form of current salary or severance provisions, the board has made a business judgment. That
       judgment normally will receive the protection of the business judgment rule unless the facts 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

       Ex: See Grimes v. Donald (infra)

5. Gross Negligence (i.e. Not Being Informed) – When making any business decision, to fall under the
   protection of the business judgment rule, a director or officer must be informed. This means that all
   material information reasonably available was gathered before the decision was made. By failing to obtain
   such information, a director can be deemed to have acted with gross negligence in making the decision.

   i) Difficult to Overcome Presumption and Impose Liability – Because the courts will consider all the
      surrounding circumstances of a decision and require gross negligence on the part of the decision-
      maker before the presumption of the business judgment rule is overcome, it is only in egregious cases
      where the officer or director will be held personally liable.

   ii) Decision-Making Procedure Important – The process is exceptionally important in avoiding a ruling
       of gross negligence. Directors must do more than “go through the motions” in approving major business
       transactions. Directors must gather all relevant information, must take whatever time is reasonably
       available in the circumstances before deciding, and must interrogate management closely rather than
       merely “rubber stamping” management‟s recommendations

       a. Relying on Information from Employees – MBCA § 8.30(d) – A director, who does not have
          sufficient knowledge is entitled to rely on information, opinions, reports or statements, including
          financial statements and other financial data, prepared or presented by reliable corporate executives
          or legal counsel.
          Smith v. Van Gorkom – P (shareholders of Trans Union) sued the CEO (VG) and board of directors of Trans Union. Trans
          Union had hard time generating taxable income. Thus, VG met, without anyone knowing, with corporate takeover specialist
          and assembled proposed per share price for sale of company at 55/share. However, there was no evidence that 55 represented
          per share intrinsic value of the company. Furthermore, VG was approaching mandatory retirement and thus the deal looked
          even more suspicious. VG eventually called a senior management meeting where he disclosed the offer. However, there
          were no copies of the proposed merger and only 2 members supported the idea. Nevertheless, at a board of directors meeting
          the deal was approved with only an oral presentation, no copies of the deal, and no disclosure about how he came to terms.
                   Held: The Court held that the directors had been grossly negligent in failing to inform themselves adequately about
          the transaction they were approving. The majority seemed especially influenced by the fact that (1) it was VG who had
          promoted the deal and named the eventual sale price; (2) the board had made no real attempts to learn the “intrinsic” value of
          the company; (3) the board had no written documentation before it and relieved completely on oral statements, made by VG,
          and (4) the board made its entire decision in a two hour period, with no advanced notice that a buyout would be the subject of
          the meeting and where there was no real crisis or emergency.

          b. Post-Decision “Curative” Action – The Court in Van Gorkom also concentrated on the question of
             whether there were post-decision acts that cured the negligence and bad business decision. This
             analysis is rather unique because in other liability situations there is no similar “curing the
             negligence” defense available.

              Ex: In Van Gorkom, the D‟s claimed that it had reserved the right to take any higher offer during the “market test” period
              to prove the intrinsic value of the company and thereby curing any negligence that had occurred. The court, however,
              found this to be illusory because of tight limits that the agreement placed upon the board‟s ability to accept such offers.

          c. Aftermath of Van Gorkom: A Significant Decision – The decision in Van Gorkom made many
             board of directors more diligent about the process they used to analyze and approve decisions. In
             response, many companies created specific provisions in their corporate charters which shielded
             directors for personal liability for breaching a similar duty of care.

D. Causation – MBCA § 8.31(d) – Places the burden on the challenging shareholder to shw that the directors‟
   inattention was the proximate cause of any corporation injury. Thus, even if the directors breached a duty under
   the business judgment rule, their liability is not automatic.

  A. Shareholder Suits Generally – Two remedies available to shareholders to vindicate interests. Shareholders
     can either sue in their own capacity to enforce their rights as a shareholder (i.e. a direct action), or they can sue
     on behalf of the corporation to enforce corporate rights that affect them indirectly (i.e. a derivative action).

     1. Derivative Suits Defined – In a shareholder‟s derivative suit, an individual shareholder brings a suit in the
        name of the corporation against an individual wrongdoer. The wrongdoer can be either an insider (e.g.
        officer who has breached the duty of due care or the duty of loyalty) or it may be an outsider (e.g. third party
        who injured the corporation by breaching a contract, committing a tort, etc.).

     2. Distinction from Direct Suit – In the most general sense, the distinction if based on who has been directly
        injured: if the injury is done to the corporation the suit is a derivative action; if the injury is to one or
        numerous shareholders, the suit is direct.

         Derivative Examples – Breaches in fiduciary duties, self-dealing, excessive compensation, and corporate opportunity doctrine

         Direct Examples – Challenging the dilution of voting rights, compelling dividend declared by not paid, compelling inspection of
         shareholders‟ lists or corporate books and records, prohibited from inspection, protection of minority shareholders

     3. Recovery – In a derivative suit, the recovery is always by the corporation and the plaintiff benefits only to
        the extent that his shares in the corporation become more valuable due to the corporation‟s recovery. In a
        direct action, the plaintiff may be able to put the money directly into his own pocket.

  B. Requirements for Maintaining a Derivative Suit – There are three main procedural requirements …

     1. P must have been a SHAREHOLDER AT THE TIME OF THE ACTS complained of (the
        “contemporaneous ownership rule”)

     2. P must STILL BE A SHAREHOLDER at the time of the suit; and

     3. P must make a DEMAND UPON THE BOARD of the corporation requesting that the board attempt to
        obtain redress for the injury the corporation has suffered

         i) Futile Exception: No Demand Necessary – Derivative suits can be pursued by a shareholder without
            the permission of the Board if it is alleged that a demand for action by corporation would be futile b/c…

             a. A majority of the board has a material financial or familial interest; or

             b. A majority of the board is incapable of acting independently for some other reason such as
                domination or control; or

             c. The underlying transaction is not a product of valid exercise of business judgment

         ii) Rejection by Board: Protected by Business Judgment Rule – If a demand is made and rejected, the
             board rejecting the demand is entitled to the presumption of the business judgment rule...


             …The stockholder can allege certain FACTS WITH PARTICULARITY that the board‟s response to the
             demand was self-interested, dishonest, illegal, or insufficiently informed and thus rebutting the
           Grimes v. Donald (1996) – Shareholder P (Grimes) sought a declaratory judgment claiming that certain Employment
           Agreements made between the Board of Directors of DSC Communications Corporation and its CEO, D (Donald). The
           Agreements provided for a situation called a “Constructive Termination Without Cause,” wherein Donald can declare
           termination as a result of unreasonable interference in the good judgment of Donald by the Board or substantial stockholder
           of the Company in Donald‟s carrying out his duties and responsibilities.” If a Termination w/out Cause was declared,
           Donald was entitled to a significant compensation severance package. Grimes wrote the board claiming that it breached its
           fiduciary duties because the potentially sever financial penalties which the Company would incur in the even that the Board
           attempts to interfere in Donald‟s management of the Company will inhibit and deter the Board from exercising its duties.
           However, the board refused to bring action. Held: Although a demand was made, the complaint fails to include
           particularized allegations which would raise a reasonable doubt that the Board‟s decision to reject the demand was the
           product of a valid business judgment. Thus, following the refusal, the complaint failed to state a valid claim.

C. Special Litigation Committees – Since the mid-1970‟s, there has been wide-spread use by corporations of
   independent committees to defeat derivative litigation. Such committees are usually made up of directors who
   are independent and have no financial stake in the transaction, and the committee conducts an investigation into
   the purported claims. However, in virtually all instances, the committee recommends that the suit be dismissed.

   1. Two Part Test – In reviewing the decision of the board, courts often follow the Delaware procedure…

       i) Procedural Inquiry – The court should determine whether the committee acted independently and in
          good faith, and whether the committee used reasonable procedures in conducting its investigation.

       ii) Substantive Inquiry – Even if the committee passes all the procedural requirements, a court may still
           look to the merits of the case and determine by applying the business judgment rule whether the suit
           should be dismissed.

           Zapata Corp. v. Maldonado – Maldonado (P) instituted a derivative action on behalf of Zapata against ten officers/directors
           alleging breaches in fiduciary duty. Maldonado did not first demand that the board bring this action stating instead such
           demand‟s futility because all the directors were named as defendants and allegedly participated in the acts. In response, the
           Board created an Independent Investigation Committee composed of two new directors to investigate the claims.
           Eventually, the Board concluded that each action should be dismissed in the best interest of the Company. Thus, the issue of
           the case involves whether an appointed committee has the power to move for a dismissal brought by a shareholder on behalf
           of the company. Held: The Court established a two step inquiry into whether the committee‟s recommendation to dismiss
           would be respected: (1) Procedural Inquiry – the Court should inquire into the independence and good faith of the
           committee and the bases supporting its conclusions. The corporation should have the burden of proving independence, good
           faith, and a reasonable investigation. (2) Substantive Inquiry – the Court should determine, applying its own independent
           business judgment, whether the motion should be granted. In doing this, the Court must carefully consider and weigh how
           compelling the corporate interest in dismissal is when faced with a non-frivolous lawsuit. Here, this was met.

D. Settlement of Derivative Suits – Generally, if the corporation settles the subject matter of the derivative suit
   claim, the corporate settlement is binding on all derivative suits under res judicata. Unless the shareholder can
   then allege fraud or a fiduciary breach that would justify vacating the judgment, the claim is extinguished.

   1. Subsequent Claims of Breach of Fiduciary Duty – Even when the subject matter of the original derivative
      suit is settled by the corporation, the stockholder can still bring a subsequent cause of action claiming that
      the settlement constituted a breach of fiduciary duty (e.g. duty of care or loyalty).

E. Policy Debates Concerning Derivative Lawsuits – Two major controversies surround derivative lawsuits…

   1. Strategic Implications? – Following the rulings in Grimes and Zapata, it seems that it is in the best
      interests of the shareholder never to make a demand to the board of directors. If such a demand is made, it
      gives the board the opportunity to either appoint a committee to deny the claim or deny the claim outright.
      Either way, though, it allows the board to gain the presumption of the business judgment rule and gives
      them the opportunity to articulate their arguments to the court early on.
2. Frivolous Lawsuits? – The area of derivative lawsuits is highly controversial and strong arguments can be
   made both in favor and against such suits…

   i) Arguments Favoring Derivate Suits – Those who favor such suits and believe that they truly are in the
      “shareholders‟ interest” believe that (1) such suits are practically the only effective remedy against
      insider wrongdoing, and (2) a successful, or even threatened, derivative suit will have a useful deterrent
      effect toward all potential wrongdoers.

   ii) Against Criticizing Derivative Suits – Opponents who argue that derivative suits are not
       “shareholders‟ suits” believe that (1) the mere prosecution of a derivative suit often wastes a lot of the
       time and energy of the corporation‟s senior executives, and any resulting benefit to the corporation is
       less that the value of this time and energy, (2) that corporate managements will fear such suits and thus
       become risk averse in trying to maximize shareholder value, and (3) because it is often in the
       corporation‟s best interests to settle such suits even when there is no merit, this gives incentive to
       plaintiff’s lawyers to bring suits with little probability of success (but which are settled anyway) and
       thus in the end only the lawyers, not the corporation, are enriched.

  A. Generally – Fiduciary duties are owed by those who control and operate corporations to the shareholders.
     Directors, officers, and controlling shareholders are obligated to act in the corporation‟s best interests,
     principally for the benefit of the shareholders. However, an underlying debate exists concerning whether
     corporations owe a duty to the public as a whole.

  B. Shareholder Maximization v. Social Responsibility – Many courts assert that fiduciary rules should proceed
     from a theory of shareholder maximization. The theory posits that any fiduciary rule – whether governing
     boardroom behavior or the use of inside information – must maximize the value of the shareholders‟ interest in
     the corporation.

     1. Milton Friedman: “The Social Responsibility of Business is to Increase its Profits” – Argued that the
        only duty of directors is a responsibility to conduct the business in accordance with the shareholders’
        desires, which generally means to make as much money as possible while conforming to the basic rules of
        society, both those embodied in the law and those embodied in ethical custom (i.e. no fraud or deception)

         i) Fake Social Responsibility –. To Friedman, “pseudo charity” is acceptable because underlying the
            guise of social responsibility is the goal of maximizing the value of the company. For example, if
            making a donation will increase the good will of the corporation, and thus indirectly the value to the
            shareholders, then this action falls within the fiduciary duty of the executive.

         ii) True Social Responsibility – On the other hand, “true charity” should be forbidden because there is
             no goal to maximize shareholder value. Rather, in essence, the director is spending someone else‟s
             money (i.e. the shareholder) in a way that is not in the best interests of his employers. Permitting such
             behavior gives the executive the power to “tax” the shareholders and accepts the socialist view that
             political mechanisms, not market mechanisms, are the appropriate way to determine the allocation of
             scare resources.

     2. Traditional View – A business corporation is organized and carried on primarily for the profit of its
        stockholders, and the powers of the directors must 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 non-distribution of profits among stockholders in order to devote them
        to other purposes (i.e. social or charitable causes).

         i) Declaring Dividends – Courts will not interfere in the management of the directors to declare (or not)
            a dividend unless it is clearly made to appear that they are guilty of fraud or misappropriation of
            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 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 toward the stockholders.

            Dodge v. Ford Motor Co. – Over a 5 year period, Ford issued annual special dividends ranging from 4 M to 11 M. In 1916,
            however, Henry Ford announced that in the future no special dividends would be paid. Rather, profits would be reinvested in
            the business – to expand the existing plant and to build an iron ore smelting plant so as to permit the company to make its
            own metal parts. In addition, the price of the company‟s cars would be reduced. Dodge brothers (P) had a share in special
            dividends of $1M and only would receive $120 K indefinitely with the new announcement. Therefore, they brought suit
            alleging that the proposed expansion ought to be enjoined b/c it was not in the best interests of the company and its
            shareholders. Held: Court ordered the special dividend to be paid but refused to enjoin the expansion of the plants. Because
            it had been tradition to issue dividends under similar circumstances, it seems that a refusal to declare and pay further
            dividends is an arbitrary refusal to do what the circumstances required the apparent immediate effect would be to diminish
            the value of shares and the returns to shareholders. A corporation is organized for the benefit of stockholders, not for
            charitable purposes. Thus, it was not up to Henry Fort to say that the company was already making enough money, and that
            no dividend was appropriate.
      ii) Framing the Decision – Modern economists think that the Dodge decision was ludicrous because they
          believe that Ford usually changed more than the equilibrium and this decision was merely an adjustment
          to increased demand (i.e. when demand went up the price went up, but then w/ expansion of the supply
          followed, then it naturally meant that the price would fall too). Thus, Ford got in trouble merely for
          making a good business decision. If Ford had framed the decision around the economic issues, rather
          than claiming that the company had made enough money, it may have been upheld in court.

   3. Modern View – Through subsequent cases, more discretion has been given to corporate executives to make
      strategic “social” contributions. However, seemingly under all these decisions, there was an underlying
      rationale concerning how the contribution served to benefit the corporation.

      i) Recognize Changed Social/Philanthropic Environment – Modern conditions require that corporations
         acknowledge and discharge social as well as private responsibilities as members of the communities
         within which they operate

      ii) Statutory Support – Many states enacted statutes which provided that any corporation could donate to
          community funds and charitable, philanthropic or benevolent instrumentalities in sums the directors
          “deem expedient and as in their judgment will contribute to the protection of the corporate interests.”

          A.P. Smith Mf. Co. v. Barlow (1953) – A.P. Smith Manufacturing Co.‟s Board of Directors decided that it was in the best
          interests of the company to join with others in the Annual Giving to Princeton University and appropriated the sum of $1500
          to be transferred to the University. The Board claimed that it was a sound investment, that the public expects corporations to
          aid philanthropic and benevolent institutions, that they obtain good will, and that their donations create a favorable
          environment for business operation. However, dissenting shareholders objected saying that (1) the P‟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 NJ statutes which expressly authorize the contribution may not
          constitutionally be applied to the P, a corporation created before their enactment. Held: Court ruled that public policy
          supporting the statutory enactments is far greater than the alteration of the preexisting rights. Thus, Court permits the
          donation because it was within the limits of the statute and made in the reasonable belief that it would aid the public welfare
          and advance the interest of the P as a private corporation and as part of the community in which it operates.

C. Policy Debate: Should the Law restrict Social Responsibility Spending? – Some academics have argued that
   the laws restricting charitable contributions by corporate executives are unnecessary because there are other
   market forces that already restrict such behavior, such as…

      i) Labor Market – If a corporate director decides to contribute too much (or presumably too little) money
         in social causes, that director is compromising future employment possibilities. Thus, in looking at their
         position in a future labor market, corporate executives will be constrained in their decisions.

      ii) Capital Market – If a company “wastes” money on social and charitable causes, the potential dividends
          will naturally be smaller. This reduces expected returns for a potential investor. Therefore, if a
          corporation contributes too much, many people will be unwilling to invest and the company will suffer.

      iii) Product Market – If a company contributes too little in social or charitable causes, the public may
           regard this as negative and refuse to buy the corporation‟s product or services.

      iv) Takeover Possibility – A company who “wastes” money in social causes rather than strengthening its
          own operations will possibly be subject to a takeover or buyout. Thus, corporate executives have reason
          to avoid wasting profits on social causes.

  A. Generally – The duty of loyalty for corporate managers put corporate interests ahead of their own applies not
     only to their dealings with the corporation but also to outside business dealings that affect the corporation.
     Financial harm to the corporation is just as real when a manger takes a profitable business opportunity from
     the corporation as when the manger enters into an unfair transaction on behalf of the corporation.

  B. Corporate Opportunity Doctrine – A corporate manager (director or executive) may not usurp corporate
     opportunities for his own benefit unless the corporation consents. The plaintiff has the burden of proving the
     existence of a corporate opportunity.

     1. General Rule – If there is presented to a corporate officer or director a business opportunity which…

         (1) the corporation is FINANCIALLY ABLE to undertake,

         (2) is from its nature in the LINE of the CORPORATION’S BUSINESS and is of practical advantage to it,

         (3) is one in which the corporation has an INTEREST OR A REASONABLE EXPECTANCY,

         (4) and, by embracing the opportunity, the SELF-INTEREST of the officer or director will be BROUGHT
             in CONFLICT with that of the corporation,

         …then the law will NOT PERMIT him to seize the opportunity for himself

         i) Financially Able to Undertake – In theory, an opportunity is not realistically a “corporate opportunity”
            unless the corporation was financially capable of acting upon it.

             a. Criticism – Even if a manger shows the corporation lacked the funds to take advantage of the
                opportunity, it can always be argued that the corporation could have raised the funds by borrowing
                money or by issuing new stock. After all, the manger had sufficient access to capital to take the
                opportunity for himself.

                 Ex: See Broz (infra)

         ii) Line of Business – An opportunity is a corporate opportunity if it is closely related to the corporation‟s
             existing or prospective activities. This will cover prospective activities if the business does not already
             engage in that line of business but has a special expertise or functional relationship with it.

             Ex: If a company already makes cold medicine, a business that makes contact liens wetting solution would be within its “line
             of business” because the methods of marketing and distributing the products, through drug stores for example, overlap
             enough to permit significant economies to scale if the business were combined.

         iii) Interest or Reasonable Expectancy – A corporation would have found to have an interest in an
              opportunity if it already has some contractual right regarding the opportunity. A corporation has an
              expectancy with respect to an opportunity if its existing business arrangements have led it to reasonably
              anticipate being able to take advantage of that opportunity.
             Ex: Suppose that Corporate rents office space in a particular building. If the C has a lease that gives them the contractual
             right to renew the space but the officer chooses not to and then rents it, then C had an interest in the opportunity. If C has a
             lease that does not give a contractual right but the officer signs a lease to start right after C‟s lease ends, then C would be
             found to have an expectancy in the opportunity to renew the lease.
       iv) Other Factors Considered by Courts – There are a number of additional factors which courts may
           consider in deciding whether an opportunity is a “corporate opportunity” including…

            a. Capacity in which Opportunity was Received – Whether the opportunity was offered to the officer
               or director as an individual, or rather as a corporate manger who would convey offer to the

                i. ALI § 5.05(b) – Under the ALI Principles, a line-of-business opportunity is not considered a
                   “corporate opportunity” when an outside director learns of it in a noncorporate capacity.

            b. How Insider Learned of Opportunity – Whether or not the officer or director learned of the
               opportunity while acting in his role as the corporation‟s agent (e.g. at a trade meeting).

            c. Use of Corporate Resources – Whether the officer or director used corporate resources to take
               advantage of the opportunity (e.g. using the company jet to scout out the opportunity)

C. Corporation’s Consent Relinquishes Right to Recover – Even if a court determines that an opportunity is a
   corporate opportunity, the corporation‟s interest is negated if corporation voluntarily consented to the taking.

   1. ALI Approach (§5.05) – A director or officer may not take advantage of a corporate opportunity unless:

       i) The director or senior executive FIRST OFFERS the corporate opportunity to the corporation and
          makes disclosure concerning the conflict of interest and the corporation opportunity …

       ii) The corporate opportunity is REJECTED by the corporation; and …

       iii) Either …

            a. The rejection of the opportunity if FAIR to the corporation;

            b. The opportunity is rejected in advance, following such disclosure, by disinterested directors in a
               manner that SATISFIES the standards of the BUSINESS JUDGMENT RULE;

            c. The rejection is authorized in advance or ratified, following such disclosure, by disinterested
               shareholders, and the REJECTION is NOT equivalent to a WASTE of corporate assets.

D. Potential Future Opportunities – The right of a director or officer to engage in business affairs outside of his
   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.

   Broz v. Cellular Information Systems, Inc. (1996) – Broz was both president of RFBC and a member of Board of Directors for
   Cellular Information Systems, Inc. RFBC owns and operates an FCC license area entitling RFBC to provide cellular telephone
   service to a portion of rural Michigan. CIS is a competitor of RFBC. The rights to a licensing area next to one which was owned by
   RFBC came on the market and Broz was approached to purchase it. After hearing about the deal, Broz went to multiple officers of
   CIS to inquire whether CIS was interested in the licensing area as well. Upon hearing back from all three that there was no interest,
   Broz exercised an option to buy the area. During this same time, however, CIS was being purchased by PriCellular, another company
   that was trying to bid on the same area. Once the option was exercised and Broz bought the area and PriCellular bought CIS, this
   action was commenced alleging breach of fiduciary duties by Broz toward CIS. Held: Broz was presented the offer to buy the area in
   his individualized, rather than officer, capacity. Then he inquired into CIS‟s desire to compete/bid for the area and it was made clear
   that CIS was financially incapable and uninterested. There is no requirement that Broz need to have taken into account the possibility
   that PriCellular would acquire CIS and thus create another possible future conflict of interest in his position on the Board of
   Directors of CIS
E. Shifting Burden of Proof

   1. A party who challenges the taking of a corporate opportunity has the burden of proof of proving that such
      an opportunity existed and was usurped from the corporation.

   2. If such party establishes this, the director or the senior officer has the burden of proving that the rejection
      and taking of the opportunity were fair to the corporation or under other permissible circumstances.

F. Remedies – A director who usurps a corporate opportunity without consent must share the fruits of the
   opportunity as though the corporation had originally taken it. Remedies include

   1. Liability for profits realized by the usurping manager,

   2. Liability for lost profits and damages suffered by the corporation, and

   3. Imposition of a constructive trust on the new business or the subject matter of the opportunity.

   A. Generally – Corporate fiduciary duties extend to those who control the corporate governance mechanisms. Not
       only are directors and officers responsible, but also any shareholder with voting control, i.e. a controlling or
       dominant shareholder. With the power to select the board and approve fundamental changes, a controlling
       shareholder can act to the detriment of minority shareholders. For this reason, courts impose fiduciary duties on
       controlling shareholders that generally parallel those of directors.

       1. Controlling Shareholders – A controlling (or dominant) shareholder, whether an individual or parent
          corporation, has sufficient voting shares to determine the outcome of a shareholder vote. Board majorities
          are usually chosen by majority vote, and any shareholder who can assemble a voting majority wields
          effective control

   B. Fiduciary Duty of Dominant Shareholder – A dominating or controlling shareholder is a fiduciary, whose
       dealings with the corporation must be subjected to rigorous scrutiny and the burden is on the majority
       shareholder 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 (i.e. all the shareholders, including minority)

   C. Parent-Subsidiary Dealings – Many cases involving the duties of a controlling shareholder to non-controlling
       holders arise in the context of the relationship between a parent and its not-wholly-owned-subsidiary.

       1. Wholly-Owned Subsidiaries – When a subsidiary is wholly owned and there are no minority shareholders,
          the parent has virtually unfettered discretion to do with the subsidiary corporation as it pleases. Duties
          exist only to creditors, and, to a limited extent, future minority shareholders.

       2. Partially-Owned Subsidiaries – Parent-subsidiary dealings in the ordinary course of business are subject to
          fairness review only if the minority shows that the parent has preferred itself at their expense. If so, the
          courts presume the parent dominates the subsidiary‟s board and places the burden on the parent to proves
          that the transaction was “intrinsically fair” to the subsidiary.

          i) Self-Dealing – Concerns the situation where a parent corporation is on both sides of a transaction with
             its subsidiary. 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

          ii) “Intrinsic Fairness” Test – When there is self-dealing involved in a transaction, the interested party
              (i.e. parent) must prove that the transaction was intrinsically fair to the interests of the minority
              shareholders (i.e. subsidiary).

              a. Shifting Burden of Proof – Under this standard, once that the minority holders of the subsidiary
                 show that there has been self-dealing by the parent corporation, the burden of proof shifts to the
                 parent corporation to prove that its transaction with the subsidiary company was objectively fair.

                  Sinclair Oil Corp. v. Levien – Sinclair Oil owns 97% of the stock of Sinclair Venezuelan Co. (Sinven). Sinclair
                  controls the board of directors of Sinven. Sinclair causes Sinven to pay out extremely high dividends (in fact, dividends
                  in excess of Sinven‟s earnings) during a 7-year period. The plaintiffs (who are among 3% minority shareholders in
                  Sinven) sue Sinclair arguing that this dividend policy violates Sinclair‟s fiduciary duty. Furthermore, Sinclair and
                  Sinven make a contract in which Sinven agrees to sell all of its crude oil and refined products to Sinclair at specified
                  prices. The contract includes minimum and maximum quantities and it does not order the contractually-specified
                  minimums. The plaintiffs claim that the contract constituted self-dealing, and that it should be struck down unless
                  Sinclair shows that the contract was fair. Held: The court ruled in favor of D regarding the dividends but for P‟s
                  regarding the contract.
                Dividends – The dividends were paid in proportion to stockholdings, so the P‟s got their pro rata share of all dividends
                paid. Therefore, the setting of the dividend policy is not self-dealing by Sinclair and thus not subject to the intrinsic
                fairness test. Instead, the policy must be judged by the business judgment rule. Since the P‟s cannot show that the
                dividends resulted from improper motives and amounted to waste, the business judgment rule is satisfied, and the
                dividend policy must be upheld.

                Contract – The contract meant that Sinclair was taking Sinven‟s oil for itself, rather than allowing the oil to be sold on
                the open market. Therefore, the contract was self-dealing. Such a self-dealing contract will only be upheld if the parent
                satisfies the “intrinsic fairness” test. Here, Sinclair did not bear the burden of showing why Sinven‟s failure to enforce
                the contract against Sinclair was intrinsically fair to the minority shareholders in Sinven. Therefore, Sinclair is liable to
                the minority shareholders for their share of the damages that Sinven could have obtained for the breach.

D. Duty of Complete Disclosure to Minority Shareholders – When a controlling shareholder or group deals with
   the non-controlling shareholders, it owes the latter a duty of complete disclosure with respect to the transaction.

   1. Majority Not Required to Subordinate Interests – Majority shareholders do not have to put their interests
      behind those of minority shareholders. Rather, if the decision is one that a disinterested board would choose
      to pursue, controlling shareholders must only make full disclosure to their fellow shareholders when they
      propose such a transaction.

   2. Must Furnish Minority With Adequate Information – Even if the controlling shareholder is not a
      director or officer, most courts have held that his fiduciary obligation to his fellow shareholders includes the
      obligation to furnish these fellow shareholders with all the information they reasonably need to protect their
      own interests.

       Zahn v. Transamerica Corp. – A corporation had two classes of common shares, class A and class B. The class B shares held
       the voting control. The class A shares, which were entitled to twice as much in liquidation as class B shares, could be redeemed
       by the corporation at any time for $60. The class B shareholder, Transamerica, since it was an “insider,” became aware that the
       company‟s tobacco inventory had become dramatically more valuable than shown on the company‟s books. It therefore decided
       to have the company sell its assets to a third party and liquidate. To do this, Transamerica had the corporation redeem all of the
       minority‟s class A shares and then liquidate the remaining assets. The result was that the controlling shareholder received the
       lion‟s share of the company‟s liquidation value, but the class A shareholders were never given the valuable information that
       would have motivated them to exercise their conversion rights. When the class A shareholders figured this out, they brought suit.
       Held: Court held in favor of the P‟s. A dominating or controlling shareholder is a fiduciary, whose dealings with the corporation
       must be subjected to rigorous scrutiny and the burden is on the stockholder not only to prove the good faith of the transaction but
       also to show its inherent fairness form the viewpoint of the corporation and those interested therein. Because the Class B
       shareholders did not act in good faith when they caused the board to redeem the Class A shares and concealed the information
       about the value of the inventory, the Class B holders breached their fiduciary obligation to the Class A shareholders. Such a call
       is voidable in equity at the instance of a stockholder injured thereby.

       i) Business Judgment Rule and the Zahn Decision – The board did have the right to prefer the Class B
          holders over the Class A holders by calling for redemption of the Class A stock at $60 per share,
          because a disinterested board would have done this (i.e. a profitable business judgment). The wrong
          committed by the Class B dominated board was that it failed to disclose to the Class A the fact that the
          inventory was valuable and that the liquidation was expected.

E. Remedies – Where there has been a violation against the rule against self-dealing, there are two possible
   remedies: (1) rescission and (2) restitution in the form of money damages. Thus, either way, the goal is to put
   the parties in the position they would have been had the transaction never occurred at all.

   1. Rescission – If it is possible to rescind (i.e. take back) the transaction, this is normally the appropriate
      remedy for self-dealing.

   2. Restitutionary Damages – If because of the passage of time or the complexity of the transaction, it is not
      feasible to rescind it, the appropriate remedy is restitutionary damages. Thus, the dominant shareholder will
      be required to pay back to the corporation any benefit he received beyond what was fair.

  A. Generally – Courts have shown substantial deference to self-dealing transactions when they are approved or
     ratified by a majority of informed shareholders. However, the analysis can be very different depending on
     whether the approval comes from a majority of solely disinterested shareholders or a majority of both the
     disinterested and interested shareholders.

     1. Disinterested Majority = Business Judgment Rule – Where a majority of the shares are case by informed
        shareholders who neither have an interest in the transaction nor are dominated by those who do, most
        courts do not required that a defendant show “fairness.” Instead, courts view the transaction under the
        business judgment rule and shift the burden to the plaintiff to show that the transaction constituted waste or
        that is no person of ordinary sound business judgment would say that the consideration was fair.

     2. Interested Majority – Courts remain suspicious of self-dealing transactions if shareholder ratification is by
        a majority of shareholders interested in the transaction. Thus, various methods of analyzing ratification
        have been developed including…

         i) Delaware Code § 144 – Interested Shareholders

            (a) No Contract or Transaction between a corporation and [an interested party, i.e. officer, director, or
            entity in which there is a financial interest by officer, director, or majority of shareholders] shall be void
            or voidable SOLELY for this reason…if:

                    (1) [DISCLOSURE AND BOARD APPROVAL] The material facts as to the director's or
                        officer's relationship or interest and as to the contract or transaction…

                       Are disclosed or are known to the board of directors or the committee,


                       The board or committee in good faith authorizes the contract or transaction by the
                       affirmative votes of a MAJORITY of the DISINTERESTED DIRECTORS, even though the
                       disinterested directors be less than a quorum;


                    (2) [DISCLOSURE AND SHAREHOLDER APPROVAL] The material facts as to the
                        director's or officer's relationship or interest and as to the contract or transaction…

                       Are disclosed or are known to the shareholders entitled to vote thereon,


                       The contract or transaction is specifically approved in good faith by VOTE of the


                    (3) [FAIRNESS AND APPROVAL] The contract or transaction is FAIR as to the
                        CORPORATION as of the time it is authorized, approved or ratified, by the BOARD of
                        DIRECTORS, a COMMITTEE or the SHAREHOLDERS
ii) If Less than Unanimous Approval = Shifting Burden of Proof – Shareholder ratification of an
    “interested transaction,” when 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 waste of corporate assets

   Fliegler v. Lawrence (1976) – Shareholder derivative suit brought on behalf of Agau Mines (Agau = P) against its officers
   and directors and United States Antimony Corporation (USAC = D). Issue involves whether the individual defendants, in
   their capacity as directors and officers of both corporations, wrongfully usurped a corporate opportunity belonging to Agau
   and whether all defendants wrongfully profited by causing Agau to exercise an option to purchase that opportunity.
   Lawrence (then president of Agau) acquired some antimony properties. After offering to sell the properties to Agau‟s Board
   of Directors and being rejected, Lawrence sold them to a closely-held corporation (USAC) with the option retained by Agau
   to purchase the land at a later date. Subsequently, Agau decided to exercise the option and buy all the shares of USAC in
   exchange for 800,000 shares of Agau‟s stock. This was approved by the stockholders of Agau, but individual stockholders
   brought this action to block such action. Held: Court concludes that defendants have proven the intrinsic fairness of the
   transaction. Agau received properties which by themselves are clearly of substantial value. But more importantly, it received
   a promising, potentially self-financing and profit generating enterprise with proven markets an commercial capacity

iii) MBCA Approach – Shares voted by an interested shareholder are not counted for the purposes of
     shareholder ratification. However, even if such shares are not counted to approve the transaction, they
     are counted for the purpose of making quorum.

  A. Generally – Knowing whether or not a particular type of instrument or investment will be deemed a security is
     important for at least two reasons: (1) it tells you whether the registration requirements of the Securities Act
     apply to the transaction, and (2) relating to the antifraud provisions of the Acts

     1. Primary v. Secondary Markets for Securities – Trading in corporate securities, such as stocks and bonds,
        takes place on two basic types of markets: (1) the primary market, in which the issuer of the securities (i.e.
        the company that created the securities) sells them to investors; and (2) the secondary market in which
        investors trade securities among themselves without any significant participation by the original issuer.

         i) The Securities Act of 1933 – Principally concerned with the primary market of securities. Two goals:
            (1) mandating disclosure of material information to investors, and (2) to prevent fraud.

         ii) The Securities and Exchange Act of 1934 – Principally concerned with the secondary market of
             securities. Also created the Securities & Exchange Commission (SEC) as the primary federal agency
             charged with administering the various securities laws

  B. What is a “Security” – Since the Securities Act only applies to the sale of “securities,” it is vital to know what
     constitutes a security. Section 2(1) of the Securities Act gives a definition of the term that is vastly broad and
     includes a long list of items including any note, stock, bond, evidence of indebtedness, certificate of interest or
     participation in any profit-sharing agreement, investment contract, certificate of deposit, or any put, call, or
     other option on any of the above.

     1. Stock – A share of stock will almost always be a security. Thus in the usual case of a for-profit corporation
        that issues shares of stock to represent an interest in the corporation‟s assets and future profits, these shares
        clearly are securities.

         i) Factors – Five common features of stock: (1) the right to receive dividends contingent upon an
            apportionment of profits; (2) negotiability; (3) the ability to be pledged or hypothecated; (4) voting
            rights in proportion to the number of shares owned; and (5) the ability to appreciate in value (United
            Housing Foundation v. Forman)

         ii) Sale of all Stock in a Closely Held Business – Even the sale of all the stock by the owners of a closely
             held corporation will constitute a sale of a “security” and must therefore comply with the Securities Act
             (Landreth Timber Co v. Landreth)

     2. Debt Instruments – A debt instrument may or may not be a security. At one end are notes given by a
        small-business owner to a bank in return for a loan. This is not a security. At the other end are multi-
        million dollar bonds issued by a large corporation and held by many institutions or the general public.
        These bonds almost certainly will be deemed a security.

         i) Bank Loans – A note or other debt instrument that is issued to a single, or small number, of banks will
            normally not be a security.

     3. Investment Contracts – In general, the courts and the SEC have interpreted the phrase “investment
        contract” very broadly to reach agreements that a lay person would not believe to be a security.

         i) Definition– An investment contract for the purposes of the Securities Act means a contract, transaction
            or scheme whereby a person invests his money in a common enterprise and is led to expect profits
            solely from the efforts of the promoter or a third party. (SEC v. W.J. Howey Co.)
   a. “Howey Test” – Three requirements for establishing an INVESTMENT CONTRACT are…


       (2) In a COMMON ENTERPRISE, and

       (3) With profits to come SOLELY FROM THE EFFORTS OF OTHERS.

   b. Test Limited Solely to Investment Contracts – This test should only be applied to determine
      whether and instrument is and investment contract and should not be applied in the context of other
      instruments enumerated in the Securities Act. (Landreth Timber Co v. Landreth)

ii) “Solely” the Efforts of Others – Some courts have concluded that the word “solely” should not be read
    as a strict or literal limitation on the definition of an investment contract. Rather, a more realistic test
    should be adopted: whether the efforts made by those other than investors are undeniably significant
    ones, those essential managerial efforts which affect the failure or success of the enterprise.

   SEC v. Glenn W. Turner Enterprises – Involved companies selling “adventures” that allow, progressively, the ability to
   sell adventures to other (i.e. pyramid schemes). The way that business is generated is through meetings where money is
   thrown around and a movie is shown to demonstrate how the CEO became a millionaire by selling this. Case involved
   whether the right to sell “adventures” constituted a security. Held: This was an investment contract. Even though the
   investor must himself exert some effort if he is to realize a return on his initial investment, in essence, he is purchasing the
   right to share in the proceeds of those efforts and the scheme is no less an investment contract merely because he contributes
   some effort as well as money to get it.

iii) Sale of Land or Tangibles – Even though what A is ostensibly doing is buying from B land or some
     tangible item, this may be found to be the purchase of a security if B or third persons will play the key
     role in helping A make a profit from his investment

   Ex: D, which owns a large Florida citrus grove, sells purchasers small parcels or orchard land along with a service contract to
   tend to the land. Under the service contract, D will harvest and market the fruit, and distribute to the purchasers part of the
   profit. Held: Since the buyer would be relying solely on D‟s efforts, and not his own, to make money from the parcel of land,
   the sale contract is an “investment contract” and thus a “security.” (SEC v. W.J. Howey Co.)

iv) Sale of LLC Interest – Whether the sale of an interest in a LLC is a security will depend on whether the
    profitability of the LLC after the acquisition will depend in part on the buyer’s efforts (in which case the
    buyer‟s interest is not an “investment contract”) or will depend solely on the efforts of person other
    than the buyer (in which case the buyer‟s interest will be an investment contract).

   a. Control – Often, distinction is based on whether the investors “exercised significant control over
      the management of the corporation” (SEC v. Shreveport Wireless Cable Television Partnership)

       Great Lakes Chemical Corp. v. Monsanto Co. – The D‟s (Monsanto & STI) together own all the membership interest
       in NSC LLC. They sell all their interest to P (Great Lakes). P later sues the D‟s alleging that they misrepresented NSC‟s
       financial condition, and therefore violated the federal securities law. The D‟s defend on the grounds that the LLC
       interests they sold are neither “stock” nor an “investment contract” and thus are not securities under federal law. Held:
       There is no security here. P is not correct to say that an LLC is the functional equivalent of a corporation which would
       justify tearing an LLC interest as stock – LLC interests may be stock-like, but they are not traditional stock and should
       not be treated as stock for purposes of the securities law definition. Furthermore, the particular LLC interest held here by
       P is not an investment contact. For an investment vehicle to be and investment contract, the holders‟ profits must come
       solely form the efforts of others. Here, while it is true that P as a member of NSC had no authority to directly manage
       NSC‟s business (the operating agreement said that the business should be managed by managers, not by the LLC‟s
       members), P had the right to remove any manager with or without cause, and to dissolve the company. This power of
       removal and dissolution gave P the power to “directly affect the profits it received” from NSC, and therefore, P‟s profits
       did not come solely from the efforts of others. Thus, it was not an investment contract.

  A. Generally – Rule 10b-5 is the securities antifraud rule promulgated under the Securities Exchange Act of 1934.

     1. Rule 10b-5: Employment of Manipulative & Deceptive Devices – 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

             (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.

     2. Standing – Only actual purchasers or sellers may recover damages in a private 10b-5 action. This
        standing requirement avoids speculation about whether and how much a plaintiff might have traded.
        Liability would be staggering if non-purchasers could base a claim on the speculative assertion that they
        would have purchased had disclosure been less discouraging.

     3. Burden of Proof – The plaintiff has the burden of showing the elements listed below in order to
        successfully claim a 10b-5 cause of action: material deception, scienter, reliance, causation, & damages

  B. Material Deception – Rule 10b-5 prohibits false or misleading statements of material fact. Not only are
     outright lies prohibited, so are half-truths. This means a true, but incomplete, statement can be actionable if it
     omits material information that renders the statement misleading.

     1. “Materiality” – In Basic, the court defined information as “material” if there is…

             (1) a SUBSTANTIAL LIKELIHOOD that

             (2) a REASONABLE INVESTOR

             (3) would consider it IMPORTANT in deciding whether to buy, hold, or sell the stock.

             …in other words, if there is a substantial likelihood that the disclosure would have been viewed by the
             reasonable investor as having significantly ALTERED the “TOTAL MIX” of information available.

             Ex: Look at significance of statement/omission compared to total revenues, whether a statement or risk would have been
             necessary or whether the risk was expected by the investors, etc.

         i) Merger Discussions – If merger discussions are so preliminary and speculative that a reasonable
            investor would not consider them important in deciding whether to buy or sell, the discussions are not
            material. Furthermore, a company can probably avoid 10b-5 liability by saying “no comment.”

         ii) Silence – If a company or an insider simply remains silent, and thereby fails to disclose material inside
             information, as long as the company or insider is not affirmatively misleading, and as long as it or he
             does not buy or sell the company stock during the period of non-disclosure, there is no violation.
           a. Exception: Where Silence is Actionable – Silence is actionable, however: (1) when the company
              itself is trading its own securities, (2) when the company fails to correct misinformation it caused
              and that is actively circulating in the market, or (3) when the company knows that insiders are
              trading on nondisclosed information not available to the public.

   2. Manipulative or Deceptive Conduct (i.e. “Fraud or Deceit” Requirement) – The Supreme Court has
      held that Rule 10b-5 only regulates manipulative or deceptive conduct, not unfair corporate transactions or
      breaches of other fiduciary duties.

       i) Simple Breach of Fiduciary Duties is Not Manipulative or Deceptive – If a director, officer, or
          controlling shareholder violates his fiduciary duties to the corporation of which he is an insider, but this
          violation does not involve any misrepresentation or any non-disclosure of something that he is
          obligated to disclose, the breach does not give rise to a 10b-5 cause of action.

       ii) Exception: Failure to Disclose – If the insider (director, officer, controlling shareholder) lies or fails to
           disclose something to the board of directors, shareholders, etc. (and thus also breaches fiduciary duties),
           however, then there is a cause of action under 10b-5.

           Santa Fe Industries, Inc. v. Green – D (Santa Fe Industries) slowly was acquiring control over the stock of Kirby Lumber
           Corp. When it increased its control to 95%, D availed itself to the short-form merger law of Delaware, which allowed the
           parent corporation (owning at least 90%) to merge and make payment in case for the shares of the minority shareholders,
           without their approval or giving them advanced notice. Before availing itself, D hired Morgan Stanley to appraise the value
           of the stock, which came to $125/share. Thus, D offered $150/share. P‟s, minority shareholders in Kirby, objected to the
           terms of the merger and filed a suit in federal court. They alleged that the real value was $772/share and that D had obtained
           a fraudulent appraisal of the stock from Morgan Stanley and offered $25/share above it in order to lull the minority
           shareholders into erroneously believing that the D was being generous. Thus, they claimed that when D went through with
           the merger at such an unfairly low price, D was engaging in a kind of “fraud or deceit” upon the minority shareholders.
           Held: Look to language of the statute. A claim under 10b-5 only exists if the conduct alleged can be fairly viewed as
           manipulative or deceptive. Here, the actions were neither manipulative nor deceptive. There needs to be a very specific
           deceptive or manipulative misrepresentation at the heart of the deal. Just because there was alleged bad treatment of the
           minority shareholders does not mean that there was fraud.

           Ex: D, the chief scientist of XYZ Corp., is aware that his employees have just made a major discovery that is likely to be
           translated into significantly higher earnings for XYZ. At a time when the board of directors is not yet aware of the discovery,
           the board asks D whether there have been any major developments in his department, and he falsely says “no.” The board
           then issues D stock, or a stock option, perhaps as part of a general plan for incentives for top executives. If D accepts the
           stock or options, he has violated 10b-5 because his false denial of significant developments is fraud in connection with the
           purchase or sale of securities. The same would be true if the board did not ask D about the development, he failed to disclose
           it, and he accepted the option they awarded him.

C. Scienter – Scienter means that the defendant was aware of the true state of affairs and appreciated the
   propensity of his misstatement or omission to mislead. To meet this requirement in 10b-5 actions, a plaintiff
   must prove either knowledge or recklessness. Mere negligence is not enough.

D. Reliance and Causation – The reliance requirement tests the link between the alleged misinformation and the
   plaintiff‟s buy-sell decision. A plaintiff must show that (1) “but for” the defendant‟s fraud, the plaintiff would
   not have entered the transaction or would have entered it under difference terms; and (2) that the fraud
   produced the claimed losses to the plaintiff.

   1. “Fraud-on-the-Market” Theory – The theory is that those who trade on public trading markets rely on the
      integrity of the stock‟s market price. In an open and developed stock market, the efficient capital market
      hypothesis posits that market prices reflect all publicly available information about the company‟s stock.
      On the assumption that material misinformation artificially distorts the market price, courts infer that
      investors had relied on the misinformation.
       i) Rebutting the Presumption – A defendant can rebut the presumption of reliance and avoid the “fraud
          on the market” theory by showing either (1) the trading market was not efficient and the challenged
          misrepresentation did not in fact affect the stock‟s price; or (2) the particular plaintiff would have traded
          regardless of the information.

          Basic Inc. v. Levinson (1988) – Basic was a publicly traded company primarily engaged in the business of manufacturing
          chemical refectories for the steel industry. Beginning in September 1976, Combustion Engineering, Inc., began having
          meetings and telephone conversations about offers to acquire Basic. Basic made three public statements denying that it was
          engaged in merger negotiations. On December 18, Basic suspending trading of its shares and issued a statement that is had
          been approached about a merger. On December 19, Basic‟s board approved the merger. On December 20, Basic publicly
          announced its approval. Respondents are former Basic shareholders who sold their stock after Basic‟s first public statement
          and before the suspension of trading. Respondents brought a class action against Basic and its directors, asserting that he D‟s
          issued three false or misleading public statements and thereby were in violation of § 10(b) of the Exchange Act and of Rule
          10b-5. Respondents alleged that they were injured by selling Basic shares at artificially depressed prices in a market affected
          by petitioners‟ misleading statements and reliance thereon. Held: Materiality depends on the significance the reasonable
          investor would place on the withheld or misrepresented information. Furthermore, because most publicly available
          information is reflected in market price, an investor’s reliance on any public material misrepresentations may be presumed
          for the purposes of a 10b-5 cause of action. Case is remanded to be judged consistently with these two holdings.

E. Damages – The plaintiff must prove that he suffered damages. Courts use various theories to measure damages
   under 10b-5, but punitive damages are not available.

   1. Rescission – Rescission allows the defrauded plaintiff to cancel the transaction. If the plaintiff sold, he gets
      his stock back; if he bought, he returns the stock and the seller refunds the purchase price. Rescission is
      suited only to face-to-fact transaction where the parties can be identified.

   2. Disgorgement Damages – If rescission is not possible because the stock has been resold, rescissionary
      damages replicate a cancellation of the transaction. A defrauded seller recovers the purchaser‟s profits and
      a defrauded buyer recovers his losses.

F. Policy Question: Is Silence better for the Company and its Shareholders? – Courts had found in some
   circumstances that it would be in best interests of the shareholders to not disclose information (e.g. b/c was the
   only way to preserve the merger in Basic) and thus there was no obligation. This is called the “efficient lie”
   theory. However, this theory was eventually rejected under the idea that, if on aggregate this was allowed, the
   market would not be as efficient because no information could ever be trusted and the system would fail.

  A. Generally – A person engages in insider trading if he buys or sells stock in a publicly-traded company based on
     material, non-public information about that company. In general, the federal securities laws bar only that
     insider trading that occurs as a result of someone’s willful breach of a fiduciary duty.

     Ex: Jones is sitting by himself in a restaurant and happens to over hear Smith tell his dining companion at the next table that “I just
     heard that we brought in a huge new well off the coast of Saudi Arabia.” Jones happens to know that Smith and his companion both
     work for Oilco, a major oil company. Jones can buy stock in Oilco with impunity, even though his is acting on material, non-public
     information. This is because there was no breach of any fiduciary duty here.

     1. Rule 10b-5 – Rule 10b-5 does not expressly state that an insider who buys or sells based on material non-
        public information, without making any affirmative misstatements, had engaged in “fraud or deceit.”
        However, the SEC has interpreted the rule as if it does.

         i) “Disclose or Abstain” Rule – The insider has a choice: he must either disclose the inside information
            or abstain from trading. In other words, the insider is never required by 10b-5 to make disclosure of
            any facts, no matter how material. All that 10b-5 requires is that the insider not trade while in
            possession of such undisclosed facts.

              a. Dissemination of Information – If the insider decides to disclose the information, is not enough
                 that he waits until the company has made a public announcement of the inside information. Rather,
                 they must wait until this information has been widely disseminated to the marketplace.

         ii) Requirements for Cause of Action – The same 10b-5 requirements are applicable to insider trading
             cases. Thus a plaintiff must show that:

              (1) he was a purchaser or seller,

              (2) that there was trading on material non-public information,

              (3) that this constituted fraud or deceit (i.e. manipulative or deceptive conduct),

              (4) that the defendant had the requisite scienter (knowledge or recklessness),

              (5) that there was reliance and/or causation, and

              (6) he suffered damages.

  B. Various Applications of 10b-5 Insider Trading Liability

     1. Fiduciary Duty of Insiders – The federal securities laws bar only that insider trading that occurs as a result
        of someone’s willful breach of a fiduciary duty.

         i) Insiders – Insiders who obtain material, non-public information because of their corporate position –
            directors, officers, employees, or controlling shareholders – have a clear fiduciary duty to the
            corporation and its shareholders not to trade.

         ii) Constructive (Temporary) Insiders – Constructive insiders who are retained temporarily by the
             company in whose securities they trade – such as accountants, lawyers, and investment bankers – are
             viewed as having the same 10b-5 duties as corporate insiders.
   iii) Strangers – A stranger with no relationship to the source of the material, non-public information –
        whether from an insider or outsider – has no 10b-5 duty to disclose or abstain. Strangers who over hear
        the information or develop it on their own have no 10b-5 duties.

       Chiarella v. United States – Chiarella was employed in the composing room of a financial printer. Using his access to
       confidential takeover documents that his firm printed for corporate raiders, he figured out the identity of certain takeover
       targets. Chiarella then bough stock in the targets, contrary to the explicit advisories by his employer. He later sold at a profit
       when the raiders announced their bids. Held: The Supreme Court reversed Chiarella‟s criminal conviction under Rule 10b-5
       and because Rule 10b-5 did not impose a “parity of information” requirement. Merely trading on the basis of nonpublic
       material information, the Court held, could not trigger a duty to disclose or abstain. Chiarella had no duty to the
       shareholders with whom he traded because he had no fiduciary relationship to the target companies or their shareholders.

2. Tippers – Insiders and outsiders with a confidentiality duty who knowingly make improper tips are liable as
   participants in illegal insider trading. The tip is improper if the tipper will, or has reasonable expectation, to
   personally benefit, directly or indirectly, from his disclosure – such as when a tip is sold, given to family or
   friends, or tipper expects that tippee will return the favor.

   i) Tippees – A tippee assumes a fiduciary duty if they knowingly trade on improper tips. A tippee is
      liable for trading after obtaining material non-public information that he knows (or has reason to know)
      came from a person who breached a confidentiality duty or had improper motives (see “tippers” above)
       Dirks v. SEC – Petitioner Dirks received material nonpublic information from “insiders” of a corporation during an
       investigation of fraudulent corporation practices at Equity Funding of America. After receiving such information, he openly
       discussed it with a number of clients and investors, some of whom traded their holdings in Equity Funding securities. Dirks
       also went to the WSJ, but they declined to run a story b/c they feared the information may be libelous. Eventually, the SEC
       investigated and found massive fraud. Dirks was charged with aiding and abetting violations of the SEC Exchange Act §
       10(b) and Rule 10b-5 by retreating the allegations of fraud to members of the investment community who later sold their
       stock. Held: Court ruled that there was no breach of fiduciary duty and thus no improper violations. Dirks had no duty to
       abstain from use of the inside information he obtained. The tippers received no monetary or personal benefit for revealing
       the information and nor was their purpose to make a gift of valuable information to Dirks. Thus, there was no breach in
       fiduciary duty.

3. Misappropriation Theory – Under the misappropriation theory, 10b-5 liability arises when a person trades
   on confidential information in breach of a duty owed to the source of the information, even if the source is
   a complete stranger to the traded securities.

   i) Rationale – The misappropriation theory premises liability on a fiduciary-turned-trader‟s deception of
      those who entrusted him with access to confidential information (i.e. theft of confidential information
      for the purposes of securities trading).

       Ex: One who learns of the information as a result of a fiduciary relationship with a company planning a tender offer for X
       Corp. can be liable for trading in X Corp. stock. Similarly, one who learns secret information as a result of working inside a
       publisher or broadcaster that‟s about to publish a story on X Corp. would probably also be covered. Even a person who
       learns the information as the result of securities research done at a money-management company would be liable if the
       information “belonged” to the money-management company.

       United States v. O’Hagan – D (James O‟Hagan) was a partner at a law firm that represented Grand Metropolitan PLC
       regarding a potential tender offer for the common stock of the Pillsbury Company. The public announcement was made on
       October 4, 1988. However, before such announcement was made and while his law firm was still representing Grand Met,
       O‟Hagan began purchasing call options for Pillsbury stock. By the end of September he owned 2,500 unexpired options
       (more than any other individual investor) and some 5,000 shares of common stock. When the stock rose from $39 to $60, he
       sold and made more then $4.3 million. Thus, the SEC formally indicted him alleging that he defrauded his law firm and
       client by using for his own trading purposes material, nonpublic information regarding the planned tender offer. Held: Court
       agrees that misappropriation theory satisfies 10(b)‟s requirement that chargeable conduct involve a “deceptive device or
       contrivance” used “in connection with” the purchase or sale of securities.
ii) Criminal Liability – One who misappropriates confidential information will almost always be liable
    for criminal liability for wire and/or mail fraud.
   Carpenter v. United States – D is a reporter from the Wall Street Journal. He is one of the authors of the “heard on the
   street” column, an important daily column that talks about various stocks. D observes that the column often has an effect of
   the stocks of the companies written about. He therefore systematically gives advance notice to a stockbroker about which
   companies will be written up and whether the information will be favorable or unfavorable. The stockbroker then trades on
   this information. D is aware that the WSJ views all news material learned by employees during the course of employment as
   being WSJ‟s property, which the employee must keep confidential. Held: Since D used the mails and phones in fulfillment
   of this scheme, he is guilty of mail fraud and wire fraud. By breaching his duty of confidentiality with respect to information
   he learned on the job, he misappropriated the WSJ‟s property and thus implicates criminal liability. However, the Court was
   spit (4-4) on whether D also violated 10b-5. Thus, this is not precedent for that point.

iii) Tender Offers – SEC Rule 14e-3 makes it illegal to trade on the basis of non-public information, even
     if this information does not derive from the company whose stock is being traded (i.e. target company)

   Rule 14e-3 – If any person … has commenced, a tender offer, it shall constitute a fraudulent, deceptive
   or manipulative act … for any other person who is in possession of material information relating to
   such tender offer which information he knows or has reason to know is nonpublic and which he knows
   or has reason to know has been acquired directly or indirectly from:

   (1) The offering person,

   (2) The issuer of the securities sought or to be sought by such tender offer, or

   (3) Any officer, director, partner or employee or any other person acting on behalf of the offering
       person or such issuer,

   …to purchase or sell or cause to be purchased or sold any of such securities … UNLESS within a
   reasonable time prior to any purchase or sale such information and its source are publicly disclosed by
   press release or otherwise

   Ex: Chiarella would fall squarely under this provision because his information about the takeover was derived indirectly
   from the acquiring company.

iv) Other Confidential Relationships – The misappropriation theory turns on whether the recipient of the
    information had a fiduciary responsibility not to trade on the information. However, law is ambiguous
    about when the relationship of trust and confidence should exist. Thus, the SEC adopted Rule 10b-5-2
    to remove such ambiguity.

   Rule 10b-5-2 – Includes a non-exclusive list of three circumstances in which a duty of “trust or
   confidence” will be found to exist on the part of the recipient of information…

   a. If the recipient “agrees to maintain [the] information in confidence.”

   b. If the discloser and the recipient “have a history, pattern, or practice of sharing confidences, such
      that the recipient of the information knows or reasonably should know that the [discloser] expects
      that the recipient will maintain its confidentiality”

   c. There is a presumption of a duty of trust or confidence if the recipient is a “spouse, parent, child, or
      sibling” of the discloser. However, the recipient can rebut this presumption by showing that, in light
      of the relationship between the two family members, the recipient “neither knew nor reasonably
      should have known” that the discloser expected that the information would be kept confidential.
              United States v. Chestman – Involved a situation where the president of a company told his sister that the company was
              going to be sold. The sister told her husband, who then told his broker, who traded on the non-public information. Each
              person in the chain told the next to keep the information confidential. According to the government‟s case, the husband
              misappropriated information from his wife (sister) which he then tipped to his broker. Held: In the absence of any
              evidence that husband regularly participated in confidential business discussion, the familial relationship standing alone
              id not create a fiduciary relationship between he and his wife or any other members of the family. Thus, there was no
              misappropriation here and no applicable 10b-5 liability.

                   Different Outcome under 10b-5-2 – If the case had been brought subsequent to the enactment of Rule 10b-5-2,
              there would clearly be liability here. This is because each had agreed to keep the information confidential, and thus
              availing the group of (a).

C. Damages/Remedies to Insider Trading (3 possible; only one adopted by federal statute)

   1. Out-of-Pocket Measure – The difference between what the stock was purchase/sold and what the stock
      would have been worth if the insider information would have been divulged to the public

       i) Problem – Insider may only make a little money for trade, but would have to pay each and every
          shareholder affected (i.e. gain far disproportionate to the penalty)

   2. Erosion Measure – As soon as the insider begins to trade, if some news of what insider is doing comes out,
      the stock will begin a gradual downward decline. This downward decline is the damage that should be paid.

       i) Problems – What happens if nobody realizes the trading occurred (i.e. the most egregious case
          possible)? Not liable for any damages? Why hold the insider liable for indirectly divulging information
          when a directly releasing the information would not have created liable?

   3. Disgorged Profits/Losses (Federal Statute) – The insider needs to give up whatever money was made or
      not lost to the corporation and this amount is divided pro rata between all shareholders affected.

D. Policy Debate – During the 1930‟s (after depression), there was no debate in opposition to the rules against
   insider trading. However, during the 1960‟s, academics began to debate whether it be a crime to trade on
   insider information. Some of the biggest criticisms are…

   1. “Missing Victim” Problem – The first criticism is that there is often difficulty finding a victim who should
      be compensated. The insider‟s profits (or avoided losses) presumably were derived from people who would
      have bought (or sold) shares at the original price (i.e. the ones that the insider bought) but couldn‟t and had
      to buy them at a higher price (and created the profits of insiders). However, there is no duty owed to these
      people. They are merely potential investors.

   2. “Benefits” Problem – There are benefits that flow from insider trading. For example…

       i) Makes the Market More Accurate – The communication of valuable information (i.e. the change in
          the stock price by indirectly introducing information that would have been absent from the market
          altogether without the insider trading). Thus, the shareholders are often better off because the price
          more accurately reflects the value of the shares.

       ii) Creates Incentive for the Insiders – Creates incentives for the insiders to create good deals that will
           indirectly benefit their shares. However, there is the underlying temptation to use fraud or make bad
           decisions to make money as well.
3. “Fourth of July” Problem (i.e. No Significant Harm) – The Forth of July is celebrated for the sole reason
   of not being Canadian (i.e. you can see the effects of the opposite choice). Similarly, because there are
   many other markets that exist in the world that allow insider trading, it is a very tenuous argument that the
   market would collapse in the absence of insider trading laws.

4. “Freedom of Contract” Problem –There is no good reason to not allow each corporation to decide its
   stance on insider trading on its own. Shouldn‟t each corporation have the ability (i.e. freedom of contract)
   to allow or forbid insider trading as long as this choice was disclosed to each potential investor (i.e. through
   an explicit mention in the corporate charter)

  A. Generally – To deter price manipulation by insiders in public corporations and encourage insiders to acquire
     long-term interests in their corporations, Section 16(b) of the Securities Exchange Act of 1934 requires
     officers, directors, and 10% shareholders must pay to the corporation any profits they make, within a six-
     month period, from buying and selling the firm‟s stock

     1. Securities Exchange Act § 16(b) – For the purpose of preventing the unfair use of information [i.e. insider
        info] which may have been obtained by such beneficial owner, director, or officer [or more a stockholder
        of more than 10% of the shares] by reason of his relationship to the issuer, any profit realized by him from
        any purchase and sale … within any period of less than six months … shall inure to and be recoverable by
        the issuer, irrespective of any intention on the part of such beneficial owner, director, or officer in entering
        into such transaction…

         i) Summary – Section 16(b) imposes automatic, strict liability on any director, officer, or 10%
            shareholder who makes a profit in short-swing transactions within a six month period. Recovery is to
            corporation, and suit may be brought either by the corporation or by a shareholder in a derivative suit.

         ii) No Proof of Intent or Scienter Necessary – The objective standard of § 16(b) imposes strict liability
             upon substantially all transactions occurring within the statutory time period regardless of the intent of
             the insider or the existence of actual speculation

         iii) Incentive to Bring Suit: Plaintiffs’ Attorney’s Fees – The real incentive for §16(b) litigation is that
              attorneys‟ fees of a successful derivative suit plaintiff are recoverable. Thus, many short-swing profits
              cases are manufactured by attorneys who use a shareholder for purposes of derivative standing.

  B. Match ANY Transactions that Produce a Profit – Section 16(b) liability is predicated on the matching of any
     purchase with any sale, regardless of order, during any six-month period in which the sales price is higher than
     the purchase price. There is no tracing of shares, and recovery is frequently measured by matching later lowest-
     cost purchases with earlier higher-cost sales.

     1. No Offset for Losses is Necessary – There is no need to offset any losses – that is, any purchases and sales
        in which the sales price is lower than the purchase price need not be matched and can be disregarded.

  C. Officer or Director Status must exist at EITHER Sale or Purchase – For officers or directors, officer or
     director status at the time of either the purchase or sale is sufficient – not necessarily both.

     1. Rationale – The theory is that by trading when he was an officer or director, the insider had access to
        nonpublic information and was in a position to manipulate the price of the stock.

  D. Shareholder Status (10%) must exist “Immediately Before” BOTH Transactions – For 10% shareholders,
     it is necessary that the person have held more than 10% immediately before both the purchase and the sale that
     are being matched.

     1. 10% of ANY Class of Stock – A person falls within §16(b) if he owns 10% or more of any class of the
        company‟s stock – he need not own 10% of the total mix nor 10% of the class in which he is trading.

     2. Rationale – The rationale is that 10% shareholders are less likely to have access to inside information or to
        corporate control mechanisms than directors or officers. Their insider status and presumed access to inside
        information and the control mechanisms must exist at both ends of the matching transactions.
       Reliance Electric Co. v. Emerson Electric Co. – Respondent, the owner of 13.2% of a corporation‟s shares, disposed of its
       entire holdings in two sales, both of them within six months of purchase. The first sale reduced the respondent‟s holdings to
       9.96% and the second disposed of the remainder. Thus, the question presented here is whether the profits derived from the
       second sale are recoverable by the Corporation under § 16(b). Corporation argued that it should keep the profits b/c both
       transactions were part of a single plan to avoid liability under § 16(b) Held: The profits are not recoverable. A “plan” to sell that
       is conceived within six months of purchase clearly would not fall within § 16(b) if the sale were made after the six months had
       expired. Thus, the court sees it no different where the 10% requirement is involved rather than the six-month limitation

       Foremost-McKesson, Inc. v. Provident Securities Company – Respondent, Provident, was a personal holding company and
       petitioner, Foremost, was a potential purchaser when Provident was tentatively deciding to liquidate and dissolve. When the
       liquidation occurred, Foremost bought 2/3 of Provident‟s assets through various debentures which were (at option) immediately
       convertible into more than 10% of Foremost‟s outstanding common stock. However, Provident quickly distributed the debentures
       to its stockholders and thereby reduced the amount of Foremost debenture (which was convertible into common stock) to less
       than 10%. Provident‟s holdings as of the sale were enough to make it a “beneficial owner” under the terms of 16(b) and thus it is
       seeking declaration of non-liability. Held: In the purchase-sale sequence, a beneficial owner must account for profits only if he
       was a beneficial owner (i.e. more than 10%) before the purchase

E. Beneficial Ownership – A person is covered under § 16(b) if he is “directly or indirectly the beneficial owner.”

   1. Aggregation to make 10% – According to the SEC, holdings of shareholders percent must be aggregated if
      one shareholder has voting control or the power to dispose of the other‟s shares

   2. Spouse or Children – A person will generally be held as beneficial owner of securities held in the name of
      his or her spouse and their minor children (including trusts created for kids). Attribution is likely when the
      spouses share the economic benefit and/or one spouse influence or controls the other‟s investment decisions.

       Ex: Blau v. Lehman Case – Partner of investment bank (Lehman) becomes a director of a company that the investment bank
       later makes transactions with (but no actual inside information thus no 10b-5 claims). 16(b) implications? Held: Partner is held
       liable because his is an officer or director and the trading is attributed to his partner status at Lehman. Lehman is also liable
       because buying and selling and the officer status is attributed to the partner involvement

F. Unorthodox Transactions – When the stock transaction is unorthodox – e.g. when shares are acquired in a
   merger or in an option or delayed transaction – the courts have to inquire into whether the transaction should be
   treated as a matchable “sale” or “purchase” for the purposes of § 16(b).

   1. Two Part Test – The defendant must show that both of the following are the case before his disposal of the
      shares will be deemed no a §16(b) sale:

       (1) that the transaction was essentially INVOLUNTARY (as where the exchange of his shares for cash or
           stock in a surviving company was automatic under state law or occurred at the option of someone else)

       (2) the transaction was a type in which the defendant almost certainly did NOT have access to INSIDE

       Kern County Land Co. v. Occidental Petroleum Corp. – Occidental (D) was trying to acquire Old Kern (P) but Old Kern was
       trying to block it. Thus, Occidental announced an offer where it would buy Old Kern shares from third parties and by the end had
       accumulated over 10% of the common stock. To block the merger, however, Old Kern negotiated a merger with Tenneco, who
       would acquired the assets, property, etc. of Old Kern and carry on its business. To counter this, Occidental negotiated an
       arrangement with Tenneco which gave Tenneco the option to purchase all the preferred stock of Tenneco that the Old Kern stock
       would become if the merger was effectuated. By the terms of the agreement, however, the option could not be exercised until six
       months and one day after the expiration of Occidental‟s original tender offer. Two days after six months, the option was
       exercised by Tenneco to buy back the preferred stock from Occidental and Occidental made a $19 M profit. Thus, New Kern
       (Old Kern & Tenneco) instituted a suit against Occidental to recover the profits which Occidental had realized of its dealings with
       Old Kern stock. Held: Neither the option nor the exchange constituted a “sale” under § 16(b). It is very unlikely, given the
       adversarial nature of the hostile takeover, that there was any inside information. Just b/c it had more than 10% of the stock does
       not mean that it had insider information. In fact, the merger deal was kept secret from Occidental the entire time and their
       attempts to examine the books were frustrated.

  A. Generally – A director or officer, who is charged with breach of the duty of due care, the duty of loyalty, or
     other wrongdoings, can face very substantial damages. Because of this possibility, directors and officers have
     struggled to find protection.

  B. Indemnification – In which the corporation reimburses the director or officer for expenses and/or judgments he
     incurs relating to his actions on behalf of the corporation

     1. Mandatory Indemnification – If director who, in connection with work, is sued and PREVAILS in
        litigation, he MUST be indemnified completely from the corporation.

         i) Broad Requirement of Success – This does not require that the case go to trial or that it is won on the
            merits. Even if they win on technicalities, summary judgment, directed judgment, etc, then the officer is
            still entitled to indemnification

         ii) Exception: Settlements

     2. Permissive Indemnification – iN addition to mandatory-indemnification statutes, most states allow for
        permissive indemnification. Thus, there is a large zone of circumstances in which the corporation may, at
        its choosing, indemnify the director or officer, but it is not required by law to do so.

         i) General Rule – Most states allow permissive indemnification so long as the director or officer: (1) acted
            in good faith, (2) was pursuing what he reasonably believed to be the best interests of the corporation,
            and (3) had no reason to believe that his conduct was unlawful.

         ii) Limits – Indemnification is PROHIBITED under circumstances, including where…

             a. Director is found to have acted in KNOWING VIOLATION of the law (e.g. Foreign Corrupt
                Practices Act)

             b. Director is found to have received IMPROPER FINANCIAL BENEFIT (e.g. Insider Trading)

             c. Director PAYS A FINE OR PENALTY where the policy behind the law precludes indemnification
                (settlement and/or plea bargain)

             d. The amount in question is a payment made to the corporation in a DERIVATE ACTION

  C. Directors/Officers Liability Insurance – Which can be paid either to the corporation (to make whole for any
     indemnification payments it makes to the individual) or directly to the officer or director.

     1. Corporate Reimbursement – This part of the insurance coverage reimburses the corporation for
        indemnification payments it makes to a director or officer. Thus the corporation is made whole again (at
        least up to the policy limits) when it indemnifies the director or officer. This will make the corporation
        much more likely to grant permissive indemnification.

     2. Personal Coverage – This part of the insurance coverage reimburses the director or officer directly for his
        losses (litigation expenses, settlements, and/or judgments) to the extent that he is not indemnified (or
        prevented from being indemnified) by the corporation. This part of the coverage allows for protection of
        directors or officers even with the limits placed by state statute on permissive indemnification

  A. Proxy Usage Generally – Few shareholders have the time or inclination to physically attend shareholders‟
     meeting and vote their shares in person, whether for the election of directors, approval of a merger, or for some
     other action requiring a shareholder vote. The solution to this problem is the use of a proxy.

     1. Proxy – A document whereby the shareholder appoints someone (usually a member of management or
        board of directors) to cast his vote for one or more specified actions.

     2. Proxy Contests – When multiple, opposing parties compete to gain proxies through submitting proposals to
        the shareholders, the focus of the SEC‟s regulations is to provide a regulatory system which ensures that the
        shareholders have adequate information before they exercise their right to vote by filling out a proxy card.

     3. SEC Regulation – The SEC has the broad powers to regulate: (1) the mechanics of the proxy system and
        reporting documents; (2) the information that must be furnished to a shareholder when his proxy (i.e. vote)
        is solicited, and (3) even more broadly, the information that must furnished to each shareholder annually,
        whether or not his proxy is solicited.

  B. Implied Private Actions for Proxy Violations – § 14(a) – Nothing in the Securities Exchange Act of 1934 or
     the SEC‟s rules expressly grant a private investor the right to sue if the proxy rules are violated. However, the
     Supreme Court has recognized an “implied private right of action” on behalf of individuals who have been
     injured by a violation of the proxy rules under § 14(a) of the Exchange Act.

     J.I. Case Co. v. Borak (1964) – Civil action brought by respondent, a stockholder of petitioner J.I. Case Company, charging that a
     merger was effected through the circulation of a false and misleading proxy statement by those proposing the merger. It is alleged that
     the petitioners solicited proxies of Case stockholders for use at a special stockholders‟ meeting at which the proposed merger was to
     be voted upon; that the proxy solicitation material circulated was false and misleading, and that the merger was approved at the
     meeting by a small margin of the votes and thus would not have been approved but for the false and misleading statements in the
     proxy solicitation material and the shareholders were damaged thereby. Held: A right of action exists as to both derivative and direct
     causes, and remedies in such actions are not limited to prospective relief. Rather, because the possibility of civil damages or
     injunctive relief serve as a most effective weapon in the in the enforcement of proxy requirements and it is the duty of the courts to
     provide remedies as are necessary to make effective the congressional purpose, federal courts have the power to grant all necessary
     remedial relief including recession or damages.

  C. Requirements for Federal Proxy Fraud Case

     1. ALL Shareholders have Standing – Nearly all courts allow even a plaintiff who did not grant a proxy vote
        to sue. This is because even if plaintiff did not give a proxy, he may still have been inured by the fact that
        other shareholders were duped into giving a proxy and into approving the proposed merger or election.

         i) Requirements under §14(a) – The shareholder/plaintiff must show that there was…

              (1) A MATERIAL MISSTATEMENT OR OMISSION in the proxy materials distributed, and…

              (2) A CAUSAL LINK between the misleading proxy materials and some damage to shareholders.

         ii) Proving “Materiality”

              a. It is NOT necessary that the misstated or omitted fact would have SOLELY CAUSED a reasonable
                 shareholder to change his vote.

              b. All that is required is that the fact would have been regarded as IMPORTANT or had ACTUAL
                 SIGNIFICANCE in the decision-making process of a reasonable shareholder.
       iii) Proving Causation

          a. Presumed if Material and Proxy was Necessary for Approval – When materiality has been
             proved, a shareholder has made a sufficient showing of causal relationship if he proves that the
             merger could not have been carried out without the submission of the proxy materials to the
             minority shareholders.

          b. No Causation: Unnecessary Minority Class – However, if plaintiff is a member of a minority class
             whose votes are unnecessary for the proposed transaction to be approved, plaintiff may not recover
             no matter how material or how intentional the deception in the proxy statement.

              Mills v. Electric Auto-Lite Co. (1970) – Petitioners were shareholders in Auto-Lite until it merged with Mergenthaler.
              It is alleged that before merger was approved by shareholders of Auto-Lite, a misleading proxy statement was sent out by
              Auto-Lite management to solicit shareholders‟ votes in favor of the merger. Proxy statement was misleading because it
              told Auto-Lite shareholders that their board of directors recommended approval of the merger without also informing
              them that all 11 of the board were nominees of Mergenthaler and were under the control of Mergenthaler. Furthermore,
              because the merger was only approved 950,000 of 1,160,000, 317,000 of which were from the proxy, the votes were
              necessary and indispensable to the approval of the merger. Held: Where a misstatement or omission in a proxy statement
              is determined “material,” the determination embodies a conclusion that the defect was of such a character that it might
              have been considered important by a reasonable shareholder who was in the process of deciding how to vote. There is
              no need to supplement this requirement.

D. Remedies – Three possible forms of remedies are available where there have been proxy violations…

   1. Injunction – If the proxy solicitation was for approval of a proposed transaction, the court may grant an
      injunction preventing the transaction from going forward.

   2. Setting Aside the Transaction – The court may also set aside a transaction that has already been carried
      out. For instance, it might order a merger to be undone. However, a merger should be set aside only if it
      would be in the best interest of the shareholders as a whole to do so.

   3. Damages – Finally, the court may order that damages be paid to the plaintiff and other shareholders.
      However, the plaintiff bears the burden of proving that actual monetary injury occurred before he can
      recover monetary damages.

       i) Reimbursing Litigation Expenses – The corporation should also reimburse the costs of establishing
          the violation. To allow other shareholders to obtain full benefit from the plaintiff‟s efforts without
          contributing equally to litigation expenses would be to enrich the others at plaintiff‟s expense. The fact
          that a suit has not yet produced and may never produce a monetary recovery does not preclude an award.

E. Policy Issues regarding Private Cause of Action

   1. Actual Benefit to Corporation Irrelevant – By permitting all liability to be foreclosed because a merger
      was ultimately “fair” would allow the stockholders to be by-passed and judicial appraisal of the merger‟s
      merits could be substituted for the actual and informed vote of the stockholders.

   2. Over-Enforcement? – Are there some situations where allowing a private action should be prohibited?
      Situations where the cases would be so preposterous that a private action should not be allowed (e.g. dating
      example, 24 hour rule, lost earnings, etc.)

   3. Backwards Establishment of Right to Sue? – Prior to Borak, these types of cases were disposed by civil
      enforcement by the SEC. This is opposite from the usual case (i.e. private right supplemented by public
      enforcement) because public enforcement is being supplemented by private enforcement.

  A. Attempts to Manipulate Shareholders’ Control – To avoid subjecting a decision to a shareholder vote, the
     management of a corporation may attempt to use alternative methods to achieve the same results. These
     attempts, therefore, are aimed at manipulating or decreasing the ability of the shareholders to exercise
     corporate control through voting.

     1. Context – These methods are very common when a company‟s management attempts to adopt defensive
        mechanisms to prevent a hostile takeover.

  B. Supermajority Provisions – Supermajority requirements give minority participants a veto power unavailable
     under majority rule. This power can cover specified matters (i.e. approving mergers, appointing officers, fixing
     dividends, or issuing new stock), or all matters.

     1. MBCA § 7.27(a): Supermajority Voting Provisions in Articles of Incorporation – The articles of
        incorporation may provide for a greater quorum or voting requirement for shareholders…

     2. MBCA § 7.27(b): Supermajority can only be changed by Supermajority Vote – An amendment to the
        articles of incorporation that adds, changes, or deletes a greater quorum or voting requirement must be
        adopted by the same vote required to take action then in effect or proposed, whichever is greater.

  C. Issuing Preferred Stock with Voting Rights to Avoid Shareholder Approval – One method that Supreme
     Court has ruled is legal and permissible is to issue preferred stock to all common stockholders with a provision
     that all subsequent mergers, acquisitions, or sales required supermajority approval of this new class of stock.

     1. Unnecessary to Alter Articles of Incorporation – By issuing a new class of stock, the board of directors
        or management can create new supermajority voting requirements without the requisite shareholder
        approval necessary to change the articles of incorporation. This allows the corporation to do an “end-
        around” to a potentially hostile majority shareholder.

         i) Limitation: Cannot be a Pretext – If it is questionable whether the new class is preferred stock at all
            (i.e. same entitlement to dividends and liquidation rights as common sharholders), then the issuance will
            be struck down. However, if a new category of preferred stock is actually created and the decision is not
            a subterfuge or pretext, this strategy will be permitted.

         ii) Fiduciary Duties are Still Relevant – Even if permitted, there are still issues concerning whether there
             is a breach in fiduciary duties when alterations such as these are implemented. The technique may be
             legal, but not always in the best interests of the shareholders.

            Telvest, Inc. v. Olson (1979) – Telvest is the owner of 20% of Outdoor Sports Industries, Inc. and is said to be the
            instrument of a group called the “Engle Group” who were infamous for looting companies and eliminating their stockholders
            on less than favorable terms. OSI believed that Telvest was planning on doing this to it. Thus, it sought to change its voting
            scheme to a supermajority vote rather than the simple majority which was already accepted under the corporate charter. To
            do this, in lieu of a shareholder meeting, the board of directors met and created a series of stock, designated as preferred
            stock, which carried with it, in certain circumstances, the right to vote on mergers, consolidations, sales of assets, etc. The
            voting right created by this preferred stock provide for a supermajority vote of 80% in order to approve any business
            combination or transaction with any party who, at the time, is the owner of 20% or more of the outstanding voting stock of
            OSI. Held: Voting rights of the common shareholders are affected by the issuance of the preferred stock. Not only are the
            20% shareholders‟ voting rights lessened but any shareholder that wanted to approve a transaction with a 20% shareholder is
            also weakened. The voting rights of shareholders cannot be changed without amendment to the certificate of incorporation,
            and here, in absence in such, company will be enjoined from issuing the preferred stock. Furthermore, it was questionable
            whether “preferred stock” is actually preferred stock at all (entitlement to dividends/liquidation same), and the issuance of
            preferred stock violated rule that all dividends need to be issued pro rata without any discrimination or preference
D. Policy Issues about Shareholder Voting Control

   1. Why not allow shareholders to vote regarding everything? – In addition to efficiency arguments, there
      are also arguments concerning agency law. The fact that the shareholders are extensively removed by three
      or four steps from running that business is the underlying reason to allow for limited liability. If the
      shareholders are actually controlling the day-to-day decisions, they are less removed and thus the reasoning
      for keeping limited liability becomes more attenuated.

   2. Why is there voting in corporations at all?

      i) Politics v. Corporations – In politics we vote. In the marketplace we don‟t. In the marketplace, we
         “vote” by exiting or not using particular services or goods. There are two archetypes in the categories of
         private v. public goods (public can be enjoyed by multiple people at once; e.g. parks, police, etc.).
         Public goods have a free-rider problem associated, and thus the government is best at providing (i.e.
         politics voting is best; taxes subsidize)

      ii) Corporations and Voting– Since shareholders “buy” their way into the community, they should be
          entitled to voting (just like taxes, in a way, entitle to voting in politics). Creditors are different b/c they
          have a specific contract that they negotiate with a specific rate of return. Shareholders, on the other
          hand, don‟t have a specified rate of return and have more open-ended contract, and therefore, they
          should have some sort of control to fill in this openness.

   3. Is Voting a Good Protection for the Shareholders? – Although it might be that “rational apathy” might
      prevent anyone from actually checking up on the directors, the threat that a shareholder can actually become
      a majority holder (via buying or proxies) reduces the rational apathy problem.

  A. Agreements Restricting the Board’s Discretion – Shareholder agreements where the participants limit their
     discretion as shareholders (e.g. they agree to vote for a certain slate of directors or for/against a merger) are
     almost always valid. However, a problem arises when shareholders agree to restrict discretion as directors.

     1. Purchasing Shareholder Votes is Forbidden – Purchasing another shareholder‟s right to vote is flatly
        prohibited in corporate law. There are often disputes, however, about whether shares are “purchased” (e.g.
        paying reimbursements akin to selling votes).

         i) Collective Action Problem – Even though each shareholder may not make much of a difference (and
            thus it is rational to sell a vote), if everyone did the rational thing and sold their vote then one person
            could directly influence the entire election. This is desired to be prevented, and thus it is prohibited.

         ii) Exchange of Shares for Higher Dividends – Often, an alternative method of achieving the same results
             is to permit conversion or exchange of voting shares into non-voting shares with higher dividends.

  B. Traditional View – Agreements Restricting Board’s Discretion are Invalid – Any agreement that
     substantially fetters the discretion of a board of directors has traditionally been regarded as unenforceable.

     1. Rationale – The courts reason that the board of directors has a fiduciary obligation to the corporation, all of
        its shareholders and creditors, and an agreement that results in the board of directors‟ not being able to use
        its own best business judgment might result in unfair and unnecessary injury to a minority shareholder (or
        creditor) who did no agree to whatever restrictions are provided

     2. Traditional Power of Shareholders – Shareholders can only control the corporation to the extent that they
        are able to elect directors that will bow to the will of those who united to elect them. The majority
        stockholders can compel no action by the directors, but at the expiration of the term of office of the
        directors the stockholder have the power to replace them with others whose actions coincide with the
        judgment or desires of the holders of a majority of stock.

         McQuade v. Stoneham (1934) – Majority shareholder (Stoneham) and two minority shareholders (McQuade & McGraw) agreed
         that all would use their best efforts to keep one another in office as directors and officers at specified salaries. Subsequently,
         Stoneham and McGraw refused to try to keep McQuade in office as director and treasurer. After he was dropped he sued for
         breach and for specific performance. Held: The shareholder agreement was invalid because the restrictions put on directorial
         discretion were invalid as a matter of public policy. The court reasoned that stockholders may not, by agreeing among
         themselves, place “limitations…on the power of directors to manage the business of the corporation by the selection of agents
         at defined salaries.” In other words, the board must be free to exercise its own business judgment.

  C. Modern View – Limited Permissibility – Through a series of cases, many states have granted limited
     permissibility to agreements restricting a board‟s discretion.

     1. Directors are Sole Shareholders – 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

         i) New York Test (i.e. Clark v. Dodge) – To be valid in the state of New York, it is required that…

              (1) ALL SHAREHOLDERS have SIGNED the agreement (or at the very least that the person now
                  attacking the agreement had previously consented to it)…

              (2) There was NO INDICATION that anyone would be INJURED by the contract, and…

              (3) The IMPAIRMENT of the board‟s powers was SLIGHT or NEGLIGIBLE.
      Clark v. Dodge (1936) – P (Clark) owned 25% and D (Dodge) 75% of two different corporations. They signed an agreement
      whereby D was to vote for C as director and general manager and to pay him ¼ of the business‟ income, so long as he remained
      “faithful, efficient, and competent.” D argued that this agreement violated the McQuade rule since it purported to restrict the
      discretion of the board of directors. Held: The agreement was upheld despite McQuade. The court seemed to rely on two
      respects in which this agreement was different than the one struck down in McQuade: (1) all shareholders had signed the
      agreement, and there was no sign that anyone would be injured by the contract; and (2) the impairment of the board‟s powers
      were “negligible,” apparently since P could always be discharged for cause, and his ¼ of income could be calculated after the
      board determined in it discretion how much should be set aside for the company‟s operating needs.

   2. No Injury to Other Interests – Even if the directors are not the sole shareholders, an agreement will be
      upheld even though it limits the discretion of the board of directors if there is no injury to other interests.

      i) Widely Used Test (i.e. Galler v. Galler) – Agreement is valid if three requirements are satisfied…

           (1) There must be NO MINORITY INTERESTS that are INJURED by it…

           (2) There must be NO INJURY to the PUBLIC or to CREDITORS; and…

           (3) The agreement must NOT VIOLATE any clear STATUTORY PROHIBITION

          Galler v. Galler (1964) – The two principal owners of a corporation, Benjamin and Isadore, each owned 47.5% of the stock.
          They signed a shareholders‟ agreement in which they agreed to pay certain dividends each year and to pay, in the even either
          should die, a specified pension to his widow. Benjamin died and Isadore refused to carry out the agreement. Held: The
          agreement was upheld even though it limited the discretion of the board of directors. The court required an agreement to
          satisfy three tests before it would be upheld: There must be no minority interests that are injured by it; there must be no
          injury to the public or to creditors; and the agreement must not violate a clear statutory prohibition.

D. Rationale for Allowing Shareholder Agreements in Closed Corporation Context – An investor in a closed
   corporation often has a large total of his entire capital invested in the business and has no ready market for his
   shares should he desire to sell. He feels, understandably, that he is more than a mere investor and that his voice
   should be heard concerning all corporate activity. Without a shareholder agreement, specifically enforceable
   by the courts, insuring him a modicum of control, a large minority shareholder might find himself at the mercy
   of an oppressive or unknowledgeable majority.

E. Policy Problem: Deviating from Corporate Form & Limited Liability – When allowing shareholders to
   have a significant amount of control, it begins to look more like a partnership rather than a corporation, and thus
   questions the rationale for allowing the entity to enjoy limited liability status

  A. Control Premium – A controlling block of shares in a corporation will often be worth more, per share, than a
     non-controlling block. The premium in excess of the prevailing market price is amount an investor is willing
     to pay for the privilege of directly influencing the corporation’s affairs

     1. General Permissibility – The general rule is that the controlling shareholder may sell his control bock for a
        premium and may keep the premium for himself without implicating any breach of fiduciary duty.

         Zetlin v. Hanson Holdings, Inc. (1979) – P owned 2% of the outstanding shares of Gable Industries, Inc., with D‟s (Hanson
         Holdings) owning 44% (in conjunction with other people). D‟s sold their shares to Flintkote for a premium of almost double the
         market price. Zetlin contends that the minority shareholders are entitled to an opportunity to share equally in any premium paid
         for a controlling interest in the corporation. Held: It has been long settled law that, absent looting of corporate assets, conversion
         of a corporate opportunity, fraud, or other acts of bad faith, a controlling stockholder is free to sell, and a purchaser is free to buy,
         a controlling interest at a premium price. Minority shareholders are entitled to protection against abuse by controlling
         shareholders. However, they are not entitled to inhibit the interests of other stockholders. It is for this reason that controlling
         shares are usually sold at a premium price. The premium is amount an investor is willing to pay for the privilege of directly
         influencing the corporation‟s affairs.

     2. Exceptions – There are three major exceptions to the general right to sell a block for a premium…

         i) Looting – A holder of controlling shares may not knowingly or recklessly sell control to a buyer who
            will use control to “loot” the corporation. If seller suspects the buyer will steal corporate assets or
            engage in unfair self-dealing transactions, the seller becomes liable for any damage caused by the buyer.

         ii) Sale of Office – Often the seller of a control block will promise to give the buyer working control over
             the board and to slowly replace the members. Courts prohibit these types of agreement sif the buyer did
             not acquire enough control to have elected his own slate or where the sales price exceeds the premium
             suggesting the price included a prohibited sale of office.

         iii) Diversion of Corporate Opportunity – A controlling shareholder cannot convert an offer made ot the
              corporation into one to the shareholder alone. If the control buyer offers to deal with all shareholders on
              an equal basis (e.g. proposing a merger or buying corporate assets), the controlling shareholder may not
              divert this corporate opportunity to himself by failing to disclose the opportunity or demanding it.

             Pearlman v. Feldman – Company produced steel during Korean War when prices were regulated. Because there were many
             more buyers than sellers, the buyers were trying to offer many indirect advantages/perks (e.g. low interest loans, etc.) to get
             the steel since prices were regulated. Defendants wanted to avoid this and secure a consistent supply of steel, so they bought
             up 60-70% of the shares of a seller. However, to do this, the majority bloc told the defendants that they could only have the
             70% if they paid a premium to the majority (not all shareholders). Minority was upset and sued. Held: There was evidence
             that another purchaser had originally approached the majority holders to merge, a transaction through wchih all of the
             shareholder would have shared in any control premium. Thus, any premium has to be offered to the entire shareholders
             rather than merely to the minority.

  B. Contractual Modifications to Shareholder’s Freedom of Sale or Transfer – Shareholders are free to make
     contractual modifications to the shareholder agreements to protect their interests.

     1. Right of First Refusal – Often, shareholders will agree to rights of first refusal in that when a controlling
        shareholder wants to sell his shares…

         (1) The minority shareholders have the right to purchase the shares at the offered price before any/all third
             parties, and…

         (2) If the minority refuses, then the majority will buy the minorities’ shares for the premium price.
   2. Sale of Assets Does NOT Trigger Right of First Refusal – Under some “right of first refusal” agreements
      where the first refusal is available for any “offer” or “sale” of the corporation, the sale of some (or all) of
      the corporation‟s assets does not trigger the redemption rights.

      Frandsen v. Jensen-Sundquist Agency, Inc. (1986) – Plaintiff (Frandsen) was the owner of all the shares of Jensen-Sundquist, a
      holding company whose principal asset was a majority of the stock of the First Bank of Grantsburg. Jensen subsequently sold
      52% of the stock to a “majority bloc” consisting of members of his family. Under the shareholder agreement, however, Jensen
      wrote in a “right of first refusal.” Later, the majority wanted to sell its shares to First Wisconsin Corporation. However, Jensen
      attempted to exercise his right to first refusal. Because the majority didn‟t want to sell the shares back to Jensen (re: fear of losing
      their jobs), the majority agreed to sell its shares in the bank (rather than the holding company; i.e. sold the asset) so that the
      holding company would be liquidated. Held: The right of right of first refusal was one to buy the shares of the majority if they
      offered them for sale. It was not triggered by a sale of the assets of the holding company. Although Jensen argues that the term
      “sale” or “offer” are ambiguous, rights of first refusal are to be narrowly interpreted. Thus, there was no sale here. There was a
      merger where the shares were extinguished rather than sold.

C. Remedies

   1. Return Premium to the Corporation – The most logical remedy is to return the premium to the
      corporation. At least arguably, it is the corporation‟s assets or equity control that has been sold to produce
      the control premium and thus it is the corporation that should get the premium back.

   2. Payment to Non-Controlling Shareholders – By giving back to the corporation, however, gives the
      purchaser – the very person who agreed to pay the premium – an unanticipated an undeserved windfall.
      Thus, the court may decide to order the seller to repay directly to the minority shareholder their pro rata part
      of the control premium instead.

D. Policy Issue: Should the Controlling Shareholders have the Right to Sell for Premium? The majority of
   courts recognize the rule from Frandsen because…

   1. Fairness – The case recognizes the idea of freedom of contract. If shareholders wish to make contractual
      modifications to the rule, then they should be allowed. The courts should not interfere.

   2. Utility Argument – Without allowing a controlling shareholder to collect a premium for his shares, it may
      be impossible for the shareholders to be able to ever replace him.

  A. Generally – Most control changes occur in negotiated “friendly” mergers and acquisitions. The management of
     two corporations negotiate the terms, structure, and future management. When they reach a deal, they present it
     to the shareholders of the acquired (and sometimes the acquiring) company for approval.

  B. Statutory Merger – A statutory merger is a combination accomplished by using a procedure prescribed in the
     state corporation laws. Under a statutory merger the terms of the merger are spelled out in a document called
     the merger agreement, drafted by the parties, which prescribes the treatment of the shareholders of each
     corporation. Considerable flexibility is available.

     1. Must be Approved and Ratified – If the statutory merger is used, approval by votes of the boards of
        directors and subsequent ratification by the shareholders of each of the two corporations is required.

     2. Must Allow for Appraisal Rights – Shareholders of each corporation who voted against the merger are
        entitled to demand that they be paid in case the fair value of their shares (determined by agreement or by a
        judicial proceeding).

  C. Practical “De Facto” Mergers – Under the judicially created de facto merger doctrine, a handful of courts
     have interpreted the statutory merger provisions to give shareholders in functionally equivalent asset sales the
     same protections available in a statutory merger. Under this doctrine, if the asset sale had the effect of a
     merger, shareholders receive merger-type voting and appraisal rights.

     1. Methods of De Facto Mergers

         i) Subsidiary Method: The “Triangular” Merger – If a company creates a subsidiary, transfers all its
            assets to the subsidiary, and then becomes the subsidiary’s 100% shareholder, the subsidiary can be
            merged with only the approval of the parent corporation without approval of the parent shareholders and
            with out appraisal rights.

         ii) Purchase of Shares: The “Short Form” Merger – A company could offer all its shares to another
             company and then the 100% shareholder can declare a short-form merger of the two companies. This
             avoids both the shareholders‟ approval and appraisal rights.

         iii) Purchase of All the Target Corporation’s Assets – Occurs when one corporation buys all the assets of
              another corporation for stock or cash. The cash or stock is then distributed to its shareholders and
              liquidates. Thus, the only entity left is one corporation with the assets and shareholders (if stock
              distributed) of both.

     2. Analysis of De Facto Merger

         i) Prevailing View – In most jurisdictions, courts accept that corporate management can structure a
            combination under any technique it chooses. To maximize flexibility, form trumps substance. Each
            combination technique has its own legal significance and equal dignity.

         ii) Minority View – Under the minority view (see Glen Alden, infra), the dispositive question between a
             merger and an asset acquisition is whether the agreement fundamentally changes the corporate
             character and whether the transaction has the effect of a merger.
Farris v. Glen Alden Corp. (1958) – Two corporations entered into a „reorganization agreement,‟ subject to stockholder
approval, which contemplated the following actions: (1) Glen Alden is to acquire all of the assets of List; (2) Glen Alden is to
issue shares of stock to List to distribute to its shareholders; (3) Glen Alden is to assume all of List's liabilities; (4) Glen
Alden is to change its corporate name; (5) present directors of both corporations are to become directors of List Alden; (6)
List is to be dissolved. Two days after the agreement, notice of the annual meeting of Glen Alden was mailed to shareholders
together with a proxy statement analyzing the reorganization agreement and recommending its approval. At this meeting the
holders of a majority of the outstanding shares voted in favor of a resolution approving the reorganization agreement. P sued.
Held: An agreement between two corporations where one corporation dissolves, its liabilities are assumed by the survivor, its
executives and directors take over the management and control of the survivor, and, as consideration for the transfer, its
stockholders acquire a majority of the shares of stock of the survivor, then the transaction is no longer simply a purchase of
assets or acquisition of property, even if done by contract, and is rather a merger under corporation law. The dispositive
question between a merger and an asset acquisition is whether the agreement fundamentally changes the corporate
character. Here, it did b/c the company now became a diversified holding company rather than a coal company, it had 7x‟s
the amount of long-term debt, and there would be serious financial losses by the stockholders (i.e. $38/share to $21).

  A. Freeze-Outs – A “freeze-out” is a transaction in which those in control of a corporation eliminate the equity
     ownership of the non-controlling stockholders. The insiders somehow force the outsiders to sell their shares,
     or the insiders find some other way of eliminating the outsiders as common shareholders. The net result of a
     freeze-out is that the controlling shareholders go from mere control to exclusive ownership of the corporation.

     1. Close Scrutiny – Courts seem to scrutinize freeze-out transactions closely on an assumption that minority
        shareholders need to be protected from inherent conflicts of interest and against self-dealing by insiders.

     2. Analysis – Freeze-out transactions required that the insiders be on the both side of the transaction (i.e. the
        insiders probably control the corporation‟s board of directors and are instrumental in having the board
        approve the transaction, but they also stand to benefit if the transaction occurs. Courts will look at the
        totality of the circumstances through two basic tests when analyzing a freeze-out…

         i) “Business Purpose” Test – The transaction must be undertaken for some valid or legitimate business
            purpose. The majority controlling shareholders violate their fiduciary duties when they cause a merger
            to be made for the sole purpose of eliminating a minority on a cash-out basis.

         ii) “Fairness” Test – The transaction must be basically fair, taken in its entirety, to the outside minority
             shareholders. Three basic aspects of “fairness” that courts examine:

              (1) Fair PRICE;

              (2) Fair PROCEDURES under which the corporation‟s board decided to approve the transaction

                  (I.e. relating to how transaction was timed, initiated, structured, negotiated, disclosed to the
                  directors, and how the approvals of the directors and the stockholders were obtained),

              (3) Adequate DISCLOSURE to the outsider shareholders concerning the transaction.

     3. Remedies for Freeze-Out Mergers – The normally appropriate remedy for an impermissible freeze-out
        merger is rescission. However, when it is not appropriate or feasible to do so (i.e. passage of time, reliance
        by other shareholders on the merger, etc.), rescissory damages are an alternative remedy.

         i) Present Value Damages – The rescissory damages must be determined based on the present value of
            the shares, that is, what the stockholder would have if the merger were actually rescinded.

         ii) Criticism – This will create the incentive to sue only when the company value increases in future

         Coggins v. New England Patriots Football Club, Inc. (1986) – Sullivan purchased an AFL franchise with nine other investors.
         In return each of the investors received 10,000 shares of voting common stock. Subsequently, Sullivan was ousted of control by
         the other voting shareholders, and thus, he began an effort to regain control of the corporation. Eventually, Sullivan succeeded in
         obtaining ownership of 100% of the voting shares, and he immediately used his control to vote out the hostile directors, elect a
         friendly board, and arrange his resumption of the presidency and complete control. He also created a new corporation with which
         he merged. After the merger, the voting stock of the old company would be extinguished, the nonvoting stock would be cashed,
         the name would switch, and Sullivan would exchange 100% voting old for 100% voting new. The merger was approved not only
         by Sullivan (i.e. voting class) but also by a majority of the nonvoting stockholders. However, a nonvoting shareholder initiated
         this action claiming that transaction was unfair. Held: The merger was illegal. The sole reason for the merger was to effectuate
         a restructuring of the Patriots that would enable the repayment of personal indebtedness incurred by Sullivan. Defendants did not
         show any legitimate business purpose nor did they show a conflict of interests between the league owners and the old
         corporation. Although rescission would be the proper remedy, because the transaction occurred a decade prior, damages are
         appropriate. The amount of damages is the present value of the shares.
B. Merger serving as a Sale of Assets and Redemption – Another de facto non-merger occurs when a
   transaction takes the form of a merger but it was in substance a sale of assets followed by a redemption.

   1. Permissible because Legally Distinct – Delaware law states that a conversion of shares to cash that is
      carried out in order to accomplish a merger is legally distinct from a redemption of shares by a corporation.

       Rauch v. RCA Corporation (1988) – GE acquired RCA Corporation. Pursuant to the terms of the agreement, all common and
       preferred shares of RCA stock were converted to cash. Plaintiff, a holder of 250 shares of preferred stock, commenced a class
       action on behalf of the holders of preferred stock. Plaintiff claimed that the merger constituted a liquidation, dissolution, or
       winding up of RCA and thereby a redemption of the preferred stock, as a result of which holders of the preferred stock were
       entitled to $100/share in accordance with the redemption provisions of RCA‟s certificate of incorporation. The certificate stated
       that the preferred stock “may be redeemed by the Corporation…at its election…at a price of $100 per share.” Held: A
       conversion of shares to cash that is carried out in order to accomplish a merger is legally distinct from a redemption of shares by
       a corporation. Here, the preferred stock was subject to redemption by RCA at its election. Nothing in RCA‟s certificate of
       incorporation indicated that the holders of Preferred Stock could initiate a redemption, nor was there provision for any specified
       event, such as a merger, to trigger a redemption. There was no election here, and thus the plaintiff‟s claim fails.

C. Merger serving as a Recapitalization – A “recapitalization” is an adjustment of the capital structure of a
   corporation (e.g. reducing or eliminating par value of common stock, creating new securities, etc.). One
   popular type of recapitalization is the elimination of accrued dividends owed to preferred shareholders. This
   can be done either by amending the articles of incorporation or use of a merger.

   1. Merger serves as Alternative to Amending Articles – The accrued dividends may be eliminated or
      reduced by indirect means by merging the corporation into another corporation, and having the survivor‟s
      articles not provide for payment of any accrued preferred dividends.

   2. Generally Permitted with Shareholder Approval – Courts generally allow the use of the merger
      technique for the purpose of eliminating the preferred shareholders dividends, as long as all needed
      shareholder approvals are obtained (i.e. the approval of the common shareholders).

       Newport Case – Corporation set up with both common and preferred shareholders. The preferred shareholders are entitled to
       cumulative dividends. However, many years had actually passed since the last time dividends were paid, and the corporation was
       worth barely enough to pay off its own equity. Eventually, the common shareholders made the following proposal: form another
       subsidiary corporation, merge the two companies, preferred would get 60% of the new subsidiary, and common shareholders
       would get 40%. Majorities of both the common and preferred shareholders approve. However, a preferred minority shareholder
       brings suit complaining that the agreement significantly changed the rights of the shareholders because the dividends in arrears
       were lost and that the company used the merger as a subterfuge for recapitalization (i.e. the common shareholders used the merger
       technique to force the preferred shareholders to approve it b/c they controlled whether the preferred would ever get paid). Held:
       Merger was valid. Recapitalization of a company is different than a merger, and the stock holders are not protected.

  A. Hostile Takeovers – A hostile takeover is the acquisition of a publicly held company (the “target”) over the
     opposition of the target‟s management. When a corporation becomes the subject of a hostile bid, the
     management and board of the target corporation will usually try to repel the bid, either in the hopes of
     improving the offer, or in the hopes of somehow remaining independent.

     1. Tender Offer – A tender offer is an offer to stockholders of a publicly owned corporation to exchange their
        shares for cash or securities at a price above the quoted market price.

         i) Williams Act – Forbids surreptitious attempts of hostile takeover and institutes procedural regulation.
            Generally, the Act holds that when an offer is made, it must be made publicly with the shareholders each
            having a pro rata opportunity to take advantage of it, it must be held open for a certain time period, etc.

     2. Options for Management – When facing a hostile takeover, management of the company must choose to

         (1) Pay “greenmail” to bidder, …

         (2) Resort to various other defensive strategies, or …

         (3) Accept the inevitable and allow the company to be taken over under the best possible negotiated deal.

  B. Paying Greenmail – Instead of being taken over by a hostile takeover, the target company may decide to pay
     “greenmail” to the bidder. This occurs when the target company buys back a partial or entire stake that the
     bidder has already built by paying him an above-market, premium price.

     1. Analysis of Repurchasing “Greenmail” Shares – There is an inherent danger in the purchase of shares
        with corporate funds to remover a threat to corporate policy when a threat to control is involved because the
        directors are, of necessity, confronted with a conflict of interest. Thus, the burden of proof should be on
        the directors to justify that the purchase was one primarily in the corporate interest.

             a. Meeting Burden - Directors satisfy the burden of proof by showing…


             b. Limitations – Directors will not be penalized for an honest mistake of judgment, if the judgment
                appeared reasonable at the time the decision was made. However, if the board primarily because of
                the desire to perpetuate themselves in office, the use of corporate funds for purpose is improper

         ii) Control Premium Permitted – If a corporation desires to obtain its own stock, it is unreasonable to
             expect that the corporation could avoid paying what any other purchaser would be required to pay

     2. Criticism: Repurchasing Shares Provides Little Protection – Buying off one person often provides no
        protection against later pursuers, except possibly to the extent that the premium paid to the first pursuer
        depletes the corporate resources and makes it a less attractive target.

         i) Alternative Method – The same reduction of corporate assets could be achieved by managers simply
            by paying a dividend to all shareholders or buying shares from all other shareholders that want to sell.

         ii) Standstill Agreements – In return, target company also can require the bidder to enter into a standstill
             agreement whereby he agrees not to attempt to re-acquire the target for some specified number of years.
          Cheff v. Mathes (1964) – Defendants were members on the board of the Holland, which was approached by Maremont to
          inquire about a merger with his company. When he was told it was unfeasible, Maremont began acquiring Holland stock.
          Maremont had a reputation for liquidating a number of companies. Furthermore, formal reports were given to the board
          stating that Maremont had realized quick profits through sales or liquidations of companies. Thus, after being presented this
          information, the board passed a resolution to buy the shares owned by Maremont at a premium. Plaintiff, owing 60 shares of
          stock, brought suit claiming that the purchase was for the purpose of insuring the perpetuation of control by the incumbent
          directors. Held: If the actions of the board were motivated by a sincere belief that the buying out of the dissident shareholder
          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. However, if the board acted solely or
          primarily because of the desire to perpetuate themselves in office, the use of corporate funds for such purposes is improper.
          Here, the evidence presented in the court leads inevitably to the conclusion that the board of directors, based upon direct
          investigation, receipt of professional advice, and personal observations of the contradictory nature of Maremont and his
          explanation of corporation purpose, believed, with justification, that there was a reasonable threat to the continued existence
          of Holland, or at least existence in its present form, by the plan of Maremont to continue building up his stock holdings.

C. Analysis of Other Defense Mechanisms – Whenever a target‟s management decides to use a variety of other
   defense mechanisms to deter a hostile takeover, courts will analyze the decision under three requirements…

   1. LEGITIMATE CORPORATE OBJECTIVE – First, the board and management must show that they had
      reasonable grounds for believing that there was a danger to the corporation’s welfare from the takeover
      attempt. The insiders may not use anti-takeover measures merely to perpetuate themselves in power – they
      must have reasonable grounds for believes that they are protecting the stockholders’ interests.

   2. REASONABLE RESPONSE – Second, the directors and management must show that the defensive
      measures they actually used were reasonable in relation to the threat posed. This entails an analysis by the
      directors of the nature of the takeover bid and its effect of the corporate enterprise.

       i) Relevant Factors – Including…

          a. Inadequacy of the price offered,

          b. Whether the acquirer had a reputation for looting, liquidation, or as a green-mailer,

          c. Impact on “constituencies” other than shareholders (e.g. creditors, customers, employees, and
             perhaps the community generally), and …

          d. Quality of securities being offered in exchange.

       ii) Special Knowledge Presumed – When a board claims an offer price is inadequate, there are concerns
           that the decision is driven by a desire to maintain their positions. The Court decided in Unocal, however,
           that the efficient market hypothesis will not be followed (i.e. market price is accurate) and that the board
           of directors will be presumed to have special knowledge about the intrinsic value of the company.

   3. GOOD FAITH AND REASONABLE INVESTIGATION – Third, the board must make the two above
      showings by demonstrating that it acted not only in good faith but upon reasonable investigation.

       i) Factors Weighing Against – Thus, if measures were hurriedly passed, without extensive discussion or
          analysis, and at urging of management, the measures are less likely to be sustained than if they were
          carefully considered over a period of time.

       ii) Independent Directors – The court is much more likely to find that the decision was made in good faith
           if the takeover measures were approved by a board whose majority were disinterested (i.e. outside)
           directors. The court will presume that an independent director, who does not rely on the corporation for
           the bulk of his livelihood, will have less of a conflict of interest than an insider.
D. Possible Defense Mechanisms

   1. Two-Tiered Tender Offers – This is a tender offer that contains two parts. In the first part, the bidder pays
      a high cash price for most (usually 51%) but not all of the target‟s stock. In the second or “back-end” step,
      the bidder acquires the remaining shares in the target company by merging the target into itself and pays
      with either a lower price or debt securities of lower value.

      i) Coercive Technique – Without such a technique, a shareholder would have no reason to tender their
         shares early (i.e. better to wait to see if value increases with a potential merger). Thus, bidders like the
         device because it coerces the target‟s holders to tender into the offer: if they don‟t all of their shares will
         be acquired at the lower back-end price.

      ii) Benefit of Two-Tiered Offers: Defeat Collective Action Problem – Courts decided not to outright
          prohibit two-tiered offers because they can be useful for shareholders to defeat a collective action
          (prisoner‟s dilemma). This is because if the two-tiered offer was not available (i.e. back-end was either
          higher or the same as front-end), then all shareholders would benefit from not tendering their shares and
          waiting to see if value increases from new management.

   2. Poison Pills – One of the most common defensive strategies, the poison pill can be adopted by the board of
      directors without any shareholder approval. These plans attach rights to outstanding common stock which
      can be redeemed later for either the target‟s stock or a potential acquirer‟s stock at a cheap price.

      i) “Flip-In” – The pill‟s flip-in element is usually triggered by the actual acquisition of some specified
         percentage of the issuer‟s common stock (usually around 20%). If triggered, the flip-in pill entitled the
         holder of each right – except the acquirer and its affiliates or associates – to buy two shares of the
         target issuer’s common stock or other securities at ½ price. The deterrent effect of such a pill arises
         out of the massive dilution the pill causes to the value of the target stock owned by the acquirer.

      ii) “Flip-Over” – The pill‟s flip-over element is usually triggered if, following the acquisition of a
          specified percentage of the target‟s common stock, the target is subsequently merged into the acquirer
          or one of its affiliates (can also occur by merely acquiring of certain percentage of shares). In such an
          event, the holder of each right becomes entitled to purchase common stock of the acquiring company
          at ½ price, thereby impairing the acquirer‟s capital structure and drastically diluting the interest of the
          acquirer’s other stockholders.

      iii) Redemption – Most pills include a redemption provision pursuant to which the board may redeem the
           rights at a nominal price at any time prior to the right being exercised.

   3. White-Knight – Another option for is to find a bidder who is friendly to target‟s management and who at
      that management‟s request will acquire the target so it won‟t be acquired by the unwelcomed bidder. Often,
      this white knight also promises to keep the target’s original management in place after the acquisition.

   4. “Lock-Up” Provisions – These types of provisions have effect of precluding purchase by another bidder.
      This is such because it creates negative ramifications for shareholders rejecting the takeover by the
      favored bidder (e.g. cancellation fee; crown jewels provision, i.e. sale of best assets, etc.)

      i) Not Per Se Illegal – Lock-up provisions are not per se illegal but they must be used to expand the
         competition, not to destroy it.

          Ex: If a lock-up provision was the only way to convince other bidders to enter the auction for the company, then presumably
          such a provision would be upheld.
   5. Exclusionary Repurchases (i.e. Self Tender) – Finally, a target may try to repulse the hostile bidder by
      embarking on its own aggressive program of share repurchases. Furthermore, in doing such a repurchase,
      the target company may also try to exclude the bidder from participating in the share repurchasing program.

       i) Prohibited in Modern Times – Following the Unocal case (infra), the SEC amended its rules to
          prohibit issuer tender offers other than those made to all shareholders.

           Unocal Corporation v. Mesa Petroleum Co. (1985) – Mesa, owner of 13% of Unocal stock, commenced a two-tier “front-
           loaded” cash tender offer for 37% of the outstanding shares at a price of $54/share. However, “back-end” of the transaction
           exchanged Unocal shares for highly subordinated “junk bonds.” Thus, Unocal‟s board met to discuss options. After
           presentations concerning their duties (by corporate counsel) and explaining why the tender offer was grossly inadequate (by
           independent investment bankers), the board voted to reject the offer. Further, it decided to pursue a self-tender offer at the
           exclusion of Mesa at $72/share. Unocal justified its decision on the idea that if Mesa were allowed to participate, it would
           defeat the entire purpose of the defense mechanism. Mesa challenged actions claiming breach of fiduciary duty because the
           board was not treating all shareholders similarly. Held: Unocal‟s board, consisting of a majority of independent directors,
           acted in good faith, and after reasonable investigation found that Mesa‟s tender offer was both inadequate and coercive.
           Under the circumstances, board had both power and duty to oppose a bid it perceived to be harmful to corporate enterprise.
           The device Unocal adopted is reasonable in relation to the threat posed, and the board acted in the proper exercise of sound
           business judgment. The court will not substitute its views for those of the board if the latter‟s decision can be attributed to
           any rational business purpose.

E. Decision to Sell the Company Shifts Duty – If the company‟s management decides that it is inevitable that the
   company will be sold and the board will no longer retain control, the rules governing their actions shift.

   1. Incremental Bidding – If a company announces to pursue “incremental bidding,” this means that the
      company will continue to keep offering a little higher price on each subsequent bid. This serves as a signal
      to courts that it is improper to sell quickly and to a white knight bidder

   2. NEW DUTY TO MAXIMIZE PRICE – At this point, courts impose on management and the board the duty
      to obtain the highest price for the shareholders. This means that the target‟s insiders cannot favor one
      bidder (e.g. white knight) and all would-be bidders must be treated equally.

       Revlon, Inc. v. MacAndrews & Forbes Holding, Inc. (1985) – Revlon involved a long-fought battle in which Pantry Pride
       sought to acquire Revlon. In the early stages of the battle, Revlon‟s board rejected Pantry‟s initial hostile tender offer of
       $45/share as grossly inadequate, adopted a poison pill, and announced a share repurchase plan. Revlon also began looking for a
       white knight, and found one in Forstmann Little. Forstmann and Pantry began topping each other‟s bids. The Revlon board
       finally approved Forstmann‟s bid of $57.25/share versus Pantry‟s then-highest $56.25/share. Furthermore, Revlon gave
       Forstmann a “crown jewels” option to buy two key Revlon subsidiaries for below market value if another acquirer go more than
       40% of Revlon shares, it agreed to a no-shop provision, and it agreed to a $25 million cancellation fee. Finally, Revlon also gave
       Forstmann financial data unavailable to Pantry. Held: Lockups and related agreements are permitted under law where their
       adoption is untainted by director interest or other breaches of fiduciary duty. The actions taken by Revlon directors, however, did
       not meet this standard. While concern for various corporate constituencies is proper when addressing a takeover threat, that
       principle is limited by the requirement that there be some rationally related benefit accruing to the stockholders. There is no such
       benefit here. Furthermore, when Revlon board authorized management to negotiate a merger or buy out with a third party, the
       board was putting the company up for sale. At that point, question of defensive measures became moot and directors‟ role was to
       auction the company for the best price. By attempting to protect themselves (i.e. the directors) from personal liability (i.e. from
       the notes), the directors breached their fiduciary duty to the shareholders.
F. Policy Arguments concerning Hostile Takeovers – There are a variety of arguments both in favor and against
   the use of hostile takeovers.

   1. Disciplinary Function – The new ownership will more efficiently run the business

       i) Rebuttal – This also forces management to be always be in a defensive strategy;

   2. Protects Shareholder Against Perpetuation of Management – It protects against conflicts of interest in
      the management because it serves to destroy a perpetuation of management;

       i) Rebuttal – The acquiring board has similar conflicts of interests (i.e. the “empire building” strategy”)

   3. Good Offers make the Shareholders Money – Hurts the shareholders if the board prevents a takeover that
      will make the shareholders money

       i) Rebuttal – Short-sighted; the true value of the company will be achieved in the long-run (this is
          against the efficient-market hypothesis however); furthermore, often hostile takeovers (resisted) will end
          up being a bidding war and resisting initially will yield a higher price in the long-run

   4. Harm to Employees – The hostile takeover may result in the liquidation of the corporation and serve to the
      detriment of the corporation‟s employees.

       i) Rebuttal – Fiduciary duties don’t exist to employees. They are protected by unions and contracts.

   5. Control Premiums are Inherently Unfair – Hostile takeovers often involve some shareholders receiving a
      significant control premium. It is inherently unfair, however, to allow the majority shareholders to benefit
      from the takeover if it is against the interests of the minority shareholders.

       i) Rebuttal – Corporate premiums have been validated in many friendly merger contexts. Thus, they
          should be allowed in the hostile takeover context as well.

   6. Encourages Greenmail – Allows raiders to elicit Greenmail from a corporation and its shareholders

       i) Rebuttal – The premium paid to the green-mailer is not that different than an ordinary auction for any
          set of assets (e.g. art investment)

   7. Collective Action Problem – Once an offer is made, it is better for shareholders if management can resist.
      However, shareholders collectively (all shareholders in the world) would be better off if it did not exist b/c
      mgmt worried about free-riding on their expenses to acquire and thus there are less than efficient amount of
      total acquisitions that take place in the market

  A. Generally – Bonds and debentures are forms of debt owed by corporations, typically to individuals and to
     institutes such as pension funds, insurance companies, and mutual funds. Debentures are long-term unsecured
     debt obligations, while bonds are long-term debt obligations secured by property of the debtor.

     1. General Aversion to Secured Debt – Most debt obligations to banks are secured but most other debt
        obligations are not. The aversion to secured debt in non-bank borrowing reflects the fact that a security
        interest in a corporation‟s property disadvantageously constrains business decisions. With a single lender,
        like a bank, it may be feasible to waive security, while with debt held by many persons that may not be so.

     2. Subordination Agreements – An alternative to secured (v. unsecured debt) is a subordination agreement,
        which allows debt to be issued in layers of priority.

         Ex: A corporation might issue senior debentures and subordinated debentures, with the latter being entitled to payment only after
         the claims of the former have been fully satisfied.

  B. No Fiduciary Duty; Contractual Rights Only – Rights of bondholders are governed by private contract.
     Thus, the debt security-holder can do nothing to protect himself against actions of the borrower which
     jeopardize its ability to pay the debt (e.g. incurrence of substantial additional debt) unless he establishes his
     rights through contractual provisions set forth in the indenture.

     1. Debtor’s Sale of “Substantially All of its Assets”

         i) Successor-Obligor Clause – Provides that a borrower which consolidates, liquidates, mergers, or sells
            “substantially all of its assets,” does not have an option to continue holding the debt. Rather, the buyer
            must either convey the debt OR pay it off at the face amount.

         ii) Interpreted in Context of Underlying Purpose – The boilerplate language often used in successor-
             obligor clauses must be understood in context of their underlying purpose.

             a. Transfer of Debt Possibly to Detriment of Bondholders – Debt holders are harmed when debt is
                transferred to another entity which has a significantly worse “risk profile” (i.e. likelihood of
                repayment is much less). (see

                      However, this is not the underlying propose for successor-obligor clauses…

             b. Real Purpose: Protect Corporation – The majority of courts have ruled that the real purpose of
                successor obligor clauses is to protect corporations from bondholders forcing them from having pay
                off debt because any (even small) changes in the corporate structure.

                 Sharon Steel Corporation v. Chase Manhattan Bank (1983) – UV Industries had issued debentures that bore interest
                 at rates lower than the prevailing market rate. Thus, the debentures market value was less than their face amount. UV
                 later adopted a plan to liquidate by selling all of its assets and distributing the proceeds to its shareholders. UV had three
                 lines of business and proceeded to sell off the first two, leaving UV will one subsidiary plus cash of $322 M subject to
                 claim of the debenture holders. Sharon Steel bought all of the remaining assets (including the cash). Because it was not
                 feasible for UV or Sharon to buy back the debentures in market transactions, however, the question then arose whether
                 by virtue of the liquidation of UV the debentures became due and payable. The bondholders claimed that they were due
                 while Sharon claimed that the debt was not due (he wanted to hold onto the 7% debt rather than a prevailing market rate
                 to re-borrow the same about of money ~ 10%) Held: Boilerplate successor obligor clauses do not permit the assignment
                 of public debt to another party in the course of a liquidation unless “all or substantially all” of the assets of the company
                 at the time of the plan of liquidation are transferred to a single purchaser. Here, the transaction only involved 51% of the
                 book value of UV‟s total assets. In no sense, therefore, are they “all or substantially all” of those assets. The successor
                 obligor clauses are not applicable. UV is in default on the indentures and the debentures are due and payable.
   2. Incurrence of Substantial Additional Debt

       i) Leveraged Buyouts (LBO’s) – In leveraged buyouts, the corporate takes on substantial debt through
          additional bonds to repossess their outstanding shares. This often worries any previously existing bond-
          holders because it reduces the likelihood that their bonds will be repaid to the benefit of shareholders.

           a. Reduced Present Value – Once there is additional debt issued and the chances of repayment are
              reduced, the present value of the previously existing bonds are reduced in value.

               i. Rebuttal: Freedom of Contract – Freedom of contract allows for this risk to be avoided, and
                  the efficient market hypothesis assumes that the bonds were discounted in value because of the
                  potential opportunity that additional debt would be undertaken by the corporation.

               ii. Rebuttal: No Fiduciary Duty – Furthermore, unlike shareholders, the corporation‟s directors do
                   not owe fiduciary duties to any bondholders

                   Metropolitan Life Insurance Co v. RJR Nabisco, Inc. (1989) – Cause of action arose when RJR Nabisco
                   proposed a $17 billion leveraged buy-out of the company‟s shareholders, at $109/share. Plaintiffs (Met Life) allege
                   that RJR‟s actions have drastically impaired the value of bonds previously issued to plaintiffs by, in effect,
                   misappropriating the value of those bonds to help finance the LBO and to distribute an enormous windfall to the
                   company‟s shareholder. As a result, they allege that they have unfairly suffered a multimillion dollar loss in the
                   value of their bonds, and they bring a cause of action under a breach of implied covenant of good faith and fair
                   dealing. They seek redemption of their bonds. Held: There being no express covenant between parties that would
                   restrict eh incurrence of new debt, and no perceived direction to that end from covenants that are express, Court does
                   not imply a covenant to prevent the LBO and thereby create an indenture term that was not bargained for here and
                   was not within the mutual contemplation of the parties.

C. Policy Question: Is it Fair that Bondholders and Shareholders are treated differently? – Because
   ultimately the parties are free to contract specifically out of any risk inherit with the issuance of debt, the law
   does not make too much of a difference. The interpretation of a court is only relevant to that particular
   transaction. Other parties are free to choose different, more specific language to allocate and prevent risk.

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