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Business Law Notes - Agency Partnership
Forms of Business Organization
1. General Partnership
2. Limited Partnership
3. Limited Liability Companies
4. Limited Liability Partnerships
1. Definition: "Agency is a mutually consensus (factual)
fiduciary relationship between 2 legal persons, where (p.
2): a. Manifestation by Principal that A shall act for him
b. A’s acceptance, and understanding that P is to be in
Key terms: -Principal: right to control conduct of A
-Agent: person whom by mutual asset acts on behalf of another
P and subject to his control
-consensus: not necessarily contractual, nor intended, just
-fiduciary relationship: duty of agent to act SOLELY for
benefit for P
-consequences: liability either by
a. Contract side, or
b. Tort side: (see next point)
2. Tort Liability: e.g. Respondent Superior/ Master-Servant
relationship. A servant subjects Master to personal liability
to 3d parties while acting within scope of employment. Req'ts:
b. Conduct of Agent while w/i scope of employment
3. Formation of Agency: Consent is essence of relationship.
There are NO FORMALITIES req'd to form an agency. Agency
can be inferred from conduct of parties, except:
a. Conveyance of Real Property: The "Equal Dignity
Clause" in the Statute of Frauds requires a writing
signed by the Grantor; however, if agent acts on behalf
of Grantor, he requires a separate signed writing.
II. AUTHORITY: 1. Liability of P to 3dp:
P is liable: A principal will be liable under an agency
contract made for the benefit of P if:
a. Agency relationship
b. Agent acts within scope of employment (had actual/apparent
authority, was an agent by estoppel, had inherent authority,
or P ratified the act))
P is not liable: A principal is not liable under agency
a. Agent acts without authority, or
b. Agent acts in excess of authority given.
***Exception to No Authority/No liability rule: i) Inherent
A. ACTUAL AUTHORITY: -(FROM AGENT’S PERSPECTIVE: an agent
has actual authority to act na given way on P’s behalf if
P’s words or conduct would lead a reasonable person in A’s
position to believe that P had authorized him to so act)
-implies Principal created authority unilaterally through
words or conduct
-requires communication from P to A that authority's been
2. Implied Authority: inferred from words or conduct, custom
i) Acquiescence: if P knowingly fails to object to authority
ii) Incidental: authority to do acts that are reasonably
necessary to accomplish the authorized transaction, or usually
iii) Custom and Usage: e.g. ship's captain, or authority
to sell Real Property
B. APPARENT AUTHORITY: (FROM 3dp’s PERSPECTIVE: an A has
apparent authority to act in a given way on a P’s behalf
to a 3dp if the words or conduct of the P would lead a reasonable
person in 3dp’s position to believe that ht eP had authorized
A to so act)
-the agent is authorized to act as an agent (acts within
the scope of his employment)
-the agent professes to act as an agent
-the 3d party reasonably believes that the agent was given
-P is liable if no actual authority, but there's apparent
-e.g. P is liable on actual and apparent authority: I write
a letter to Agent to sell my car. I sent a copy of the letter
to 3d party. Yes there's actual and apparent authority.
-e.g. P is liable based on apparent authority: same case,
in P's letter to agent, he writes, "don't sell my car
until you talk to me." Here, no actual authority, but
there is apparent authority vis-à-vis 3d party.
3. AUTHORITY BY ESTOPPEL: FROM P.O.V. of 3dp--”RELIANCE”
(A person who is not otherwise liable as a party to a transaction
purported to be done on his behalf, is liable to persons
who have changed their position b/c of their belief that
the transaction was entered into on his behalf, if: a. he
intentionally or carelessly caused such belief, or b. knowing
such belief he did not try to notify 3dp)
-P negligently or intentionally caused or allowed 3d party
to reasonably believe that the agent had authority and
- 3d party reasonably relies on this to her detriment and
changes her position.
-P knowingly did not take reasonable steps to notify 3dp
-"Lock case:" 3d P is a traveling salesman who
goes into hotel where he hands over jewelry for bailment
to front desk person who purports to be manager of hotel.
P is given receipt and keys to room. Next morning, jewelry
is missing. The real manager denies that the person from
last night was the actual manager, and because of this,
denies liability. Hotel held liable.
-"Hallick v. N.Y.S.:" 2 landowners had their land
condemned by State. They claimed that state lacked authority
to do so. Almost all parties appeared in pre-trial conference;
however, law states that attorneys appearing in a pre-trial
conference must have authority to settle. BOth attorneys
and only one of the l/o's showed up. Settlement was reached.
It was held that the second l/o gave his attorney authority
by estoppel to settle.
4. EMERGENCY AUTHORITY: a. Must be existing P-A relationship
b. Unforeseen emergency
c. Emergency relates to duty with which agent is charged
d. Impractical for agent to get in touch with P
EXCEPTIONS TO NO LIABILITY IF NO ACTUAL or APPARENT AUTHORITY:
5. INHERENT AUTHORITY (p. 13): (the authority to take an
action that a person in the P’s position reasonably should
have foreseen A would be likely to take, even though action
Test for INHERENT AUTHORITY: P.O.V. of Principal: Would
a reasonable person in the P’s position have foreseen that
despite his instructions, there was a significant likelihood
that the agent would act as he did?
-Policy and Source of Liability: derived solely from AGENCY
relationship, and exists for PROTECTION of 3dp who may be
harmed by Agent, e.g. Vicarious liability/ Respondeat Superior
-Policies: P can better spread the risk of losses, prop
allocation of resources is promoted, P is in better position
to control A, A may reasonably believe it’s in P’s best
interest to violate instruction, inequitable to allow P
to benefit w/o compensating innocent injured 3dp, FORESEEABLE
to P that A may violate his duty
3 types of Inherent Authority:
i) Respondeat Superior
ii)Authority given to make representation
iii) General Agency Doctrine:
1. General Agent: if authorized to conduct series of transactions
2. Specific Agent: authorized to conduct one shot deal
e.g. Logales Service Center case: 2 biz men in AZ wants
to open gas station. Persuaded Arco Inc. to lend them money.
2 biz men met with an Arco rep. who purported to be marketing
manager. The manager agreed to lend 2 biz men more money
and further agreed to discount the price of fuel Arco sold
to them. Subsequently, Arco didn't honour agreement because
they claimed that marketing manager didn't have authority
to make such a deal. Court held that Arco granted Inherent
power to manager, thus held liable.
6. RATIFICATION: if no actual or apparent authority, P is
bound if he ratifies transaction by "manifesting affirmance
by P of a prior act which as not authorized, purportedly
done on his behalf by an agent with authority."
-Key points: 1. "Purportedly done by Agent with authority"
2. Manifestation must be objective, needn't be in words
3. P must have full knowledge of facts
4. Ratification of ALL of agent's conduct
-Consequences of Ratification: 1. P becomes bound on K
b/c of ratification
2. A is no longer liable on K
3 TYPES OF PRINCIPALS:
1. DISCLOSED: "3d party knows that agent is acting
on behalf of a P at time of transaction, and 3d party knows
identity of P"
2. UNDISCLOSED: "3d party is ignorant, thinks agent
is the principal"
3. PARTIALLY DISCLOSED: "3d party has notice/knowledge
that agent is acting solely for a P, but doesn't know identity
2 TYPES OF AGENTS:
1. General Agent: authorized to conduct a series of transactions
involving continuity of service
2. Special Agent: authorized to conduct single transaction
**These distinctions are important because of potential
liability of agents
Case 1: 3d Party v. Principal All 3 types of Principals
liable on agency contract: if A acts on P’s behalf with
actual or apparent authority, or agent by estoppel, or had
inherent authority, or ratified the transaction.
Case 2: Principal v. 3d Party: -General Rule: if A and 3dp
enter into a K under which P is liable, then 3dp is liable
-EXCEPTION; when P is UNDISCLOSED or PARTIALLY DISCLOSED
and FRAUDULENT CONCEALMENT and A and P knew that 3dp would
not have dealt with them had P been disclosed
-e.g.: P intentionally tells agent to conceal his identity
in buying 3d P's car in order to get a better deal since
3d P hates P.
Case 3 and Case 4: 3d Party v. Agent, and Agent v. 3d Party
-Disclosed Principal: Agent is not liable to 3d P, only
And 3d party not liable to Agent if disclosed P.
-Undisclosed P: Agent is personally liable to 3d P; A can
enforce K against 3d P
-Partially Disclosed: Agent is personally liable even though
P is bound, but there's a "REBUTTABLE presumption"
that if A is sued personally, if he can bear the burden
that he wasn't intended to be liable, then he won't be held
-And, 3d P is liable to Agent,
Case 5: Agent v. Principal, Principal v. Agent: If Principal
is bound b/c Agent acts w/o actual authority, but has apparent
authority, then Agent is also bound to P
And, Principal is bound to Agent if Agent acts under actual
August 26, 1999
2 Main concepts: 1. AUTHORITY
2. DUTIES OWED BY AGENT TO HIS PRINCIPAL
DUTIES OWED BY AGENT:
a. DUTIES OF SERVICE: e.g. duty to use due care, obey, remain
w/i authority given.
b. 1. General Rule Competition During Employment: DUTY OF
LOYALTY/ FIDUCIARY DUTY/ DUTY NOT TO COMPETE, to act solely
to advance interests of P, not to create conflict of interests.
Can't solicit P's customers, nor compete, unless consensus,
e.g. DUTY NOT TO COMPETE by opening own biz, or enter dual
agency by representing someone else. Scenarios: solicitation
-In New York, the DUANE-JONES Rule: while Principal Agency
relationship, A can't solicit P's customers. But, acts done
to "PREPARE" to compete, not solicitation are
-e.g. Growbert v. Mowens: NY Ct of App. held that lawyers
in lawfirm violated non-compete duty while employed as agents
of firm b/c they actively solicited firm's clients
b 2. General Rule Competition After Employment: Once a
Principal-Agent relationship has terminated, the former
A is free to compete, if:
a. Doesn't violate Non-Compete K
b. In the process of competing, former A doesn't use former
P's trade secrets, include. Customer lists
b 3. General Rule Contract Not to Compete After Employment:
e.g., Agent signs K with P with clause that restricts A
from competing w/i U.S.A. for 25 years after employment
ends. A court will enforce this K, only to the extent that:
a. K must be reasonable in duration and geographical scope
b. K must either be necessary to protect trade secrets,
or services are unique, special, or extraordinary
-State law defines what is “trade secret” (something that
gives former A competitive advantage
-e.g. can lawyer solicit his former customers? Yes, doesn’t
constitute using former P’s customer list.
b 4. General Rule: Principal’s Consent for A to Compete:
Yes, P is allowed to compete, so long as there is FULL DISCLOSURE.
Duty varies depending on whether:
a. A acts as the new 3d Party. If so, A has duty to fully
b. Whether A acts as dual agency. If so, disclosure obligation
is to disclose all materials, facts that may affect P’s
decision in permitting dual agency.
e.g. Sovern owns diamond and thinks it’s worth $1,000.
He hires Mopp, an expert gemologist, who thinks the diamond
is worth $100,000. Mischievously, Mopp asks Sovern to buy
the diamond for $1,500. Sovern consents, but consent is
not valid b/c Mopp didn’t disclose true worth of diamond.
e.g. Same case, Diamond worth $1,000. Mopp asks Sovern whether
Mopp can represent Harry too, who wants to buy the diamond.
S consents, but he doesn’t know that Mopp and Harry have
had a long-standing relationship where Mopp gets commission
for his finds. Sovern’s consent is not valid b/c failure
to disclose all material facts that may affect Sovern’s
decision to permit dual agency.
p. 19, Tarnaowski v. Resop: Resop acted as agent to Tarnowski
(principal) to investigate a business he wanted to buy.
Resop didn’t disclose all the facts, and made gross misrepresentations
to Tarnowski about the profits have made in the past. Tarnowski
already signed a K with 3d party. Tarnowski sought to rescind
the K with 3d P in his first action. Court rescinded K.
In this subsequent action, Tarnowski recovered commission
Agent got from the sale as well as costs of bringing first
Held: If Agent is involved in conflict of interest, and
doesn’t get proper consent based on full disclosure to principal,
principal is entitled to:
a. rescind the transaction, and recover from culpable 3d
parties, or agent
b. P can recover from A return of any payments, lost profits,
agent’s benefits from 3d party, full indemnification from
A any expenses principal incurred
-see Northeast Central v. Norlington (NY Ct of App.)
II. GENERAL PARTNERSHIP
History: British Partnership Act of 1890 inspired USA to
draft their 1914 UNIFORM PARTNERSHIP ACT (UPA). Good law
in 46 states, including N.Y. There is a revised UPA, (RUPA)
with 4 versions, promulgated in 1990’s, latest in 1997.
RUPA is very controversial, so most states don’t use it.
1916 UNIFORM LIMITED PARTNERSHIPS ACT became law in 1949.
There’s been Revised ULPA’s, and most states are governed
by 1976 RULPA.
-Entity v. Aggregate Theory (p. 40): Old school and UPA
states that a partnership not recognized as legal person,
but rather an aggregate . NOW, RUPA says that partnership
is recognized as independent legal person and can be sued
like one entity.
-Joint Venture v. Partnership: Joint Venture: one-shot deal/isolated
transaction. Partnership: on-going relationship. If Joint
venture, it’s governed by general partnership law anyway.
-At common law, a corporation can’t be a partner in a partnership
(today, not true). So, corporations got around this by calling
the so-called partnership a “Joint Venture.” Today, a court
will call the partnership a joint venture, but will apply
General Partnership law, EXCEPT:
-issue of Authority: the extent of a joint venture to bind
the joint venture. A joint venture has less power to enter
PARTNERSHIP: NO formalities nor filings req’d. This reflects
that concept that partnerships status depends on the factual
characteristics of a legal relationship between two or more
persons, not on whether the persons think they have a partnership.
UPA Sec. 6(a): a partnership is an association of 2 or more
persons to carry on as co-owners a business for profit.
P. 46: Unless partnership agreement states otherwise, matter
affecting ordinary business can be decided by majority vote.
Extraordinary matters decided by unanimous vote; all partners
have equal power to management
1. An association: whether parties “intend” to form an association
2. 2 or more persons: person + persons; or person + corporation
3. Carry-on a business: not one shot deal, but rather continuity
4. For profit
5. as Co-owners of the firm: a. Joint-control
-ISSUE: Under what circumstances is a Court going to call
it a partnership, and apply general partnership law when
SCENARIOS: Case 1: What happens when business does very
well and everyone wants to be a partner and reap the profits?
Case 2: What happens when business fails and creditors want
to get damages, owner claims others were partners too and
must share the losses?
-e.g. B is a millionaire widow and J falls in love with
her. B paid for J’s expenses to buy some foreign art to
be sold in N.Y. B didn’t know that J was already married
with kids. Relationship deteriorated. J sued B to claim
that he had a partnership with B, thus enabling him to reap
the profits of the art sale. Judge Sweet held in favor of
-Justice Douglas in a Yale Law Journal article describes
elements of “Joint-Control:”
1. Control- to set prices or reduce costs, affirmative exercise
of control, more than veto power
2. Equity of ownership
3. Did P participate in profits
4. Did P participate in losses
-if 3 out of 4 of these elements met, then constitutes a
partnership, impose liability
-Martin v. Peyton, p. 31
Hall was partner of KN&K, and represented them in negotiating
a loan with Peyton, etc. Peyton agreed to transfer liquid
securities as a loan. The loan consisted of an agreement,
indenture, and an option to become partners. Petyon etc.
agreed that the loan itself would not constitute a partnership,
and that any profits they reaped would be purely for the
purpose of repaying the loan. Peyton, etc. got veto power,
and was kept up to date in the biz dealings. Hall later
claims that Peyton etc. became partners and should thus
share in lost profits.
-Issue: whether Petyon, etc. became partners with KN&K
in an on-going business so to share the losses they incurred?
-R.D.: a. A lot of control given to Peyton, etc. but doesn’t
necessarily mean a partnership, even if there’s veto power.
b. Court completely ignores “OPTION” or “profit-sharing”
as an issue in this case.
c. Even though UPA was in effect at the time, Court doesn’t
allude to it, which says that if there’s profit-sharing,
then there’s a REBUTTABLE presumption that there’s a partnership.
d. Where there’s a grey area, Court will honour intent of
parties as requested in their documents.
UPA Sec. 7(4) states that if there’s profit-sharing, then
there’s a REBUTTABLE presumption of a partnership
Issue: What about Loss-Sharing? Is it an indispensable element
to finding a partnership?
R.D.: UPA is silent about loss-sharing, suggesting that
loss-sharing is not pertinent.
-e.g., Steinbeck v. Jerosa (NY Ct. of App.): dispute whether
P was liable for NY income tax on gross receipts. P said
there’s an exception to tax rule that if there’s a partnership
in interstate commerce, then no tax. P claimed that he had
a partnership with his publisher located in a different
-Held: No partnership b/c there’s an indispensable element
to partnership to share profits and share losses, and if
there’s no agreement to do this, then no partnership.
**Incorrect Holding! b/c:
1. UPA is silent about loss-sharing, and
2. Ct ignores importance of UPA Sec. 18A: “Partners don’t
have to share losses (in order to qualify as partners.)”
3. Logical fallacy: ‘Denying the Antecedent:” e.g. all Dalmatians
are dogs IS NOT THE SAME AS all non-Dalmatians are not dogs.
Court essentially thinks that all non-loss sharing is the
same as “Non-partnership”
4. Court blurs 2 ideas: Loss-sharing (percentage each partners
is obligated to pay) as agreed among partners themselves,
vs. loss-sharing in terms of merely being liable to 3d parties.
WHAT IS A PARTNERSHIP FROM PERSPECTIVE OF UPA Sec. 7?
1. If there’s profit-sharing, then there’s a presumption
of a Partnership
2. But, there are a series of “NON-PRESUMPTIONS” of no partnership,
if: “there’s profit-sharing, and it’s closely tied to a
special objective, then draw no inference in favour/or against
the existence of a partnership.
E.g. of “Instances when not to infer a partnership”
A. PROFIT-SHARING IN CONNECTION WITH REPAYMENT OF DEBT
e.g. House of Ward case: debtor ran business and owed money
to creditors. Committee of Creditors ran his business with
his consent until debt was repaid. NO PARTNERSHIP b/w debtor
e.g. Lupien v. Malsbedenden: buyer of Bradley car wanted
to buy car from Cragan, Malsbenden being the lender to cragan
to build such car. Malsbenden, however, exercised control
over day to day business. Subsequently, Cragan disappeared.
So, P sues Malsbenden, but Malsbenden claims no partnership.
Issue: Whether Malsbenden is partners with Cragan so to
be liable to Lupien?
Held: Yes (but this is an unusual holding, b/c: a. No provision
in K for interest, b. loan not made in lump sum, c. No fixed
rate repayment schedule.
R.D.: Malsbenden is partner b/c he exerted extensive control
on an on-going basis by himself; he also had financial interest
B. PROFIT-SHARING LIMITED TO COMPENSATION GIVEN
C. PROFIT-SHARING LIMITED TO PAYMENT OF RENT
e.g. Tenant has lease in shopping center. Landlord put provision
in lease that he’d acquire X% of tenant’s profits annually.
D. PROFIT-SHARING LIMITED TO PAYMENT OF ANNUITIES TO SURVING
E. PROFIT-SHARING LIMITED TO REPAYMENT INTEREST ON DEBT,
OR SUBSTITUTES AS REPAYING INTEREST ON DEBT
e.g. Martin v. Peyton
F. PROFIT-SHARING LIMITED TO PAYMENT FOR GOODWILL OF A BUSINESS
e.g. an “Earn-out” provision in a K that states that “Seller
will sell buyer his business at low price only if buyer
agrees to give him X% profits annually.
PROPERTY and PARTNERSHIP
3 Distinct Concepts:
1. PARTNERSHIP’S PROPERTY: an entity called a partnership
can own property that is separate from partner’s property.
This goes back to aggregate v. entity theory.
2. PARTNER’S PROPERTY: Tangible things; e.g. partner’s
table in a lemonade stand business
3. PARTNER’S PARTNERSHIP INTEREST: partner’s equity share
in the partnership
I. PARTNERSHIP’S PROPERTY v. PARTNER’S PROPERTY--how to
make distinction of whether asset creditor wishes to attach
in a lawsuit is the partnership’s or the partner’s:
A. Look at INTENT of partners w/ respect to asset in question
by looking at Agreement.
-usually expressly stated in K, e.g. “I will make contribution
of $X as the capital contribution to the firm.”
If not expressly stated:
B. Look for INDICIA:
1. Use, Occupancy, or Possession of Land: e.g. I own a piece
of RP and all of a sudden the firm starts manufacturing
on my property, but legal title still remains in me. Courts
are split: Most courts hold that title still is in the partner.
2. RP bought with Partnership’s Money: Title in partnership
3. Record Title in Partnership’s Name: is evidence of intent,
thus partnership’s property
4. Books of Account: i.e. firm’s record of purchases
5. Miscellaneous Factors: “Who paid taxes, mortgages, insurance,
C. REAL PROPERTY: Now that a partnership can own property
in firm’s name, set forth in UPA Sec. 8(3) and (4).
II. PARTNERSHIP ‘S PROPERTY v. PARTNER’S PARTNERSHIP INTEREST:
What are partner’s right to partnership property as defined
by UPA Sec. 24?
A. SPECIFIC PARTNERSHIP PROPERTY: Sec. 24 is illusive in
defining partner’s specific partnership property. Moreover,
Sec. 25 takes away normal attributes of partner’s property
B. PARTNER’S RIGHT TO PARTICIPATE IN MANAGEMENT: (UPA Sec.
18(e)): absent express provision to the contrary, each partner
has one vote.
C. PARTNER’S PARTNERSHIP INTEREST: (UPA Secs. 24-27): it
is a property right which is not tangible, and is classified
as personal property/equity share. UPA Sec. 26 is a ‘Partner’s
Share” in profits and surplus (equity share in interest,
or right to get X% interest). “Surplus” is defined as what’s
left after partnership discharges all liability.
III. WHO’S ENTITLED TO POSSESS A PARTNERSHIP INTEREST/Equity
A. Look at POSSESSION: UPA Sec. 25: Each partner has equal
right to possess other’s right to use firm’s assets to promote
B. ASSIGNABILITY: UPA Sec. 25: A partners has no right to
transfer his own share for own interest; he can only assign
firm’s interest, i.e. assign rights of all partners in same
Sec. 27: A partner’s right to assign his partnership interest
is FREELY ASSIGNABLE, absent provision to the contrary.
However, UPA puts so many restrictions on ASSIGNABILITY
that it’s nearly impossible to do so.
1. DELECTUS PERSONI: UPA Sec. 18(g) “choice of person;”
an AE can’t become partner w/o the consent of ALL other
partners. Thus, a mere AE gets very few rights.
-Prohibition of Assignment is possible if expressly provided
e.g. Rappoport v. 55 Perry Co: 2 families were in a 50/50
partnership to manage property. K said, “no partner shall
have right to assign unless majority of partners agree.
This provision, however, was subject to an exception: doesn’t
apply to assignment to immediate family.” One of the families
assigned to their child and cited the exception. Court Held:
Delectus Personi: need consent of other partners.
UPA Sec. 27:
2. AE doesn’t get usual rights that partner gets to INSPECT
BOOKS and RECORDS:
3. AE doesn’t get right to ACCOUNTING OF FIRM’S FINANCIAL
STATUS: Mere AE only gets this right in the wake of a dissolution
4. Other partners have RIGHT TO DISSOLVE FIRM IF UNANIMOUS
5. AE has no right to GO TO MEETINGS
WHAT RIGHTS DOES AE GET?
1. AR’s rights to profits
2. AR’s rights to surplus
3. Some limited rights to force dissolution:
a. If a partnership for a term or to accomplish a specific
objective is over, then AE can enforce a dissolution
b. If partnership-at-will, then AE can force dissolution
DO WE REALLY MEAN IT WHEN COURTS WILL LITERALLY ENFORCE
PRINCIPLE OF DELECTUS PERSONI?
-Yes. Courts will literally enforce this principle w/o inquiry
into evidence to the contrary, even if egregious case. However,
Delectus Personi is counter-intuitive b/c partnership concept
is very old form of business organization, and so deeply
C. CREDITOR’S RIGHTS TO PARTNER’S PARTNERSHIP INTEREST:
UPA Sec. 25(c): Creditors of individual partners can’t
go after firm’s assets/specific partnership property. But
if firm sued as a whole, then specific partnership property
is subject to attachment.
Creditor’s rights to Partnership Interest: Creditor has
right to go after partner’s partnership interest but he’ll
be given status of mere AE (insubstantial rights).
-UPA Sec. 28: Creditor has rights like an individual partner
once he has a judgment, and he’ll then apply to the Court
to get a charging order (LIEN) to apply over intangible
(New York doesn’t require judgment.)
-”CHARGING ORDER” Not much case law. Very few rights in
1. A ct can appoint a receiver to sit as a mere AE, but
lacks many rights. He’ll just collect profits and surplus
2. Once order is granted, all non-charged partners can dissolve
3. In addition to Court appointing receiver, it can order
a foreclosure sale of partnership interest. But even if
creditor bids, they can only get rights of an AE.
Rights & Duties owed by Partners w/i Firm
1. SHARING PROFITS/LOSSES: each partner has unlimited personal
liability. If K is silent, profits shared equally. (UPA
Sec. 18(a), 40(d)).
2. CAPITAL CONTRIBUTIONS: identified by intent of partners
in an operating K, if one exists (e.g. intent of partner
when he contributed a table to the lemonade business) (UPA
Sec. 18: don’t receive interest for capital contribution).
3. RIGHT TO INDEMNIFICATION and CONTRIBUTION: (Sec. 18(b),
40(b), (d), (f)
-Individual partner is entitled to be indemnified by firm
for any obligations he undertakes on behalf of the firm
(e.g. business expenses, plane tickets, meals). Indemnification
is a “partnership’s liability”, where the “partner” has
a right to be indemnified.
-When firm doesn’t have the assets to indemnify partner,
then each partner must make additional contributions. Contribution
is the “partner’s liability” where the partnership is a
right to require contribution for lack of assets to pay
off firm’s liability. (p. 54).
4. RIGHT TO PARTICIPATE IN MANAGEMENT: (Sec. 18(e), (h):
each partner has one vote. Vote of affirmative majority
of partners is required.
-See Summers v. Dooley, p. 43
2. Judicial: A court can label a particular decision as
extraordinary and some courts can require unanimity instead
of majority, e.g. on decision to incorporate, or sell real
property. (UPA Sec. 9(3)).
5. COMPENSATION: (UPA Sec. 18(f)): Absent an agreement,
a partner is not entitle to compensation for reasonable
value of his services, b/c of the profit-sharing nature
of a partnership
6. DUTY TO RENDER SERVICES: not found in UPA, only in case
7. DUTY TO KEEP ACCURATE BOOKS & RECORDS: of accounts
and transactions. Partner has absolute right to inspect
8. DUTY TO RENDER FULL INFO TO OTHER PARTNERS w/ respect
to DEALS ENTERED INTO BY ACTING PARTNER
9. DUTY TO ACCOUNT: how much did partner spend in re K he
entered into on behalf of firm for all assets partner handles
10. DUTY OF LOYALTY TO EACH PARTNER: (UPA Sec. 21) derived
from Agency law on Fiduciary duties
-E.g. a. Claim that partner misappropriated partnership
assets for himself
b. claim that partner misappropriated a business opportunity
for himself instead of for best interest of firm
c. Claim that partner is competing with firm
-Meinhard v. Salmon, p. 72: J. Cardozo, 4-3 decision: P
and D entered into a joint-venture to lease Hotel Bristol
and renovate it. Meinhard helped finance the deal, and Salmon
was made the managing partner. Gerry, owner of the hotel
and surrounding land agreed to lease the hotel to P and
D for 20 years. When 20 yrs was up, Gerry offered to lease
the hotel again for a really good price so long as P and
D agreed to erect a building beside the hotel; the land
value around the hotel/mid town N.Y. was skyrocketing.
-Salmon didn’t inform Meinhard of the deal and justified
not doing so by stating that the duration of the join-venture
had expired. Meinhard sued claiming that Salmon breached
his fiduciary duty.
-Held: Salmon breached his fiduciary duty in a joint-venture
in which general partnership law is applied.
Key points: 1. Court takes it as given that this is a joint-venture
because there was a lack of join control, and thus partnership
law is applied.
2. A lot of Cardozo’s rationale is based on theme that salmon
had special obligation being managing partner. Today, no
one really believes that the Court’s decision turned on
“CONTROL” position of salmon. But rather, it turned on breach
of fiduciary duty.
3. Dissent: Many people believe Dissent’s argument is more
sound b/c if the deal involved a mere extension of the hotel,
and Salmon still behaved as he did, then it’d then constitute
a breach of fiduciary duty.
4. Cardozo says Salmon has duty to disclose the proposed
deal. This duty to disclose entails more than a mere phone
call. It means advising and giving opportunity to partake
1. Can a Fiduciary Duty be waived?
2. RUPA and why it is not liked
1. Can Partners add a provision to their partnership K that
each partner waives their fiduciary duty tot he firm?
-New School of thought (“Contractarians”): Economic and
policy argument that partners should be able to do what
they want; get rid of traditional paternalistic view that
fears abuse and believes in fundamental duties.
-Traditionalists: Fiduciary duty never waivable
-reality: cases don’t support either extreme view. Fair
reading of cases show that courts will enforce and recognize
limited waives if FULL DISCLOSURE and DETAILED DESCRIPTION.
-e.g. A goes into partnership with a very successful corporation.
The corporation may request a provision in the agreement
that allows them to enter into a similar K with other businesses.
Court will probably enforce this waiver.
2. RUPA Sec. 404, 103: Original UPA calls for standard of
duty of care as “ORDINARY.” Drafts of new UPA proposes incomprehensible
standard of care. RUPA Sec. 404 says “duty to avoid gross
negligence” (lower standard of care than UPA), and language
that this is not waivable. But Sec. 103 says duty is waivable
if reasonable. Original UPA standard of “good faith and
faire dealing” is also watered down by RUPA. RUPA is victory
Anti-RUPA view: Price of revision is not worth it b/c it’s
incoherent. It’s a bad idea right now, insidious, premature
b/c it turns core value of American partnership law. These
opt-outs are new to contract law and are found only in corporate
law. Should wait for it to play out. General partnerships
are very different from corporate law b/c partners are much
more vulnerable because unlimited personal liability, other
partners can expose him to unlimited liability, and people
are labeled partners w/o realizing it.
Relations b/w Firm and Third Parties
I. ISSUES OF AUTHORITY THAT BIND THE FIRM
A. A Partner is both PRINCIPAL and AGENT when dealing with
3d party, unless expressly provided. (Sec. 18).
B. Every partner is an AGENT of firm under APPARENT AUTHORITY.
Sec. (9)(2): If a partner lacks actual authority and is
not working within the scope of his duty (apparent authority)
then the firm is not bound (unless authority by estoppel,
emergency authority, etc…)
C. UPA Sec. 9: APPARENT AUTHORITY:
Sec. 9(1): Examples of Apparent authority when 3d party
v. partner: signing legal instruments related to normal
course of business, borrowing money for firm, hiring Ees
and agreeing to compensation.
Sec. 10: Conveyance of Real Property of Partnership by Person
w/o Actual Authority:
(incomprehensible rules): 1. Partnership can own and sell
2. Partnership can be bound by partner conveying RP, by
preservation in record title.
e.g.: Acting partner sell w/o authority RP of the firm which
has record title to a 3d party. Is firm bound? Analyze problem
in two ways:
1. IF RECORD TITLE IS INTACT THEN FIRM IS BOUND: 3d P honestly
thinks partner is conveying RP as RP of the firm with authority.
If 3d P buys the RP, he is bonafied b/c he wasn’t on notice
of the lack of actual authority since the record title was
apparently good. Firm is bound b/c the chain of record title
is not broken, and partner acts with apparent authority,
w/i scope of duty.
2. IF RECORD TITLE IS BROKEN THEN FIRM IS NOT BOUND: 3d
P will get equitable title, but not good record title b/c
deed is not in name of firm, thus buyer should be on notice
of bad title. In this situation, Equitable title is when
3d P has good title vis a vis Firm. Legal title is if Firm
conveys to another 3d P.
UPA Sec. 9(2): Acts not w/i apparent authority of partner
and thus, FIRM NOT BOUND.
e.g.: K for suretyship: e.g.: Partner and girlfriend go
to buy a condo. The bank requires more proof of credit.
Partner shows credit of partnership. NO APPARENT AUTHORITY
b/c not w/i scope of his employment.
e.g. Subscribing share of stock
e.g. charitable undertakings
UPA Sec. 9(3): List of acts beyond partner’s authority,
REQUIRING UNANIMITY OF PARTNERS:
UPA Sec. 9(4): Acts forbidden by partnership K won’t bind
the firm if 3d P has knowledge of the lack of authority/restriction.
D. TORT LIABILITY: UPA Secs. 13, 14, 15
General Rule: In connection w/ tort liability committed
by partner, firm is thus bound and individual partners are
jointly and severally liable in which case a partner was
acting in actual or apparent authority.
e.g. Fraud/Misappropriation of Funds
Rows v. Collier: wealthy widow walked into law firm and
wanted to invest all the money she inherited. One of the
lawyers gave her a receipt for the money, and ran off with
it. Widow sued. Firm defended by saying that the lawyer
acted beyond the scope of his duty, and thus had no apparent
authority. Court Held: in favor of FIRM.
Croissand v. Ward, p. 2: Accounting Firm: one partner misappropriated
funds of client. Client sued. Firm defended that they’re
no in the business of investing funds. Court Held: in favour
of firm, but said that apparent authority should be defined
by perspective of what a reasonable person thinks partner
is authorized to do.
E. PARTNER BY ESTOPPEL, Sec. 16
Requirements: 1. Actual Reliance
e.g.: If X represents that he is partner in Firm A, or allows
the firm to represent that he is a partner in Firm A, or
if X represents to Y that Smith is a partner with him, then
X will be liable as a partner in Firm A, and he will also
be liable for any K smith enters into. X will be estopped
from denying his partnership.
e.g. Royal Bank v. Weintraub, Gold, Albert
Law firm agreed among themselves that they’d dissolve, but
they kept the lease, phone listing in firm’s name, stationery
with firm name. Former Partner A had a client who wanted
to borrow money from bank., but bank required more credit
history/assurance. So, Former Partner A wrote a letter saying
that “the Firm” would take the money the bank loans and
put it in escrow for the client. Money was attained, and
client disappeared with it. Bank sues. Court held for Bank
b/c Partner was a partner by estoppel.
2. Can a 3d Party sue a Partner?
UPA Sec. 15: a. If Tort liability, then Partners are liable
Joint and Severally
b. If Contract Liability, then Partners are liable Jointly.
If liability is joint, then all obligors must be sued jointly.
-Under Common Law, each partner can require partners to
join all partners, and if plaintiff can’t do so, then too
bad (find, serve, get jurisdiction).
- Almost all states have softened Joint liability Rule.
New York CPLR 1501, 1502 sets forth that if firm is insolvent,
then a creditor can go after any partner whom is served
-If liability is Several, then each obligor is liable.
III. DISSOLUTION: UPA Secs. 29-40
“Dissolution:” refers only to the fact of a partner ceasing
to be associated with the business, not ending the firm.
“Winding up:” is the same as liquidation; process dissolution
of settling partnership affairs, liquidation, distributing
shares to partners.
“Termination:” point of end of liquidation; when all affairs
finished; firm ends
“Continuation:” partners elect to go on
1. Causes of Dissolution
2. Effects of Authority
3. Effects on Liability
1. TRIGGERING EVENTS-Causes of Dissolution:
a. Non-Judicial: dissolution w/o judicial intervention
b. Judicial: judicial declaration of dissolution required
A. NON-JUDICIAL DISSOLUTION:
A1. Dissolution not in Violation of Agreement:
i) End of duration of agreement specified, or accomplishment
of objective in agreement.
ii) Dissolution at the express will of any partner when
there’s a partnership-at-will:
-Can a partnership be held liable for dissolution of firm
at will in bad faith?
-Yes. Court won’t inquire into bad faith b/c of literal
application of DELECTUS PERSONI principle. Justification:
partner is so vulnerable to unlimited liability.
-Page v. Page, p 83: 2 partners entered into linen-supply
business 50/50 as partners-at-will, but it failed. Partner
B owned a separate supply company that supplied and lended
money to the business. All of a sudden, an air force base
was constructed nearby, demanding supplies of linen. But,
partner B wanted to now get rid of A. Partner B wanted to
dissolve, liquidate, and sell shares. B would be the only
one buying shares. A sued, claiming bad faith, and that
this partnership wasn’t really one at will, claiming that
the partnership was run with the agreement that they’d do
so until debts were paid off. Court Held: NO partnership
for implied term, but there’s a fiduciary duty of good faith,
and part of it includes that a partner shouldn’t be allowed
to appropriate partnership for himself when prosperity in
iii) Dissolution at the Express Will of all partners who
have not assigned interests to a mere AE, or have ....charging
iv) Dissolution b/c of expulsion of a partner, if expulsion
is pursuant to agreement:
e.g. in drafting a clause to rid to get rid of true non-cooperative
party w/o having to provide rationale.
A2. DISSOLUTION IN CONTRAVENTION OF AGREEMENT, UPA Sec.
A dissolution in violation of the K is in fact a dissolution.
Very controversial, and only permitted in America. Similar
to application of Delectus Personi principle. Justification
for applying this: partner is vulnerable.
A3. DISSOLUTION FOR SUBSEQUENT ILLEGALITY
A4. DISSOLUTION FOR DEATH OF PARTNER
A5. DISSOLUTION FOR BANKRUPTCY OF EITHER FIRM, or PARTNER
B. JUDICIAL DISSOLUTION:
(most judicial dissolution’s are litigable)
B2. Incapability of partner to carry on duties, e.g. sickness
B3. Misconduct of partner--must materially interfere w/
B4. Willful or persistent (material) breach of partnership
e.g. Potter v. Brown: accounting partnership. Senior partner
was going to die, so he wanted to transfer his share to
his protege. Other partners objected. Senior partner then
withdrew his request, but other partners already initiated
lawsuit and wanted to dissolve. Court held that it was an
immaterial breach, so no dissolution.
B5. Partners forced to operate at a loss
B6. Other Circumstances where Judge feels that Dissolution
2. AUTHORITY OF PARTNERS--Consequences:
(consequences on the normal operation...like, what happens
the day after dissolution?)
See Sec. 33-35:
I) Need to wind up/liquidate partnership--actual authority:
-UPA says that except acts done to wind up, all actual authority
to enter into new business ceases at moment of dissolution
-as to winding up acts, authority is placed equally in every
-WINDING UP includes finishing prior K, paying off debts,
collecting, paying off 3d party creditors, selling firm’s
assets, entering into new K to pay off debts....and then
taking what’s left and DISTRIBUTING AMONGST PARTNERS
ii) Need to protect innocent 3d Parties:--apparent authority
e.g., those who’ve extended credit to the firm and who were
not on notice of the dissolution
GENERAL RULE: unauthorized post-dissolution acts of a partner
will bind the firm, thus all partners are personally liable
if those acts would be in what would’ve been within the
partner’s apparent authority prior to dissolution, unless:
a. If cause of dissolution is ILLEGALITY, then partners
not personally bound b/c 3d p should’ve been on notice
b. If cause of dissolution is BANKRUPTCY of partner or firm
b/c this is public knowledge and 3d p would be on notice
c. If firm gives APPROPRIATE NOTICE: (“appropriate notice”
the UPA distinguishes between regular 3dp and those 3dp
who’ve extended credit. If it’s the latter, then they are
entitled to ACTUAL NOTICE (special treatment); but if the
former, then they’re entitled to CONSTRUCTIVE NOTICE, e.g.,
newspaper, general circulation of where firm conducts business
iii) Need to protect partners from improper acts entered
into after dissolution by partner on notice: e.g., partner
loses contribution rights
-protect partners by limiting contribution of innocent partners,
e.g., if a bad partner enters into a bad K, all partners
are bound. But among the partners, bad partner should be
primarily liable and relieve other partners of regular requirement
-e.g. if the firm dissolves, partner commits act w/i his
winding up authority, such act is authorized.
-e.g. if the firm dissolves, bad partner commits acts not
w/i his winding up authority, such act isn’t authorized.
-GENERAL RULE: Acting partner is entitled to indemnification
a. Act is w/i prior his prior apparent authority, AND
b. Dissolution must have been caused by express will of
the partner, death of partner, or bankruptcy of partner,
c. Acting partner didn’t have knowledge of the bankruptcy.
-2 schools of thoughts in re the 3 acts req’ in #b: 1.
These 3 acts are poorly drafted, don’t read statute literally;
2. these 3 acts are drafted well b/c/ specificity/plain
meaning rule suggests that the drafters intended the 3 acts
to be read literally. Also, it makes sense b/c back in the
day, all other types of dissolution should put partner on
3. WHAT ARE THE EFFECTS OF DISSOLUTION ON FIRM’S LIABILITY?
Sec. 36: Dissolution doesn’t discharge existing liability
of any partner. (the remainder of the act merely elaborates).
-e.g. Sec. 36(2): retiring partner gets out of liability
only if he gets novation releasing him from liability from
4. LIQUIDATION /WINDING UP (p. 50):
Sec. 40: we need to determine which assets are available
for liquidation. They are:
a. All firm’ s property, plus
b. any contributions that may be required (to be made by
partners to pay off liabilities)
-PRIORITY AMONG CLAIMANTS--ORDER OF DISTRIBUTION IN 4 TIERS:
(who gets paid first?--tiers of priority are ranked serially,
i.e. each prior tier must be paid off in full before lower
tier gets anything.
1. CLAIMS OF 3dp CREDITORS
2. CLAIMS BY PARTNERS, other than for capital or surplus
profits on assets, e.g., partners advances, any indemnification
3. REPAYMENT OF ALL CAPITAL CONTRIBUTIONS BY PARTNERS
4. ALL CLAIMS TO PARTNERS WITH RESPECT to PROFITS, i.e.
surplus (whatever’s left)
-what if there’s not enough assets to repay all the tiers?
Obligation to contribute, thus partners will have to put
in their share, e.g.:
Gains & Loss % Capital +Gain/=Share
X 50% $50,000
Y 25% $25,000
Z 25% $25,000
Partners XYZ agree to dissolve. They agree to the above
loss-share apportionment. Total pot after liquidation of
assets is $100,000. So they paid in full Tier 1 in the amount
of $100,000. Nothing owed to Tier 2, but Tier 3 is owed
-supposed liquidation produced a total pot of $160,000.
Tier 1 is paid off. In tier 2, X gets $50,000, if expressly
provided, and then Gain-Share. If K is silent, then $60,000
is split equally.
-partners must contribute their loss/gain % to repay the
tiers not paid off.
-If Z is bankrupt, remaining partners will have to pick
up Z’s share on top of their own.
*New York Sec. 71-a: variation which says that all unpaid
EE WAGES and benefits gets a superior priority over 3dp
5. CONTINUATION: What are the universe of possibilities
in which a firm can continue?
a. AGREEMENT SAYS SO:
b. AGREEMENT IS SILENT< but all partners unanimously
agree to continue: this is unusual. Each partner alone can
c. CAUSE OF DISSOLUTION WAS A “DISSOLUTION IN CONTAVENTION
Sec. 38: (Contravention is when a partner in a partnership-for-term
wants to dissolve prematurely before term is completed)
breaching partner can’t dissolve
all of the partners can choose to continue w/o the breaching
partner, but they must:
a. pay breaching partner off in case (ALL FIRM’S ASSETS
- FIRM’S LIABILITIES x HIS PARTNERSHIP INTEREST) excluding
b. post a bond, approved by court, to secure breaching partner
so that he’ll know he’ll get paid later
-in either case, the remaining partner must INDEMNIFY breaching
partner for all liabilities
-POLICY ISSUE: Sec. 38 only applies to one kind of breach
of partnership-for-term and partner walks out prematurely.
What about other culpable breaches, e.g. those requiring
judicial dissolution? Most cases say read UPA literally.
Others like Draschner case, p. 94, holds that P caused wrongful
dissolution, and there should be a dissolution based on
his misconduct. Breach by misconduct should be treated like
a breach in contravention, thus, he shouldn’t be entitled
to good will, which was the largest asset in the firm.
4. PARTNER EXPELLED PURSUANT TO AGREEMENT
(underlying assumption is that the expelled partner isn’t
culpable, thus should be treated better than Case 3.
-remaining partners can insist on liquidation, or agree
to continue if unanimous vote, but they must take care of
expelled partner by:
a. Discharging him of all firm’s liabilities by paying him
or by getting a novation
b. Pay him now in cash he’s owed for his firm’s interest
c. entitled to share of goodwill
THEMES OF GENERAL PARTNERSHIP:
1. Unlimited personal liability
2. You can be in general partnership w/o knowing it
3. General instability
-a limited partner has liability limited to the capital
she contributed to the firm
History: 1916 marked the finish of ULPA, 1976 recent revision
= RULPA, = 1985 amendments
The utility of limited partnership is a tool for raising
capital b/c limited liability, and special tax provisions
(pass-through income tax laws)
-1980s: when limited partnerships most popular. Not so today,
b/c LLC’s succeeded it.
Cons of LP’s: uncertainty in limited liability, major decrease
in ability to shelter paper gains, and income w/ paper losses,
a publicly traded LP no longer retains the pass-through
tax benefit (see 77-04 IRC)
2 FORMATION OF LP: unlike General Partnership, LP formation
a. Definition: there must be 1 General Partner who retains
unlimited liability, and at least 1 Limited Partner
b. Paper required: File certificate of LP (RULPA Sec. 201),
which includes firm’s name, variation of address, names
of all general partners, etc. Al General Partners must sign
certificate then file it, usually with the Secretary of
State, and at which moment, the LP is formed.
* New York: Publication Requirement (Sec. 201) take certificate
and publish it in 2 papers of general circulation in each
county of the state for 6 weeks.
3 STATUS OF LIMITED PARTNERS:
i) How do I become one? (RULPA sec. 301)
a. agreement authorizes it
b. unanimous authorization by all partners
c. AR was authorized to make me limited partner
a. General inspection of all books (sec. 305)
b. Right against general partner to be treated according
to Fiduciary laws
c. Capital contributions: LP can contribute promissory note,
or services, or case and property as consideration for partnership
Sec. 702: unless otherwise provided, LP interest can e assigned
but mere AE doesn’t become LP without one of 3 above. AE
just gets AR’s rights to profits/surplus
4. HOW DOES A LIMITED PARTNER LOSE HIS LIMITED LIABILITY
(according to old ULPA)?
(see handout for ‘Control-Liability Test”)
Old rule: p. 105: A limited partner is not liable beyond
his capital investment unless he takes part in Control of
the business. But no court has ever held a Lpartner generally
liable based on mere “possession” of control--he must exercise
it. Also, many scholars and a few courts adopted a “reliance
test”: a Lpartner acts like a General Partner, and 3dp relies
on a belief that he is a General partner based on the conduct
of the limited partner, then limited partner is exposed
to unlimited liability.
PAST & PRESENT CASE LAW: “When does “exercise of control”
a. Party is both a Lpartner & EE of co.
b. Party is Lpartner who’s also asked to advise the general
partner b/c he has a lot of experience. Does giving such
advice rise to the level of “exercising control?”
c. Lpartners have right in documents to appoint general
partner, or power to fire general partner--does this power
constitute “exercise of control?”
d. Lpartner makes all the day to day business decision
e. INCESTUOUS CORPORATE general partner: suppose we are
Lpartners and concerned about losing limited liability,
but we want to keep pass-through tax benefit. So, we propose
to form a LP, stay away from business as stockholders so
not to ‘exercise control” and hence, lose our limited liability,
(Cts are split). See Frigidaire case, p. 108: policy issue
here: legislature has authorized general partners to be
partners in LP. Thus, the court didn’t impose unlimited
liability on limited partner.
WHAT ABOUT NEW “RULPA?”
-Control-test: RULPA outlined the test, as in old statute
-Reliance-test: (as above, i.e., 3dp relied on LP’s representation
to his detriment)
-Safe Harbours: A list of common activities of Lpartners
based on case law is deemed not to trigger loss of limited
a. L partner who signs K, like EE of firm
b. Lpartner who is officer, or stockholder of firm
c. Lpartner who consults w/ general partner
d. Lpartner who exercises voting rights as listed in the
partnership agreement, including voting on any other matters
left to be voted on by other partners in he agreement,
a. We form a LP and we put in a provision that only Lpartners
make decision...is that permissible?
b. How in fact would the 5 cases under the old statute come
out today, based on safe-harbour list?
c. Frigidaire issue: Sec. 303 uses words “Lpartner won’t
lose limited liability “solely” by being an officer or director....How
to interpret “solely”? (See handout, #1-7) #1 covered in
above, but remaining 6 are not realistic situations. However,
control liability is litigated a lot.
Silly Sec. 303 provision:
Sec. 303(d): name liability: if you go to join a new firm,
and you put your name in firm’s name, you then lose your
Sec. 304: erroneous goodfaith belief: P thinks he’s a limited
partner, but mistake was made in he filing of the LP certificate
which stated that he was a general partner. If he doesn’t
correct this, he then loses his limited liability.
STATUS OF GENERAL PARTNERS
RULPA Sec. 401-405
a. General Partner has main power to make decision
2. General partner keeps same obligation and unlimited liability
to 3dp and limited partners as in a general partnership,
e.g. fiduciary duty...
3. Fiduciary duty Can Limited Partners waive all claims
based on this duty?
-plain meaning reading of RULPA says Yes to across the board
waiver (except as provided by act, or in the partnership
-an alternative reading of RULPA says that the current case
law supports a reading of the RULPA to mean that “limited
and specific waivers” are enforceable (e.g., time, scope),
but not across the board waiver.
2 main principles:
1. Conduit/Pass-through principle: a partnership IS NOT
a taxable entity. Instead, each tax item (income, gain,
loss, production, credit. . .) we ignore the firm and it
passes through to individual partners and they’ll report
it on their own income tax returns
-flow of revenue is thus taxed lower b/c no double taxation
on individual person AND firm.
2. Definitional issue: “what is a ‘partnership’ for tax
see p. 113: suppose we form a LP, but has many atypical
traits like a Corp. IRC 7701 says if entity not recognized
as a partnership by IRS, then it will be called an ASSOCIATION
and taxed doubly! Very messy area of law,
-This resulted in a ruling: IRS’ Kintner Regulation: a.
6 regulations, b. If a particular entity had 3 or 4 of the
following traits (continuity, centralized management, limited
liability, transferability) then it will be called an ASSOCIATION.
If 2 or less of these traits, then it’s a LP.
-”Check-the-box” (IRS 77-01, and see supp., both of which
don’t follow the above)
-some entities treated as per se corporations, e.g., if
you form a corp, you won’t get treated like a partnership
-if the entity is eligible as a pass=through entity, it
may elect to be treated as a partnership, but what constitutes
an eligible entity? Any general partnership, LP, any LLC
organized under state’s law.
-What if you forget to make the election? IRS will decide
for us, i.e. partnership.
LIMITED LIABILITY COMPANY
-new form of biz started in 1977
-The benefits of this form of biz org is that it’s a hybrid
of tax advantages of partnership & Limited liability
of stockholders of corporations.
-blend of RULPA and state’s corporate statute
-see Keating excerpt:
a. Statute contains Default rules
b. Operating agreement: mandatory? New York requires one,
but a LLC should have one anyway.
c. LLC v Corporation advantage of an LLC is that it’s treated
like a pass-through entity
d. What about an “S” Corporation? it can only have one kind
of stock, and limits how many people can be a part of it
e. Don’t have to find general partner with unlimited liability,
like a LP.
f. LLC is black letter certainty, no more grey areas of
potential loss of limited liability
1. FORMATION: Every state requires FILING w/ central officer,
or secretary of state, with a short piece of paper, e.g.
certificate of organization identifying the name of the
LLC, general partners, address. Some states require an operating
2. MEMBERS (investors): Every state’s statute has direct
statement, “both Managers and Members are to have NO PERSONAL
LIABILITY beyond their capital contribution.” See N.Y. Sec.
609, ULLCA sec. 303
-majority: courts will adopt and apply corporate law interpretation:
a member who causes a wrong will be personally liable (PIERCE
THE CORPORATE VEIL--apply personal liability beyond capital
-minority: plain meaning rule
-ASSIGNABILITY: memberships are assignable, but Mere AE
gets no more than cash flow, but don’t get member status.
-VOTES: votes are in proportion to capital contribution,
if K is silent
3. MANAGEMENT: Default rule: mangement is vested in members,
unless operating agreement says otherwise. Thus, if members
wish, they can renounce it, and delegate it to a manager.
-FIDUCIARY DUTY & WAIVER: some statutes follow Corporate
Law Statute. Managers owe a fiduciary duty of care, loyalty,
and will be liable if not. But if there’s a provision waiving
fiduciary duty, then not liable, unless egregious conduct.
4. SHARING PROFITS/LOSSES/DISTRIBUTIONS of INCOME;
-can write own rules in operating agreement
-if agreement is silent, then default rule like RULPA: look
to capital contributions members to determine these apportionment’s
5. DISSOLUTION: If dissolution, MUST LIQUIDATE, unless some
specified high % vote
6. LLC: can have a “one person LLC”
-generally, LLC’s are very popular as a new biz org., and
is often entered into as a joint-venture b/w 2 corporations
LIMITED LIABILITY PARTNERSHIP
LLP: a mix of Gen Partnership + Registering it =LLP w/ limited
liability to amount of capital contribution
-some states allow LP for any business, but half of the
states, including N.Y. confine LLP’s to professional. If
the state statue confines it to this, the statute will say
that for malpractice acts, for matter of professional responsibility,
members retain unlimited personal liability for own acts
-a lot of law firms and accounting firms are llp
INTRODUCTION TO CORPORATE LAW
3 Theories to origin of Corporate Law:
1. Garden of Eden Theory: This theory is rooted in the 1930s,
and is now dominant: “once upon a time there was s a Garden
of Eden in Corporate law where States governed the law,
i.e. enforced effective State regulation. At this time,
SH also had more power to govern corporation.
Weaknesses to Garden of Eden Theory:
a. Inherence Theory: this theory has debunked the Erosion
I) Earlier scholars ignored that U.S. has a deep mistrust
in large financial institutions. So many laws are passed
to regulate large institutions. If small SH have no power,
then perhaps laws should be passed to put the power back
in the SH. After the Vietnam War & Civil Rights movement,
the result was social fragmentation, and distrust in large
financial institutions. There was also Corporate misbehavior
in the 1970’s, e.g., bribe foreign officials, illegal campaign
contributions. The focus in the 1970’s was internal governmental
problems. This resulted in reform-minded people to save
ourselves: propose Majority-Vote boards, proposed Federal
charter of regulations, National Directors core
ii) It was ignored that there was a rise in debt markets??????????
iii) It was ignored that there was rise in securities markets,
i.e. stock markets: SH found that they could sell their
shares in liquid markets, and thus they had less of an interest
in the control of the corporation
iv) Spanning v. Property: hostile takeover: greedy managers
effectively punish SH
2. Erosion Theory: effective state regulation eroded
-see Ligget v. Lee
a. Corporate Franchise was only possible through concession,
i.e. getting a grant from Legislature through haggling,
and was expensive. This process resulted in effective State
Regulation. This however, is much opposed today.
b. Before, Legislature limited how much equity that could
be invested in corp.
c. Starting in 1896, Rise of General Inc. Laws that eroded
effective State Regulation, and legislature restricting
-J. Brandeis said that this began the rise of Laxity, to
see who has more lax laws, see p. 125
-Laxity v. theory of rising market discipline
-Pro-Manager control, or pro-SH control
3. Separation theory: As Corporations grew, SH lost ability
to control and make decisions, i.e. a divorce of ownership
of shares and control of corp. SH lost a lot of power to
professional managers/officers who may not have the same
interests (prestige, effective corporate structure) as SH
(getting maximum dividends).
-see Burley & Means cases,
-Professor Hurst: Legitimacy of corporation is measure by:
a. whether large corporations are effective, and b. Do they
exhibit social responsibility and comply with the law? Hurst
thinks the answer to both is yes, and is optimistic.
CORPORATE GOVERNANCE PROJECT: all of this culminated in
3 different schools of thought on how corporate law should
1. Managerialists/Pragmatists: This system works well. They
think that # of persons on BOD should be small so to make
effective decisions; should separate the CEO from Chairman
of the Board so to allow more independent judgment from
the BOD; elect directors for 5 year terms, and at the end
of their term, evaluate them on whether the accomplished
their stated goals; compensate directors with common stock,
not merely cash.
2. Chicagoans: they think Deregulation is best; competition
among states is good, i.e incorporation laws are good; hostile
tender offers are good; and it’s proper to view the corporation
as the nexus of contract making: see p. 235, p. 24: “a corporation
is the nexus where implied contract are made b/w Managers
a. Contractarian idea, i.e. Chicagoans are mere contracting
parties, not owners of the corporation, and thus, their
rights will eventually disappear.
b. Power vested in Management is a good thing b/c SH are
clueless about the market
c. Main purpose of Corporate law should be to facilitate
K formation. Where there’s no express clause, Judges should
use corporate law to figure out what’s intended.
d. Chicagoans think SH are like Principals, and Managers
are like Agents.
e. Market for Corporate control: When there are greedy managers,
then the corporation may not function efficiently, thus
the value of stock will pummel. This will result Managers
wanting to be more honest, and they’ll want to buy-out SH,
i.e. hostile takeover.
3. REFORMERS: themes:
a. Market regulations are good
b. Market failure happens more often than you think
c. Statutory & Regulatory law works to change the economy
d. Managers have too much power, and the power should be
put back in SH
e. Fiduciary duty owed from managers to Sh should be enforced
f. There should be non-waivable rules governing all corporations
g. BOD should just monitor/oversee senior managers, since
the extent of the directors duties is meeting once a month.
Also, the BOD would better function if there were independent
members, esp. CEOs who have no economic ties to the corporation,
so they can make effective decisions.
h. Individual Institutional SH should take more active role
in the corporation than merely selling stock, see p. 241.
I. Whether to Incorporate or choose another form of biz?
II. Where to incorporate?
III. How to incorporate?
I. A. Tax-Considerations
B. Non-Tax Considerations
Tax Considerations: I. Pass-Through entity: A partnership
keeps its pass-through privilege if it doesn’t go public
. The cons to this though, are that partners need distributions
right away/or at year-end because they have to pay tax at
the end of the year, so partnership can’t keep the profits/surplus
invested. However, if the partnership accumulates too much
income and there’s a failure to distribute it, then the
IRS will think it is attempting to avoid tax through its
pass-through privilege. The result: a penalty is imposed.
But, the PROS include being able to shelter the partnership’s
revenue from tax and use corporation’s losses to shelter
income, no double taxation.. However, in 1994 marginal tax
rate changed, and didn’t really allow to much tax savings
for the corporate form.
CONS of incorporating: double-taxation
PROS: 1. Since 1994 the Marginal tax rate allows corporations
to pay tax at a slightly lower tax rate than the natural
person. SO, if we’re long term investors, it’ll pay off
to form a corporation than a limited partnership.
2. Corporation can distribute its dividends to SH when it’s
the best time, unlike a partnership that requires the distributions
be made to partners at year-end so to avoid an accumulated
tax penalty, and so that partners can do their income tax
3. Fringe benefits such as health insurance are deductible.
But, not many benefits are deductible.
4. It is possible to elect to be an “S Corporation” as opposed
to a “C Corporation” so to get the pass-through privilege,
and get treated like a partnership, with the exception of
the Minimal capital gains tax
-the Cons of an S Corporation are very few. But, the investors
in an S Corporation can’t reallocate tax items like losses.
-Eligibility for “S Corporation:”
1. No more that 75 SH
2. Only 1 class of stock
3. Some kinds of corporations can’t qualify, e.g. Bank
4. All SH must agree to make an election
Pass-Through entity v. Corporation:
1. Pick Corporate form if you intend to go public within
a short time b/c publicly traded entities get taxed like
a corporation. If you convert from a partnership to a corporation
later on, then there will be tax issues.
2. Pick Pass-through entity if you intend to stay private,
e.g. if Principal wants to take out distributions, or losses
are expected in the future so to avoid double tax.
3. Pick a “C Corporation” if clients intend to reinvest
profits b/c they’re taxed marginally lower than individual
person income tax rate.
B. Non-Tax Considerations:
1. Limited liability? then pick Corporation or an LLC. However,
every state has limitations to limited liability rule:
a. Doctrine of piercing the corporate veil: if bad things
done by the corporation, then SH impose personal liability
b. ** New York Sec. 630: unlimited personal liability will
be imposed jointly and severally to the 10 largest SH in
regard to EE’s unpaid wages and benefits. This reflects
a public policy that work must be paid. This is disincentive
to forming a business in New York, but not elsewhere.
2. ACCESS to FUTURE CAPITAL: if you want this, then choose
Corporation because public investors are used to seeing
Stock, not partnership interest. This will allow more opportunities
to create different capital instruments, e.g. different
types of stock
3. CONTINUITY OF EXISTENCE: Corporations are deemed to have
perpetual existence, vs. partnerships which have a lifetime
of a term specific, or until goal accomplished. Partnerships
are also easier to dissolve.
4. Free TRANSFERABILITY of SHARES: A corporation allows
SH to sell shares to someone else.
5. Centralization of Management: Corporations are run with
a centralized management in the professional officers and
SH have no governing power. Partnerships are anti-centralized,
and all partners usually actively participate in running
6. Costs; Corporation is more expensive to form but it’s
all relative to the level of sophistication desired.
****All these provision can be drafted around
II. WHERE TO INCORPORATE?
There’s a presumption that a corporation will incorporate
a. Large Business
b. If main business activity is elsewhere
c. If public participation is likely, then incorporate elsewhere
d. New York Sec. 630 on unpaid EE wages may make corporations
1. Incorporation fee & Franchise tax is low
2. Few restrictions on management, and protect their decisions
3. Fewer big deal items need to get SH approval vote
4. Delaware has its own court for business law, i.e. the
Court of Chancery, and that promotes much clarity and certainty
in business law
III. HOW TO INCORPORATE?
-compare with other state statutes. See also, handout
1. Call Incorporating Service: a professional service incorporates
your corporation by phone, and then they’ll generate forms,
and give you a certificate, seal... This will cost about
$150-400. This is the normal way to do it.
2. Read book, Pesky Brothers in Law, “How to form a corporation
in New York w/o a lawyer for $75”
. Are you in the right jurisdiction
A. Follow State statute on how to incorporate. See N.Y.B.C.L.
Sec. 402, Del. 102, Model 2.02:
-Name of Corporation: must use “Corp.”, or “Inc.” or “Ltd.”
in corporation’s name. Some states allow “Co.”, but not
New York. You can also pick 3 reserve names, not already
taken. Also, need an incorporator who’ll sign the COI. It
can be anyone or corporation. But in New York: need an actual
person to do this.
B. Address of Corporation: Old rule: specific address, Today:
general description. New York: if you use a general description,
you must add a provision that states, “provided that the
corporation is not formed to engage in ...” There’s no need
to address power distribution.
C. Where the Registered Office and Agent is located: This
address is required so someone can be served process if
your corporation is sued. New York doesn’t require this
because by appointing the Secretary of State is sufficient,
and need only to identify the county agent & office
D. Capitalize the Corporation: “Authorize/create” # of Shares
that corporation will have power to issue. (The corporation
can’t sell its shares until it authorizes them). State whether
they’re PAR or NON-PAR, and then state what the value is.
Do the same with each class of stock.
-PAR VALUE v. NON-PAR-VALUE: this is an out-dated concept
and is just a formality, but still significant because of
its impact on the firm’s stated share & income: in many
jurisdictions, including New York and Del., dividend distributions
and stock repurchases can only come out of the corporation’s
funds in surplus, NOT from Stated Capital. The reasons for
this is to protect creditors from an insolvent firm, i.e.
by making corporations use only surplus funds for these
purposes, the corporation will preserve enough capital so
there will be something for creditors to go after.
Surplus = Assets - Liabilities - Stated Capital (see Sec.
PAR VALUE: see N.Y. Sec. 504, 506
-If we issue stock with Par Value, then the full amount
of par value of the shares we sell must be declared in Stated
Capital, and the corporation/directors therefore cannot
(reallocate) take out and use any amount that leaves less
than par-value of the corporation’s stocks in stated capital.
This creates no flexibility for surplus use. So, to remedy
this, set an Arbitrary par value & charge investors
higher than that value, then put the balance of the selling
price into assets, which results in Surplus so to later
-NO PAR VALUE: If no par value is declared, then Directors
can put all the money collected from whatever price the
shares are sole for into Stated Capital, but Directors also
have discretion to reallocate the funds to have Surplus.
LIABILITY FOR “WATERED SHARES”: Watered shares are shares
that claim to be sold, but the funds collected from selling
the share never actually appear in the Stated Capital/ get
“paid in” by the corporation (probably directly diverted
into surplus so that the company has money to readily reinvest).
If this is the case with shares w/ Par Value, then the corporation’s
liability equals the balance of the share price not in stated
income (e.g., if the corporation declares it sold shares
X at $10 and only paid in $5, then its liability will be
the missing $5.
-see American Cat Corporation: Corporation formed by D &
J, with 50/50 SH power. They decided to authorize 200 shares
of common stock with par value of $5/share ($1000 total).
They issued to themselves 100 shares. However, they only
contributed in $250 each($500 in assets). $500 from outstanding
Shares goes into Stated Capital. The problem here is that
they have no surplus, unless they earn something so to issue
Surplus = Assets - Liabilities - Stated Capital
0 $500 0 $500
-So, They should charge an arbitrary par value higher than
the one above so they can take the excess cash and put it
into surplus. If SH pay $10/share, D & J will have $1000
in assets ($500 from what D & J contributed, and $500
reallocated from Stated Capital), and State capital is still
$500 (because with an arbitrary par value, the corporation
is allowed to just declare in State Capital the par value
x # of outstanding shares), but $500 in assets.
Surplus = Assets - Liabilities - Stated Capital
$500 $1000 $500
NO PAR VALUE: Same thing. If SH pays $5/share, then that
amount must go into stated capital, but the board has the
advantage of reallocating that amount to assets. The advantages
of this: avoid watered share liability; and can have surplus,
so to issue dividends.
REALITY: It is most common to use par value shares, pick
a low par value, and then charge SH a higher value.
1. Par v. No par:
2. Different classes of shares: It the corporation only
issues one class of stock, then they’re “Common”
-If it creates additional shares, the corporation must indicate
this on the COI, and describe the differences, relative
rights of each type of shares
3. If there are more classes, then: some may be:
a. “Preferred Shares” p. 135; which allow two preferences:
i). Give SH preference to dividends before the Common SH
gets to it
ii) Liquidation preference: when the corporation dissolves,
the preferred SH will get paid the value of their preferred
share before the Common SH gets paid.
b. “Redemption Share”: see BCL Sec. 512: This creates a
class of shares that a corporation has a right to repurchase
and compel the SH to resell at stated price
c. “Convertibility Shares”: BCL Sec. 519: the SH has an
option at any time to convert her shares, so long as it’s
stated in the COI
E. Designate the Secretary of State: as upon whom service
of process may be made. Also include an address where the
Secretary of State can send the process to, but also, most
states say that the Secretary of State will be your agent
even if you forgot to include this in your COI.
F. Incorporated Sign, Notarize, and File.
1. The Corporation does not need Minimal capital
2. Corporation can amend the COI pursuant to Sec. 801-803
of statute, requiring: a. Director’s authorization, and
b. Sh agree by amount of majority specified in the statute
3. Sec. 402b states that if you want to shield Directors
and SH from liability, then must do so in the COI
4. Corporation can prefer to have SH run the company, but
must state so in the COI
5. Bylaws: not mandatory, but practical
6. Organizational meetings, p. 137: a meeting held by the
Incorporators where Incorporators elect the 1st directors,
and Incorporators adopt the initial set of bylaws. The Incorporator
is just a dummy, can be your secretary...
7. Directors’ meeting: to appoint officers, secretary, adopt
corporate seal, banking resolutions, attend to financial
structure, e.g. issue of shares, valuing of property, accept
subscription agreements signed by SH, sec. 503-04, to provide
V. POWER OF CORPORATIONS:
Every state statute describes what powers each level of
member of corporation should have, e.g. New York Sec. 202.
These powers include: a. Power to issue guarantees in furtherance
of corporation and business interest. Some states will not
allow this power if an affirmative majority vote is shown.
b. prohibit loans to Directors, unless authorized by the
BOD and is in furtherance of the corporate business
c. Make charitable gifts irrespective of corporate benefits.
1. Ultra Vires: If the corporation acts beyond its powers.
The old rule was that the corporation could have a valid
defense if it could establish that the act was beyond the
power of the corporation, but the 3dp had reason to know
it was beyond that person’s power.
-see N.Y. Sec. 203: “No corporate act shall be invalid because
of a lack of power, unless . . . The rule allows Sh action
to enjoin such an act
-see Goodman case
2. De Facto Power (most states don’t honour this defense):
see Cantor v. Sunshine Grocery: Sunshine’s COI was never
filed properly b/c it got lost somewhere. Thus the corporation
was defective. However, before Sunshine was properly incorporated,
it entered into a K, and thereafter defaulted on it. P sues
the partners of Sunshine individually/ personally liable.
HELD: Although a De Jure corporation did not exist at the
time, a De Facto one did and will be recognized as preventing
the partners from being personally liable.
3 Elements to “De Facto” Corporation defense:
a. A statute existed describing how to form a corporation
b. The partners demonstrated a good faith effort to incorporate
c. There was some exercise of apparent corporate authority
**New York Sec. 403: most states follow New York in not
honouring a de facto corporation defense just because it’s
so easy to incorporate, there isn’t any excuse.
-see Robertson v. Timberline
Active Participation: If SH actively participated in the
management of corporation then it will be held jointly and
3. PROMOTER’s LIABILITY with respect to pre-incorporation
General Rule: promoters who sign K will be held personally
liable, unless it is clear intent is expressed otherwise
in the K w 3dp that the corporation hasn’t been incorporated??????????????
-see R.J.L and Goodman , p. 140: owners of an apartment
complex contracted with Goodman/promoter to do repairs.
They signed a K as “X Corporation in formation” but this
was held not be clear enough.
Minority Rule: Quaker Hill case: the promoter should not
be held personally liable. Instead, the K he enters into
should be interpreted as a “continuing offer” intended to
be a communication with the Directors.
Corporation’s Liability: see p. 148: The Corporation is
liable if it impliedly ratifies the K, the K is deemed a
continuing offer, the corporation has taken benefits from
the K and shall be estopped from denying its liability.
-However, this doesn’t solve promoter’s liability. The promoter
will escape liability only if it receives a Novation or
the corporation Ratifies the K.
-”Ratification”: “Dual Capacity Rule”: in order for the
principal to validly ratify the K, he must have legal capacity
when the agent acted, and when the principal ratified the
4. PIERCING THE CORPORATE VEIL:
(this is the most litigated issue in corporate law)
General Rule: There is no personal liability for SH, except
1. 3 DIFFERENT THEORIES for Piercing the Corporate Veil:
a. Court ignores the corporate fiction and holds SH’s liable
b. Where the SH is another corporation, not a natural person,
then the Court will more likely pierce.
c. Enterprise liability model, p. 172: Where a group of
corporations that are all affiliated, but merely do different
things, the court will pierce the corporate veil in one
of the entities and make all the assets liable.
2. Does it matter if the claim is TORT or K?
Courts don’t make a distinction but a lot of scholars say
in a negligence claim, the claimant had no choice but to
sue. But in a breach of K claim, the injured had chances
to inquire into the financial soundness of the corporation,
negotiate, so maybe K claims shouldn’t warrant piercing
3. Never Pierce Corporate Veil of Public Traded Corp: perhaps
Ct not willing to hold passive rather than actively participating
4. PROS of Not Piercing Corp Veil/ or limiting personal
liability: Cons for Not Piercing Corp. Veil:
a. Helps in raising capital such that investors will feel
confident they won’t be sued personally a. It’s not fair
to dump losses on innocent 3dp, esp. tort claims
b. ????????? b. Limited liability encourages investors
to take bigger risks
c. It’s not fair to impose liability on passive SH
c. Insurance markets would develop
d. Diversification of Porfolio: limited liability reassures
the investor that It won’t have to worry about spending
a lot on insurance, and thus spend more on investing d.
encourages SH to monitor organizations for assets, i.e.
more SH control over managing the Corp
e. Encourages socially desirable risk taking, e.g. Medicine,
R & R, Technology experimentation
ISSUE: What Triggers will lead a Court to Pierce the Corporate
Old Rule: see Milwaukee Refrigerator case, p. 205:
1. Intermingling of financial accounts
2. Diversion of funds
3. Holding out the corporation to be a branch of a larger
4. Evasion of a Contract obligation
5. NEW RULE: “Control Unity Test” or “Alter-Ego” test:
-Corporation was just the mere alter-ego of the individual,
or a mere instrumentality, or “total and complete domination,
6. Formalities not Observed: see Berkey case, p. 173.
-If formalities such as keeping the minutes, the books,
weren’t followed, then the court may pierce
7. Under-capitalization: see Walkovszky v. Carlton, p.
165 (seminal case—the “shuttling funds” case): CONTROL-UNITY
P was severely injured by a cab driver. The company that
owned the cab was SEON where D was a SH, as well as in 10
other similar companies. D had minimal insurance, i.e. $10,000
per incident, and this led to P suing the corporation on
the grounds that it was under-capitalized and there was
intermingling of funds, and warranted the court to pierce
the corp veil so he could recover more $.
HELD: P didn’t allege “SHUTTLING of funds”, nor corporate
formalities weren’t followed, nor D was actively participating
in conducting the biz, or for personal ends.
-This case spells out the New York Rule, i.e. the “Control-Unity”
test. New York considers the role of undercapitalization
as one of the big factors, but not the only factor.
*What is the role of undercapitalization in regard to foreseeable
risk? Depends. In Walkovsky, the Dissent said the capital
in the corporation was too small, while the Majority said
that undercapitalization was not the controlling factor
in the analysis of foreseeable risk. Instead, the majority
said one should look to see whether there was “shuttling”
of funds. Other Court have adopted the Ballantine theory:
what was the role of undercapitalization in relation to
-the problem with this analysis is that the risk already
happened by the time the case appears before the Court.
Thus, the Court would probably be inclined to hold that
the risk should have been foreseeable!
8. Shuttling Funds
9. Engaged in Conduct for Personal ends.
10. INSTRUMENTALITY TEST: see Zyst v. Olsen, which stated
an alternative rule to the Control-Unity test: a. Did D
have control in fact over the corporation?
b. Was his use of the corporation harmful to P?
c. Was control and use of the corporation the proximate
cause of the harm?
Zyst v. Olsen: Olsen owned 5 separate but related corporations,
e.g. one does the building, the other purchases equipment,
etc. Corp. A contracted with Zyst to build a shopping mall.
Olsen defaulted on the K and Zyst sued corporation A. He
also wanted to pierce the corporate veil and hold Olsen
HELD: Ct pierced the corporate veil.
New York: Filing of the COI is conclusive evidence of the
existence of a corporation, except the A-G has a right to
Whether to pierce the corporate veil when there’s a contract
between the 2 parties
1. Generally Courts look at the same factors as Tort cases
to decide this
2. Academics urge the Courts not to pierce the corporate
veil in Contract relations because both parties had chance
to review the risks, and negotiate. The only exception is:
when party has been defrauded
RULE: Fraud is not required to pierce the corporate veil.
Only evidence of UNDERCAPITALIZATION + BAD FACTS:
-see Anderson v. Abbot, p. 205: Court pierced the corporate
veil because there was evidence of undercapitalization AND
egregious fact (violation of statute)
-see Zyst v. Olson: undercapitalization AND No corporate
-see Kinney Shoe case: undercapitalization AND No corporate
-see Sealand case: undercapitalization AND multiple bad
facts: No corporate formalities, shuttled assets, co-mingled
**Exception: Bartel v. Homeowners Corp: Didn’t pierce
the corporate veil because the purpose of corporate law
is to shield SH from fraud. In this case, there was no showing
of fraud, so perhaps, the Court implies that proof of FRAUD
1. CORPORATION v. NATURAL PERSON Courts are more willing
to pierce the corporate veil and hold a liable a corporation
instead of a natural person
2. PUBLICLY TRADED corporation Courts will NEVER pierce
the corporate veil of a Publicy-traded corporation, (only
3. PASSIVE NON-PARTICIPATING SH Even in Close-Corporations,
Court will RARELY PIERCE the veil and hold personally liable
those who are passive SH (but see, Minion v. Cavaney, where
it came close: Ct imposed personal liability on Defendant/lawyer/Sh
in a company that owned a pool where P ws injured. D argued
that he’s only a passive SH because he was the one that
just held the corporate documents. Not true! He was active.)
4. . 3-prong test in Zyst v. Olson (adopted in New York):
a. D had control
b. D exercised control
c. The exercise of control caused the harm.
*it is uncertain what purpose this test serves...does it
make it more difficult to pierce the corporate veil?
5. Tort Cases Courts are more willing to pierce the corporate
veil in tort cases because the injured party is an involuntary
creditor, whereas in Contract cases, the parties have negotiated
the terms of the agreement and should foresee the risks
involved. Equity also supports favourable treatment in Tort
6. Undercapitalizaiton: This is very important in California,
but not as important in New York (see Walkovsky case). Most
states hold that it’s not the sole, but a big factor in
7. Fraud in Contract cases it is independently sufficient,
but not necessary to pierce the corporate veil
8. Co-mingling funds is an important factor, especially
in New York (see Walkovsky: “shuttling funds”)
9. Lack of corp. formalities New York deems this very important
10. Alter ego/Agent/ “Domination” Although all these words
mean the same thing as co-mingling funds, in New York, each
of these words must be included in your complaint b/c they’re
11. Multiple Bad Facts If Fraud is proven, 1 bad fact is
enough to pierce. If no fraud, then multiple bad facts must
Another SYNOPSIS: based on a survey:
1. Courts tend to pierce corporate veil more often than
2. Court pierce on the Contract side more than in Tort
3. Contract-based claims usually include a claim of FRAUD
4. Court pierce more often against Corporations than natural
I. GOVERNANCE & STRUCTURE
“How corporations are supposed to be run according to Corporate
Statutes, and how power and control are allocated”
I. CORPORATE NORM: Traditional blackletter rules in state
statutes describe what the corporate norm should be:
-see NY BCL Sec. 701:
a. How many Directors are required to run a corporation?
-New York requires 3 if not provided otherwise in the COI.
Most state require 1
b. Can SH run the corporation?
-No. Business decisions are left to the BOD and can’t be
delegated to or retained by SH. (see Boot case).
**Yes. Recently, certain states have allowed SH to be directors
in non-traded (close-corp) corporations if it is provided
in the COI that all SH agree and understand that they undertake
the unlimited personal liability if the corporate veil is
*RULE: The Basic Norm is that BOD makes business decisions
on matters, EXCEPT:
1. Amending Bylaws: see Auer v. Dressel, p. 257: Courts
concluded long ago that SH have inherent power to amend
bylaws. Facts: A company had 2 classes of Stock. Common
SH’s had the right to elect 2 directors, and Preferred SH’s
could elect ??? The COI and bylaws say that the BOD has
the power to remove and amend bylaws. BOD challenged SH’
s attempt to appoint or remove directors.
HELD: SH’s have inherent power to do so!
2. Electing Directors/Filling Vacancies: The Old Rule allowed
SH’s to elect Directors. New Rule says that in regard to
filling vacancies, the BOD has the power, unless the COI
-see 4 Delaware cases, and cross-reference with Business
Judgment Rule, and Duty of Loyalty on the issue of whether
BOD has the power to amend bylaws or fill vacancies to prevent
dissidents from taking over:
a. Schnell case: BOD was faced with dissident SH who lobbied
to influence other SH. So, the BOD accelerated the annual
meeting to amend a bylaw so SH won’t have time to rally
HELD: breach of duty of loyalty by taking action to preserve
their own jobs instead of the interests of the SH, even
though BOD had the power to amend bylaws, as provided in
b. Blassius case: The COI of this corporation fixed the
maximum # of Directors at 15, whereas the bylaws fixed it
at 7. Certain SH wanted control of the BOD so they solicited
a consent decree to SH to sign over this power to amend
the bylaws to require 15 Directors, and the power to select
directors for the 8 vacancies. The present BOD didn’t want
this to happen so with its power to amend the bylaws, it
did so, and fixed the # of Directors at 9, and then appointed
2 of their own people, so that even if the SH’s succeeded
in amending the bylaw # of Directors to 15, the present
BOD would still control.
HELD: Breach of (duty of loyalty?) in that the present BOD
abused their authority by acting in a way that preserved
their self-interests, and thereby frustrating SH’s given
power to amend bylaws.
c. Stroud v. Grace, p. 274: There was a family feud over
the Miliken textile corporation. The 2 factions battled
over business policy: Milikens didn’t want Strouds to have
any BOD power, so proposed to amend the bylaws to require
that applicants have certain qualifications, and the Milikens
would have the power to decided whether they were qualified
for the position.
HELD: Court said that Blasius didn’t apply because here,
the BOD merely proposed to amend, instead of unilaterally
amending the bylaws.
d. Williams v. Guyer (supp.): BOD was afraid there may be
a dissident proxy contest over the Board, so they proposed
to the SH’s to amend the bylaws to “tenured voting rights”
or weighted voting rights. That is, longterm SH’s would
get 1 share = 10 votes, instead of the 1 share=1 vote policy.
The BOD felt that longterm Sh’s would more likely vote in
favour of management.
HELD: mere proposal to amend is OK, and doesn’t frustrate
3. REMOVING DIRECTORS: The Norm is that Directors can be
removed by SH for Cause. But this rule has been liberalized.
Many states allow power to remove Directors can be vested
in Directors themselves if provided in the COI. Some states
allow removal of Directors without cause, if provided in
4. AMEND THE COI: The Norm is that this power lays in SH.
But, today, both constituencies must act. First, BOD authorizes
the amendment, then SH’s vote on it.
5. STOCK OPTIONS: The Norm was that SH’s vote required to
create stock options. Today, it’s a BOD decision, except
in New York: must get SH approval if the stock options are
intended to go to inside EE’s.
6. GUARANTEES: The Norm is to get Sh approval. Today, SH
approval is required if the guarantee is not in furtherance
of corporate business. Otherwise, the decision lays in BOD.
**New York: requires 2/3 vote if it’s not in furtherance
of the corporate business.
7. MERGERS & CONSOLIDATIONS: The Norm before was that
Directors give approval, and then SH’s vote. Today, the
same. (Merger is when Target company is deemed to disappear
into bidder Company. A Consolidation is when both Bidder
and Target merge into a new entity).
*Short Form Mergers: (buying company already has 90% or
more of the Target Company shares. Most state Statutes authorize
short-form mergers) Only affirmative majority of BOD votes
of buying company required.
-see Santa Fe Industries
8. ASSET SALE: Both Director and Sh vote of Target Company
required. (Company agrees to sell all its assets to another
company instead of a merger. But much litigation as to whether
this constitutes a sale of a majority of the corporation’s
9. DISSOLUTION’S: BOD approval and SH vote required. **
New York: no BOD vote required.
10. COMPULSORY STOCK EXCHANGE: SH vote of Target Co. required.
(no one uses a CSE anymore b/c you can accomplish the same
thing with a merger. In a CSE, all Target’s shares are deemed
converted and eliminates SH’s of Target company by cashing
******Issue: Whether to Add more or deduct from the list?!
II. ACTION by DIRECTORS
Rule: Directors must act as a Group:
1. at a meeting,
2. with a certain quorum,
3. after being given adequate **notice.
(Individual Director acts have no authority)
Exception: 1. If no meeting, most states allow BOD must
act by unanimous written consent
2. Telephone Meetings: allowed, but must be open-line conference
3. Informal Board Action (see p. 294)
2. Quorum: some minimum number of Directors present to give
meeting validity. Most states say that there must be a majority
of entire board present. **New York Sec. 707 requires the
entire Board, i.e. all the directors the corporation would
have if there weren’t any vacancies.
*Can a corporation provide for a lesser quorum than statute
specifies? Most states say yes, if provided in the COI.
But there’s a floor minimum of 1/3 the #of?????????????
Most states say that it’s OK to have a quorum # higher than
what the statute says.
3. Notice: If it’s a regularly scheduled meeting: then no
notice required. If it’s a special meeting: then minimum
notice is required, which can be waived.
Exception #3: Will BOD be bound by informal Board actions
a. Majority Rule: see Baldwin case, p. 294: acts taken by
majority directors are NOT VALID. Informal acquiescence
by BOD is inadequate.
b. Modern Rule: Yes, such acts are valid if it’s a CLOSE-CORP,
i.e. if the Court can conclude that all Board members knew
or should’ve known of the decision at issue, particularly
on corporate benefits
-see Jordan v. LIRR: ???????????????????
c. Emerging New Rule: if a majority of Directors are frequently
in contact, and should’ve known about the action, then they’ll
What about the BOD delegating authority to COMMITTEES &
a. Committees: BOD can subdivide their work to specialized
committees, but every state statute lists the decisions
that CANNOT BE DELEGATED, e.g., amending bylaws, whether
to submit proposal for a SH vote.
b. Officers: NY BCL 715: Officers hold office until the
next meeting, p. 299. If there’s a question as to whether
one had actual authority to do something, look to the COI.
But, if it’s a question of whether the President of the
Corporation had apparent authority to do something, then
ask, “Was the act in question in the normal and usual course
of business?” If yes, then corporation’s bound.
III. FORMALITIES OF SH ACTION:
New York, Art. VI requires that SH action take place at
a meeting. There are two kinds of meetings:
1. Annual which is mandatory
2. Special which is called by the BOD
-must give minimum notice if it’s a special meeting. 60-10
days, and the purpose of the meeting must be stated. But,
notice can be waived.
RECORD DATE: How does the corporation determine which SH
get to vote/get dividend,/get notice of meeting? They merely
pick an arbitrary date and determine that all SH before
that record date shall be recognized. **In New York, this
record date can be fixed in he COI.
*HOW DO WE COUNT THE VOTES?
General Rule: 1 vote per share
**New York is a Model Act state, and thus, we count the
majority of votes cast constitutes approval from SH.
**Majority/Delaware Rule: we count the majority of SH’s
present, or represented by proxy. The effect of this rule
is to treat an abstention, though present, as a vote of
-e.g.: Let’s say SH’s want the company to dissolve. 90 SH
come to a meeting and form a quorum. The results of the
votes are: 40Y, 30N, 20 abstentions. What’s the result?
**In New York: the resolution passes
**In Delaware: the resolution doesn’t pass b/c the 20 votes
are added to the 30N.
*Exception to General Core voting Rule:
1. Vote for directors are by plurality????????????????????????
2. Extraordinary matters: depending on how important the
issue is, sometimes unanimity is required, or an affirmative
3. The Corporation could provide for a high vote requirement
in a COI.
4. 5 Special situations:
a. Written Consent required of unanimity of SH who can’t
be present at a voting meeting.??????????????? But New York
and Del. now authorize written SH consent that’s less than
unanimous if signed by enough SH with minimum # of votes.
b. Varying the 1 vote per share rule: non-voting shares
or weighted voting is allowed, but must do so in the COI
c. Hand over voting rights to your debtor, e.g, a bank.
Courts are split on this. **In New York and Del. you must
do so in the COI.
d. Cumulative voting, see p. 306: This only applies to Director
Elections. Usually the rule requires a plurality of voting,
i.e., one vote per share per vacancy, and must be in the
COI. The reason for Cumulative voting is to allow minority
SH to get some representation on the BOD. How does this
The total Number or Shares the Minority SH must cast together
in order to elect the # of Directors desired =
S (# of all shares to be voted by minority) x D (# of Directors
desired to be elected)
N (# of total Directors to be elected) +1
1000 outstanding voting shares x 1 Director the minority
wish to elect
4 vacancies + 1
equals 201 total voting shares required by minorities to
elect their 1 director in a board of 4.
HOW DO YOU FRUSTRATE CUMULATIVE VOTING TACTICS?
a. Reduce the size of the board
b. Use Committees to achieve results: the BOD can delegate
authority to committees???????????
c. Classify BOD as having 2 different meanings: Classify
some directors as having staggered length of terms, but
in New York, there’s a maximum of 4 different classes.
**In New York, if the Directors aren’t classified, then
each one serves one year until the next meeting.
d. Classify the BOD in terms of Stock Classifications: that
is, the BOD provides X # of slots for certain classes of
e. Class voting: 1. OPTIONAL: Put provision in the COI that
requires separate voting of separate classes of SH on some
matters or all matters
2. MANDATORY: State statute usually provides that any amendment
to the COI which adversely impacts fundamental rights of
a particular class must receive the consent of the affirmative
majority of outstanding shares of that class, even if that
class doesn’t have voting rights.
-e.g., an example of this situation is: if the majority
SH alters conversion rights & this adversely affects
voteless SH’s, or if subordinate class of SH are not offered
the opportunity to buy preferred stock that is offered to
-see Teamsters v. Flemming, and Datacom: The issue here
was how to resolve a conflict between SH adopted bylaws
where they’re drafted intentionally to give management power
over them. This creates anti-central management. What if
SH put this in the bylaw, but the COI says that the BOD
has no power to amend the bylaws? Flemming says that the
SH proposed and won a bylaw amendment because he first got
the majority vote of the voting SH. Absent an express provision
in a statute, then amendments to bylaw allowed. ??????????????????
-Datacom:a pension manager proposed a bylaw amendment to
prohibit the corporation from repricing SH options without
board approval. ?????????????????????????
Shareholder’s DISSENT & APPRAISAL
This is a right of a SH under certain specific circumstances
to dissent from an extraordinary act and obtain FAIR VALUE
for his shares in cash. (NOT FAIR MARKET VALUE).
HISTORY: Some extraordinary acts require unanimity of SH
vote. Overtime, it was viewed as unfair tot he majority
votes if the minority holds out. SO, the rule relaxed, and
only required 2/3 majority of the SH vote. The minority
SH that didn’t vote in favour of the extraordinary act were
compensated by giving them a right to dissent, and appraisal,
and cash out their shares.
2 POLICIES: 1. There are some extraordinary corporate acts
which the majority wants, but so changes the minority SH’s
investment that we should allow them the option to trade
in their shares for this unfairness.
2. To deter unfair conduct by majority SH’s against the
Minority at critical junctures where it is most likely to
Triggering Events: “When do SH’s get appraisal rights?”
Each state statute lists different # of triggering events,
but New York lists 5: Sec. 623, 905, 907, 910, 806b, 1005a3.
Delaware only grants remedy in the event of a Merger &
1. Merger or Consolidation: Anytime one is proposed, grant
the dissenting SH a right to dissent and appraisal, EXCEPT:
a. In Short Form Mergers: When a Parent Company who owns
90% + of the target company, and the two companies merge
without a SH vote, grant the SH’s of Target Co. right to
dissent & appraisal.
b. When a SH of a surviving company falsely assumes that
in a merger, the surviving company is the big company and
the buying company. ???????????????
2. Compulsory Stock Exchange: Grant this remedy to the SH
of the Target Co. In a CSE, the Target SH vote on the acquisition,
and if they vote in favour of the deal, then they get cashed-out.
3. Merger or Amendment to COI which adversely affects fundamental
rights of SH
**In New York, fundamental rights are listed in Sec. 806b6:
e.g., dividend preferences, voting rights of a particular
class of Stocks
4. Dissolution, where Corporate Assets sold to another Corp.,
in exchange for Securities: Here, the buying company buys
the other corporation’s assets with securities of its company.
The dissenting SH of the Target Co. will thus be forced
to accept Stock for his shares instead of cash, so grant
5. Sale of All or Most of Firm’s Assets (Except where sale
is all for cash and cash will be distributed to SH’s)
III. HOW IS THE RIGHT ASSERTED?
-only Voting SH’s have a right to this remedy
-SH must NOT have voted for the action
-Pre-NOtification by Dissenting SH to Management required
(this is important because it gives the Majority an option
not to go through with the transaction if it’s going to
cost to much to compensate the Dissenting SH)
-Corporation must have made a written offer to the dissenting
SH promising to pay FAIR PRICE and Notifying them what they
think each share is worth, i.e. FAIR DEALING
IV. WHAT HAPPENS IF DISSENTING SH’S DISAGREE WITH “FAIR
All State Statutes allow Dissenting SH’s or Corporation
to institute an action which requires a Judge to determine
what the Fair Value is.
1. see N.Y. Sec. 623(h): grants the authority to JUDGE to
decide, without outside referral, what the fair value is.
2. Valuation Process: see p. 1105: Delaware Block Technique
(majority method): see p. 1139: Here, the judge establishes
a weighted average of 3 different values of close-corporations,
i.e. assets, earnings, and market value (actual or constructed).
You multiply each of these values by their designated weight,
and then add them together, and then divide by 3.
-**New York: (employs the Delaware Block Method)The Judge
who can’t refer out will make sure that each side hires
an expert, look at both sides’ reports, and then decide.
Comments on Valuation Techniques:
1. Trading Market Exception: Half the states follow Delaware
Sec. 262 that says that SH’s of publicly traded companies
lose their valuation right by the court because a Judge
shouldn’t have to assess the value of Stock that’s got a
-Other states never had this exclusion. New York adopts
Taking-Out exclusion, p. 738????
a. Instances of Market failure
b. Exclusion penalizes large block shares
c. Effect or proposed structural change may depress market
2. Factors Judge considers when he values shares: Should
the judge exclude elements of value arising from the transaction
-Delaware says don’t consider any factors
-**N.Y.: Judge shall consider elements arising out of the
underlying transaction, any increase or decrease in value
arising from the merger
-e.g., if SH objects to the merger, he shouldn’t benefit
from the increase in value of shares arising from the proposed
3. see McCloon case, p. 1145: Should a Judge discount the
value of the shares reflecting minority interests? Small
firm with value of $1000, 10 shares, each valued at $100.
The 3dp buyer wants to buy a controlling block of 6 shares
for $750. But if there’s only 2 shares available to be sold,
should their value/price be discounted because they carry
with them no control?
-some think the discount gives a windfall to the majority
*Pro-Rata Doctrine: The Court should assess the firm as
a whole and then pro-rate it per share
*Other views: -Judge should value shares according to minority
-Parties should be treated equally: if Minority gets favourable
treatment, then majority is mistreated
IS APPRAISAL REMEDY EXCLUSIVE?
If available, must the Minority SH take it, or can he choose
YES, but only if there’s FRAUD or ILLEGALITY!
FIDUCIARY DUTY OF SH: Do I, as a majority SH who’s been
offered a good price for my shares have a duty to disclose
this to you, minority SH? Would it matter if our firm is
1. SQUEEZE-OUT/CASH-OUT/FREEZE-OUT Merger:
A squeeze out is when the Majority SH’s want to get rid
of the Minority SH and the Majority do so by forming a new
company where they form the entire New Corp BOD. They then
propose a merger with the Old Corp where they’re the majority
SH’s to begin with. The Minority SH’s will then be cashed-out
at fair value.
-lots of litigation arises from this squeezeout technique
on the issue of UNFAIR TREATMENT to Minority SH.
a. Shirley Weinberger v. UOP, p. 1189: Signal bought majority
shares in publicly-held UOP and eventually wanted to buy
out the Minority SH’s. Signal did a study of the value of
the shares, and found their market value to be $24/per share.
Afterward, Signal proposed a merger, but only at $20-21/share,
which according to its investment bankers, was more than
Signal agreed to be bound by the Majority votes of the Minority
(Shifting the to prove unfairness).
1. Conflict of Interest: Majority Directors’ of UOP had
a clear conflict of interest with Minority SH where their
LOYALTY was in question. Because of this conflict of no
fair-dealing, the burden shifted back to Majority SH to
a. Fair-dealing: Must disclose the worth of the shares and
how much buyer willing to bid (here, Mjajority SH’s failure
to disclose the study was a breach of fiduciary duty).
*Footnote 7: It would’ve been a different story if the Majority
SH’s negotiated a price with the minority, and thus, there
would be no need to disclose???????//
b. Fair-Price: Technically, Sh’s remedy here was in appraisal,
but they brough an action in FRAUD instead and sought damages.
The Court here allowed the case to proceed as an exception
tot he Rule that the APPRAISAL REMEDY IS EXCLUSIVE. The
Court values the shares the same way as in an appraisal
suit, and holds that the Delaware Block Method is not applicable.
2. RULE: SQUEEZEOUT IS ILLEGAL, unless Defendant shows
an “Independent Business Purpose” for doing so, i.e., some
business benefity aside from getting rid of the Minority.
This doctrine seemingly no longer applies because it became
1. Does this case make Squeezeout easier? It’s easier in
that D can justify it by merely showing an Independent Biz
Purpose. It’s harder in that it’s more expensive now that
breach of fiduciary duty can add damages in addition to
cashing out Minority.
2. If the Majority is willing to pay a higher price, they
must disclose this.
3. This case holding generated a lot of litigation on dissent
4. Most Courts follow Weinberger, including N.Y.
*Independent Biz Purpose:
Alpert case, pp. 1208
There was a Close-COrporation which owned an apartment building
in N.Y. 2/3 of the shares were owned by a couple, and 25%
by Alpert. The contract required any bidding company offer
the same price to Minority as it did to Majority. A Classic
squeezeout merger followed. But instead of the Minorty suing
for appraisal remedy, it sued on Illegality and Fraud of
HELD: Squeeze out was fine b/c D showed an independent biz
purpose, and there was no breach of fiduciary duty because
D sufficiently proved fair dealing and fair price.
Rule: 4-Prong Review: 1. Whether there was illegality or
2. Was the a Fair deal?
3. Was there a Fair price?
4. Did D show an independent biz purpose
1. Weinberger & Alpert show that a Minority SH can sue
for damages if she shows FRAUD or ILLEGALITY, in addition
to getting $ from being cashed-out
2. If there’s a Conflict of Interest then Burden shifts
3. Shallowness of opinion writing in New York, in the last
CONCLUSION of APPRAISAL:
1. see p. 1137: it reconciles interests of Majority &
interests of Minority 1. Drains corporate funds
2. Infra-Marginality: some investors put hiehr value on
shares than market price. If so, appraisal honours this
value 2. Courts over-value shares of dissenting SH
3. Good Measuring Mgmt: to preven managment from profitting.
Triggering events are configured to come up whenever the
Majority SH may be tempted to take over 3. Chicagoans think
it’s an obseesion with 19th property rights. Risks of the
merger are balanced by another risk in other companies.
Therefore, SH shouldn’t be compensated for taking such risks
because they will then be overcompensated
4. Subjective process of which trigger are rational????????
5. Counter-Majoritarian: this penalizes the majority for
having their way
6. Creates incentive for Minority to seek appraisal remedy
CHAPTER 6 Close-Corporations
I. How do you ALLOCATE CONTROL?
II. Deadlock & Dissolution problems, Corporate paralysis!
III. Freezeout and Freezein problem
IV. Fiduciary Duty
IV. FIDUCIARY DUTY:
#1. -HARD-CORE/RADICAL EQUALITY Fiduciary Duty, see Donahue
case, p. 391: Rod was owner of Closed Corp and wanted to
retire. So, he distributed shares to children, but he kept
control. The kids voted to repurchase Rod’s shares, but
did not offer the same price per share to SH Donahue. The
low-balled him. Donahue sued.
HELD: In a close-corporation, if the corporation repurchases
shares from the Majority SH, it must offer the same price
to the minority, affording them a chance to sell their shares
back. Radical Equality treatment is owed to Minority SH,
regardless of balancing other factors, and regardless of
the fact Close-Corporations ARE NOT LIKE Partnerships.
-Court distinguishes General Partnership v. Close-Corporations:
CC are like incorporated partnerships in that there are
few investors, no liquid markets for SH’s shares, and most
investors actively participate in running the business.
So since this is so much like a Partnership, then let’s
use its law and enforce FIDUCIARY DUTY rule of EQUAL TREATMENT
-It’s not fair for corporation to treat Rod favourably by
creating a liquid market for his majority shares.
-Court ignores however, that the Fiduciary Duty owed b/w
partners in a partnership is so important b/c any one partner
can bind the other partners to unlimited liability. It’s
evident that the court uses the Fiduciary Duty doctrine
#2: CHICAGOAN THEORY: Fiduciary Duty is based on Contractarian
approach, i.e. the court should enforce whatever the parties
originally agreed upon. If the matter is about s/t not contracted,
then the court should figure out what the parties would
have done had they thought of it.
3: NEW YORK Rule: Schwartz v. Marrion, p. 399: Generally,
when directors in a close corporation treats a particular
group more favourably (conflict of interest), it establishes
prima facie breach of fiduciary duty. AND, the burden of
proof shifts to the favoured group to prove:
1. Independent Bona fied Legal purposes for the inequality,
2. the Purpose couldn’t be achieved by any less unequal
#4: Alpert case: You can squeeze-out the Minority SH if
Majority proves independent business purpose but there’s
I. ALLOCATING CONTROL:
7 Ways of doing this: 1. Voting Agreement
2. Voting Trust
3. Classifying Stock
4. SH Management Agreements
5. Super Majority Provisions
6. Transfer of Stock Restriction
1. VOTING AGREEMENT: An agreement between all or some of
the SH on how they’re going to vote, but no transfer of
a. Specific Voting Agreement: An agreement to vote our shares
for each other for director positions, for life
b. General Voting Agreement: An agreement to vote our shares
all together, for whomever
-These agreements are valid and will be specifically enforced
by the Court
-see Ringling Brothers, General Voting Agreement was held
valid, but the Court refused to enforce because it because
of a technicality: There was no specific provision on enforcement
or on how shares should be voted (?), and there was no signed
proxy given here in which the SH gave to someone else the
authority to vote their share. (Today, this case would have
come out differently. Courts would abide by Statute and
enforce a written and signed agreement).
2. VOTING TRUST: p. 418, this agreement entails the Owner
to transfer his shares and for a specific period to a Trustee,
thereby creating a legal relationship, and the Trustee becomes
RECORD SH with LEGAL TITLE entitled to voting rights of
the shares, such that TRUSTEE can vote as he wishes, but
the Trustee issues back to the Owner the right to dividends.
Voting Trust v. Voting Agreement: PRO of Voting Agreement:
Court will recognize a signed Voting Agreement, and it will
be specifically enforced. PRO of Voting Trust: if the Voting
Trust is breached, the BURDEN SHIFTS to Breacher (majority
SH) to show ???????
-Most states govern VA and VT by statute, generally requiring:
transfer of stock to Trustee, Trustee has voting rights,
VT exists for limited duration, and some type of publicity
-see Abercrombie v. Davies, p. 421: ...
3. CLASSIFYING STOCK: You can create separate classes of
shares which would reallocate voting rights, including a
class of non-voting shares, or preferred stocks (right to
first get paid dividends or assets), class voting, or specific
class voting, weighted voting.
**Corporate Norm: This norm must be maintained in any such
agreements, otherwise the agreement will be held invalid
4. SHAREHOLDER MANAGEMENT AGREEMENTS:
What happens when the managers don’t comply with State Statutes
governing this agreement? See 4 N.Y. cases on the Corporate
a. Manson v. Curtis, P and D each owned 21% but P allowed
D to by another 21%. They signed a SH Management Agreement
that each of them would elect 3 Directors & Manson would
be left to run corporation himself for 1 year w/o interference
from BOD. D breached the K. P sued to enforce the agreement.
HELD: Agreement was held invalid because it INTERFERED WITH
CORPORATE NORM. “Can’t Sterilize the Board.”
b. McQuade v. Stoneham & McGraw, p. 425: D owned majority
share in the New York Giants. He sold of 2-3% blocks of
shares to McQuade & McGraw. But it was agreed, that
without their consent, no changes are to be made to salaries,
business policy, etc...
HELD: Invalid intrusion on Board’s policy
c. Clarke v. Dodge: P and D owned Close Corporation, where
P: owned 25% of the shares, and D owned 75%. P was the inventor
of a successful medicine, but refused to tell D the secret
formula. They signed a SH agreement where P promised to
tell D’s son the secret. P never did and D’s son sued:
HELD: This SH agreement was held valid
R.D.: all parties were a party to the agreement, and there
wasn’t a total sterilization of the board (only a slight
intrusion), and no damages...no one was hurt.
d. Longpark case, p. 432: SH agreement that gave full power
to one manager for 19 years.
HELD: Invalid sterilization of the board.
MODERN RULE: State Statues allow sterilization of the board
if it complies with the statute.
Common Rules: 1. SH can sterilize the board but it must
2. Must be in the COI
3. Only applicable to Close Corporations
4. The Stock Certificant must be legended in a conspicuous
way so to put one on notice of the SH agreement on the control
5. Any SH who agrees to this are deemed to inherit Director’s
Issue: What happens if the SH Agreement doesn’t comply with
-Some Court hold the SH agreement void
-Majority looks to Common Law, e.g. 4 N.Y. cases, asking
1. Whether there was substantial intrusion? and
2. Were all SH a party to the action?
V. SUPER MAJORITY PROVISION: Whether a closed corporation
can agree to put in super majority provisions in their COI
for Quorum or Voting requirements, at the SH meeting level
or Director Level?
Modern Rule: Most Statutes authorize high voting requirements
for all SH acts, including election of Directors.
**New York requires that the super majority provision be
in the COI, the Stock Certificate must be legended to put
buyers on notice.
**What happens if the Statute is not complied with?
Since Super Majority Clauses create a high risk of corporate
paralysis, Courts have held that strict compliance with
the Statutory requirements is necessary.
VI> RESTRICTING TRANSFERABILITY OF SHARES, p. 491
(This is like “Delectus Personi” no one can be made a partner
A. Consent Restraint: a provision that provides, “No SH
can transfer her shares without permission of the other
-Majority thinks this provision violates principle of alienability
of Corporate Directors.
-**New York: holds this provision valid, so long as you
add to the provision so to make it reasonable
B. Option Restraint: provides an option to the Corporation
or to other SH’s to PURCHASE the shares at a previously
agreed upon price, if any of the following happens: Cessation
of agency, Death, or proposed transfer
-se Allen v. Biltmore Tissue, p. 492
C. Right of First Refusal: This is most common. If a Sh
proposes to sell her shares to a 3dp, she must first offer
the shares to the corporation on the same conditions of
the deal with the 3dp.
-This provision, however, devalues the shares because eager
3dp will have to wait to see if the Corporation will buy
the shares or not. The 3dp may not be willing to pay such
a high price if that’s the case.
D. VALUATION, p. 502-04 (read)
I) Book Value
ii) Fixed Price to be revised periodically by SH. This is
not good b/c often Sh will forget to revalue the shares,
and if any of the triggers happen, like one’s death, then
the price per share will not reflect market value.
1. If there’s a restriction on transferability and we’re
dealing with stocks that are certificated, then a restriction
won’t bind a 3dp transferor, unless existence of a transfer
is legended in the stock certificate (3dp would then be
2. It’s now possible to have an uncertificated share (i.e.,
you don’t need a piece of paper to authenticate the fact
that you own shares)
-see NY Sec. 508: this authorizes a BOD to provide for uncertificated
shares: ownership of shares can be recorded ELECTRONICALLY.
The Statute demands the minimum requirements of a stock
certificate, and that the name of SH appear on the Stock
VII. MANDATORY SALE AGREEMENT:
This goes hand in hand with a Stock Transfer restriction,
but we just de-couple them. This agreement provides in a
corporate document that given a triggering event, the SH
must sell back to the corporation or another SH her share
at a pre-agreed price/formula
-e.g.’s of triggering events: death of SH
**the following 2 cases are troubling in their lack of
discussion of Fiduciary Duty:
-see Ingle v. Glanmore Motor Sales, p. 504: A longtime SH/EE
owned one quarter of the company’s stock, and in there was
a mandatory sale agreement that said that if EE stopped
being an employee, then he must sell his shares back at
a pre-agreed price (which was incredibly low..) Unfortunately,
there was no employment K, and ER took advantage of this
to get the shares of the company back at a low price.
ISSUE: Was the transfer restriction valid?
HELD: Court didn’t address a breach of Fiduciary Duty here,
but instead, talks about the nature of at-will employment.
The court’s lack of discussion of breach of F.D. is troubling.
-see Gallagher v. Lambert: There was a Mandatory Sale Agreement
where if a SH/EE was terminated before a specified date,
then the corporation is obligated to buy back all his shares
at BOOK VALUE. But, if the EE/SH is terminated after the
specified date, then corporation will repurchase the shares
at a higher rate. Here, the Majority SH’s ganged up on EE
and fired him before the specified date.
HELD: No breach of Fiduciary Duty because of the nature
of at-will employment K’s.
**Why doesn’t the Court address the 4 New York cases? Does
at-will employment trump fiduciary duty?
Schwartz v. Marrion (New York Rule): this is the lead case:
There is a SH fiduciary duty owed by Majority SH’s to treat
minority SH’s equally, unless Majority proves:
1. Independent Business purpose, or
2. No other remedial measure was possible
Alpert case: It’s OK to Squeezeout the Minority if the Majority
1. Independent Business purpose
(2. Alpert is silent on Schwartz v. Marrion’s 2d prong)
-Jordan v. Duff & Phelps (7th Cir.): There was a Mandatory
Sale provision. In this case, EE/SH wanted to quite and
gave notice of this, but little did they know that the Majority
SH’s were negotiating with another firm that wanted to buy
them. This would have had the effect of increasing the value
of the company’s shares. HELD: The Control Group and the
Corporation breached its fiduciary duty to inform the Minority
of the pending sale.
SQUEEZEOUT & DEADLOCKS, p. 453
What happens when things just don’t go well and the majority
still wants to squeeze out the minority, or the 2 factions
1. FIDUCIARY DUTY OF Shareholders: this doctrine applies
if the minority has been mistreated.
-see DONAHUE case (Massachusetts): “RADICAL EQUALITY” theory
to Fiduciary Duty:
There must be across-the-board breach of fiduciary duty,
without considering a balance of interests, if Majority
mistreats the minority SH’s by offering them a lower price
than which the remainder of shares were sold.
-see WILKES case (Massachusetts): retracts the RADICAL EQUALITY
position in Donahue. Here, the Majority SH’s squeezed out
the minority SH and refused to pay him dividends, no job,
HELD: Majority is liable because they failed to bare its
burden, i.e. When Minority SH’s prove unfairness, the burden
shifts to Majority to prove Independent Business Purpose.
Dicta: If Majority bore its burden, the burden shifts back
to Minority to show there could have been less harsh remedial
-see MAROLA case (Massachusetts): HARD-CORE RADICAL EQUALITY
is not the rule in Mass anymore!
*******DO MINORITY SH’s OWE DUTY TO MAJORITY?
-see Smith v. Atlantic Properties, p. 460: Dr. Wolfson bought
property and demanded that a Super-Majority Clause be inserted
in his SH agreement with 3 other partners (this essentially
means that 3 people are required to vote one way in order
for any decisions to be made. This also means that any one
person has veto power???????). Mr. Wolfson actually exercised
his veto power when a dispute arose over how to spend accumulated
earnings. He qualified his actions by saying that it was
against his economic interests. 3 partners sued Wolfson
for breach of fiduciary duty as a Minority SH.
HELD: in favour of 3 partners
R.D.: This case was qualitatively different from other breach
of SH duty cases where there’s a Freezeout or severance
of SH/EE employment.
Nixon v. Blackwell, p. 467
This is a good summary of Fiduciary Duty
This is interpreted to mean a rejection of the fiduciary
duty doctrine in Schwartz v. Marrion
The Founder of a company created 2 classes of stock with
no economic difference. Class A had all the voting rights
to elect Directors, and all these shares went to Employees
and the BOD (the BOD owned 48% of these shares). Class B
shares had no voting rights, and most of them went to families.
Class B SH sued because there was no liquid market for their
shares. Class A shares had a market because they could be
resold to family, and there was a fund in the Company that
could be used to buy back Class A shares. So, Class B SH
sued Majority for breach of fiduciary duty in that Majority
only created a liquid market for their shares.
HELD: There’s a conflict of interest here. When there’s
a Conflict of Interest, the burden of proof of unfairness
first goes to the party claiming breach of F.D., and Plaintiffs
sufficiently did this. (Weinberger-like analysis)
R.D.: Reject he RADICAL EQUALITY doctrine of Donahue, and
the BALANCING test of Schwartz, and Wilkes.
Issue: What do you do if our advanced planning techniques
don’t work out?
I. Fiduciary Duty
II. Provisional Directors
V. Dissolution: a. Non-Judicial
VI. Heatherington & Dooley
I. FIDUCIARY DUTY: see Wilkes and Smith case
II. PROVISIONAL DIRECTORS: (p. 524) About 20 states’ statutes
say, “especially in a deadlock situation, grant authority
to the Court to appoint someone who’ll be provisional director
to save the business, on a temporary basis, like 6 mos.”
-**New York doesn’t have this statute, but Del Sec. 353
III. CUSTODIAN/RECEIVER: in about 27 states, “put all decision
making power in the hands of custodian/receiver so that
the business can continue while parties work out their dispute,
such as resolving to dissolve, or buy-out minority SH”
-**New York doesn’t have this statute, but Del. Sec. 226
IV. ARBITRATION: this provision should be inserted in COI,
during the planning process, and not when the deadlock or
squeeze out occurs. New York is the leader in this: “A written
K to submit any controversy to arbitration is enforceable
without regard to the justiciable nature of the controversy.
So, even though business decisions can’t be heard by a judge,
so long as the arbitration clause is inserted in the COI,
then the judge can enforce it.
-see Vogel case, p. 552: two SH had a moving business. One
of the SH wanted to buy the warehouse in which they operated,
but the other SH dissented. Dispute arose, and they submitted
this controversy to the Court to resolve. The Court saw
that their COI has an arbitration provision, and held that
their SH agreement was valid. ???????\
V. DISSOLUTION: a. Non-Judicial/Voluntary
i) N.Y.B.C.L. Sec. 1001: “for there to be a dissolution,
it must be authorized by the majority of outstanding SH.”
-**New York is unique in that every other State requires
board action and then a separate vote of the majority of
outstanding SH. New York, however, only requires SH to initiate/vote
on the matter.
ii) N.Y.B.C.L. Sec. 1002, Del. Sec. 355: where a party is
not satisfied with a dissolution as a remedy per Sec. 1002,
a provision must be inserted in the COI only authorizing
that any other arrangement ??????????
-**New York also requires that this provision be LEGENDED
-Voluntary dissolution’s are rarely used because it could
be so destabilizing if any SH could force dissolution
1. Mechanics of Voluntary Dissolution: every State statute
says what procedure to take to dissolve a firm that is very
similar to the instructions on how to form a corporation,
e.g. think of a name, file at office, sign-off by relevant
state tax authority, internal file certificate of dissolution).
At the moment the certificate of dissolution is filed, the
corporation is dissolve. HOWEVER, the corporation still
exists for the purpose of paying off creditors, etc.
2. How to take care of Creditors? SPECIFIC NOTICE of the
intent to dissolve must be given to creditors that are known,
i.e. send notice by certified mail. CONSTRUCTIVE NOTICE
can be given to unknown or contingent creditors, e.g. publication
in newspaper however many times as required.
-**New York Sec. 1008: A lot of states have similar statutes
to provide a remedy to creditors’ whose claims aren’t settled,
or who weren’t given proper notice. Sec. 1008 allows the
Judge to ANNUL to dissolution, and virtually bring the corporation
back to life for the purpose of allowing creditors to sue
b. Judicial/Involuntary Dissolution
In N.Y. Art 11, there are 5 types of judicial proceedings,
the 5th is most discussed.
1. Attorney-General: A-G will take action when there’s persistent
fraud, or failure to pay taxes, etc.
2. BOD: may dissolve on grounds of insolvency, or dissolution
would be beneficial to SH
3. Shareholders: may get a majority of the voting shares
to bring petition to dissolve
4. Deadlock Petition: General Rule: SH of at least on-half
of voting shares can bring a petition based on a deadlock,
e.g. BOD can’t make a decision, or SH deadlocked in electing
new Director(s), or overwhelming internal dissension
5. New type of Dissolution: Scenario: If a Minority SH has
been mistreated, Dissolution remedy doesn’t help her much
because it requires an affirmative majority of outstanding
SH to dissolve voluntarily, or Majority of Board or SH in
the case of an involuntary dissolution.
-So, N.Y. Sec. 1104-A and 1118 provides new remedy: 1104-A:
provides that SH of 20% or more of voting shares, so long
as Corporation is not listed or quoted, i.e. a “Closed Corporation”,
can petition the court for Dissolution on either of 2 grounds:
-1. Directors or Control Group are “guilty of ILLEGAL, FRAUDULENT,
or OPPRESSIVE conduct toward complaining SH.
2. Directors or Control Group are guilty of LOOTING, WASTING,
DILUTING, or REUSING Corporate assets.
**Note: There is a perception that Sec. 1118 will be abused,
and to be fair to the Majority, there is a Buy Out Election
right to the Majority that must be exercised within 90 days
of the petition being filed. The Non-petitioning SH can
exercise this option by going to Court to offer to Buy Out
the Minority dissenting SH at Fair Value. If there’s a disagreement
on fair value, then the court decides.
1. Could the Court order a buy-out? No, it’s an election
by the Majority SH.
2. Once election is made it is IRREVOCABLE
3. see Pace Photographer case, p. 550: There’s a Closed
Corporation with a SH agreement stating that no Sh could
transfer shares, exception under the OPTION for a Majority
Control Group SH to buy out dissenting Minority SH. There
was an argument between SH and the minority SH petitioned
the court to dissolve.
ISSUE: Is the Court bound to find Fair Value as in the Restriction
in Transfer of Shares provision in their SH agreement? HELD:
No. Court is not bound by the cheap formula in the SH agreement.
4. What is Oppression? 5 definitions:
a. Scottish Co-op case, p. 538: “Oppression is a departure
from fair dealing.”
b. current English Statute, Sec. 73: “conduct that is unfairly
prejudicial to SH’s”
c. White v. Perkins, p. 534: White was the majority SH engaged
in malicious acts against Minority (reneged on a K where
he was going to lease a Gas Station to the CC). He refused
to make dividend payments; caused their CC to make loans
to another corp solely owned by White; and packed the Board
of Directors with his people, and fired Perkins. HELD: all
conduct together equaled a Classic Squeezeout & this
is oppression under VA Statute.
-Oppression can be found without finding illegality
-If the fact pattern involves a Squeezeout, then most likely
d. Professor Clarke approach: “We ought to interpret oppression
in the same way we interpret SH Fiduciary Duty, i.e. a particular
kind of conduct warrants finding of breach of Fiduciary
Duty, i.e. Oppression. Two types of such conduct are:
I) Self-dealing (diverting funds into SH’s own pocket)
ii) Classic Squeeze-out moves: like Wilkes and White cases..
*e. O’Neal Approach, p. 536: Most popular definition: “Courts
should interpret Oppression to mean the reasonable expectation
of the minority complaining SH back on day one, when SH’s
entered into their SH agreement.”
-See Kemp & Beatey, p. 529: 2 Longterm Ees in a Closed
Corporation were about to retire. The custom in the CC was
to buy out the retiring Ees at Fair Value, and in regard
to SH/EE, instead of paying them year end dividends, they
get cash bonuses. This leaves SH/EE to hold their shares.
However, right before the 2 Ees were about to retire, the
CC changed their policy and was willing to pay only contributing
EE/SH, based on their contribution. Ps’ brought action against
the CC claiming Oppression.
HELD: Such change in the CC’s policy is Oppressive. The
Ct. adopted Professor O’Neal’s definition, i.e. what was
the EE’s reasonable expectation when they entered the SH
OBJECTIVE TEST OF REASONABLENESS OF Expectations: expectations
must be reasonable, and they must have been communicated
on day one.
*Query: p. 534: The Court found oppression, and before it
was going to grant oppressed Minority SH/EE’s petition to
dissolve, the Ct. gave any SH the opportunity to buy up
Minority SH’s shares at Fair Value. (Is this the correct
interpretation of the statute’s explicit provision “within
90 days” of petition filed?
1. Does it make a difference whether Court uses Reasonable
Expectation test, or the SH fiduciary duty?
2. Can right to bring right to petition for dissolution
be waived? NO, against public policy.
3. Common Law Dissolution: On a case-by-case basis, the
Court grants dissolution if it finds bad faith on the part
of the Majority SH.
-What is the significance of the Statute then if there’s
a common law remedy? Not sure. New York Lower Courts say
that dissolution is still available if 5% of the Oppressed
Minority SH bring petition for dissolution. However, Buy-Out
option is not available to Majority.
4. See p. 528.
VI. HEATHERINGTON & DOOLEY, p528 H & D did a survey
and concluded that there are many competing values, e.g.:
a. Desire of SH to get out of the biz and just get $
b. Judges don’t like to dissolve Corporations, esp. if a
c. The Minority SH should not be given an incentive to unfairly
impede the Majority’s right to buy them out by petitioning
Therefore, H & D concluded that it’s given these discrepancies,
an Automatic Buy-out right should be afforded to Majority
SH, i.e. “any Minority SH has a right to require the Majority
SH to buy him out at Fair Value. After giving notice of
this intent, and if parties disagree to the Fair Value,
the Court will decide the it. However, If the Majority agrees
to the buy-out, then the Court will enforce it. Further,
if Majority refuses to Minority’s election to be bought
out, Ct will compel dissolution.
-PROS: This is very common, i.e. no one wants to dissolve,
and they typically negotiate a buy-out. If this is so, why
not just call it what H & D call it, i.e., an “automatic
CONS: This gives Minority way too much power to compel dissolution
or compel Majority to by them out, regardless of whether
he’s suffered any injury. This is also very expensive. Additionally,
On Day 1, the Corporation will have to commit enough capital
to pay for an automatic buy-out/or dissolution, and can
be very destabilizing to a corporation.
no more Closed Corporations!
II. Core Rules
III. Filing Requirement
IV. Content of Proxy Statement
V. Annual Report & Rules
VI. Form of Proxy
VII. Shareholder’s Communication Rules
INTRODUCTION TO SECURITIES LAW:
-We are now dealing with no longer State Corporation statutes,
but rather Fed Securities regulations
The underlying premises are:
1. There’s a perception in Congress & Nationally that
State securities offerings (rules requiring corporations
to disclose information about their securities) were inadequate,
so Fed Securities Regulations were enacted.
2. “PUBLIC GOODS THEORY”: “Free markets can’t compel people
to produce PUBLIC GOODS because they’re made available to
the public (for free/relatively cheap) and thus, one is
going to pay for them. For example, no one is going to pay
for the use of a public park. Therefore, a producer of public
goods will be deterred from producing public goods, so in
order to regulate this market, some type of intervention
into State laws is required.
3. Goal of Securities Law is to promote truthful disclosure
THREE DIFFERENT FEDERAL SECURITIES Statutes: (4 are technical):
1. Securities Act of 1933: aims at FULL, COMPLETE, and TRUTHFUL
disclosure when Issuer/Company wants to offer/sell securities
to the public, i.e. what’s the company about, the employees,
how the company has been doing, info about the securities
-REGISTRATION STATEMENT: this is a huge hunk of paper which
is the vehicle in which the company discloses information,
including a PROSPECTUS (formal document of the company’s
-Must file with the SEC for review for DISCLOSURE purposes
only (to review its completeness, only) and not for review
of the report’s merit
SEC declares whether the report is EFFECTIVE, and thereafter,
the Company can then sell securities
But, Company must first DELIVER prospectus TO POTENTIAL
BUYERS before it can start to sell securities
Securities Exempt from these requirements:
a. based on NATURE of ISSUER: e.g., US Government Treasury
Bond Market, Banks
b. based on NATURE of TRANSACTION: e.g., if the offering
is to a targeted small group, and not the general public,
then exempt from REGISTRATION statement b/c it would be
a matter of intra-state offerings which is a State concern,
2. SEC Act of 1934: a. Proxy System
b. Securities Fraud
The initial focus of the 1934 Act was Market Regulation,
so to give SEC the authority to regulate trading markets,
e.g. on exchanges to prevent fraud or manipulation
Today, the focus is much larger and also prohibits &
creates remedies for Securities Fraud, to regulate proxy
voting system, and regulate flow of corporate information;
and disclosure to markets & investors & SH’s by:
-PERIODIC DISCLOSURE/CONTINUOUS DISCLOSURE system: p. 328-29:
This requires companies covered under this rule, i.e. those
required to report, to make periodic filings of updated
information with the SEC so to make it available to the
public. The kinds of reports are:
a. ANNUAL REPORT, or Form 10 K: This is filed with the SEC,
and is not the annual Glossy. It’s like a lawyer’s document
and is long. The contents are: what biz it’s in, story of
the company, especially what happened in the last year,
certified audit statements, and Management and Discussion
b. Form 10 Q: Quarterly filing, i.e. a summary of the last
quarter’s activities, but these documents may be unaudited,
and may include just material changes
c. Form 8K: This must be filed if any of the triggers listed
in the form itself occur. Some of the trigger include: filing
for Bankruptcy, change in accountants, resignation of director,
change in control, or merger
a. PROXY SYSTEM: in connection with soliciting votes, and
State statutes and Fed rules governing it
-3 Definitions of Proxy: a. Relationship between SH and
person to whom SH gives her authority to vote her shares.
This is like an agency relationship.
b. Describes a person himself
c. Describes the piece of paper evidencing the proxy relationship,
HISTORY: As the society grew, small town meetings no longer
sufficed as all interested parties couldn’t be present in
one meeting. Therefore, Proxy system resulted, which essentially
is like an absentee ballot.
The Proxy system is very important to corporate lawyers,
e.g. how to elect directors, and it tries to find a way
in which a SH can participate in governance of the corporation.
Proxy System is also a vehicle for SH to initiate an action
& propose action to another SH. It also provides a way
to get control of public corporation cheaply: the Control
person can ask other SH to throw out bad director so that
they all can govern the corporation. PROXY CONTEST: is a
way to get control of the board, and is required to wage
a successful hostile takeover. The TENDER OFFER is a bidder
offering consideration, usually gives cash to the target
company. However, it is now a good thing.
Where a company has a Poison Pill (device making it expensive
to takeover the corporation), it can be revoked by the BOD.
But, if I’m a SH and the BOD won’t revoke the poison pill,
I may start a Proxy Contest so to ask other SH’s to throw
out the current board
Anti-Takeover Legislation: May State statutes have legislation
that makes it difficult for a corporation to be taken over
against the wishes of the BOD. **But, such legislation can
Opt-Out: If a target company resists the buying SH’s attempt
to buy them out, the SH can then wage a proxy contest to
replace the BOD with their people. Once the BOD is staffed
with their people, they will then “opt-out” of the anti-hostile
takeover statute, in effect, allowing the SH’s to complete
their takeover of the target company.
Proxy Regulations, e.g. N.Y. Sec. 609, Del. Sec. 212, Model
-Mandatory usage, i.e. Corp must recognize a valid proxy
-Proxy is effective if in a signed writing
-Proxy only has a limited lifetime, e.g. 11mos.
-General Rule: Proxies are revocable at will by SH who gave
it. SH must revoke in writing, or can merely assign proxy
to someone else, or can just show up at the Directors meeting
-Exceptions to irrevocability????: 1. If the proxy is given
a valid voting agreement?????????????
2. Proxy can be given where the corporate books show that
as of record date, SH1 is the purchaser of the shares, but
in reality, the day after record date, SH1 sold shares to
Sh2. SH2 must insist on this.
System of Proxy: PROXY RULES: Sec. 14-A, p. 1394: This
is where Congress gave the SEC broad power to make it illegal
for anyone to solicit a proxy in violation of these rules.
I. Scope: Rule 14-A: “Anyone who uses interstate commerce
and solicits a proxy with respect to a security that is
registered under the 1934 Act must comply with these proxy
1. What is a “Proxy?”
See Rule 14-A-1: “Any consent or authorization similar to
agency doctrine, with respect to voting shares.
2. What is a “Solicitation?”
See 1934 Act, Sec. 3, and p. 331: “Includes any communication
reasonably calculated to result in procurement of a proxy,
oral or written, and any solicitation I make or management
-see Studebaker case
-Excluded Solicitations under 14-A-1: routine SH communications
and reports; solicitations by public speech
3. What companies have to register their securities?
a. See Sec. 12-A of 1934 Act: any company that has its own
security traded on any national exchange, and can be preferred
stock, or common stock...
b. See Sec. 12-G, and 12-G-1: any company that meets the
following 2 tests:
1. Total assets > $10 million
2. its equity stock held of record by 500 or more people
-Excluded Solicitations under 14-A-2:
a. Management solicitations of 10 or fewer persons, e.g.
if Mgmt arranges a meeting with 10 of the largest SH to
see if they’ll vote their way, so to survey whether it’s
worth it to wage a proxy contest
b. Sec. 15-a-2-b-1: any person who does not seek a proxy
and does not furnish a proxy, and who is disinterested in
the specific vote. This frees up the institutions to take
to each other, and solicit w/o fear of being sued.
II. CORE RULE
see p. 332: Sec. 14-A-2: If I’m a covered corporation according
to these SEC rules, it is impermissible to solicit a proxy
without first giving the person we wish to solicit a PROXY
STATEMENT which contains: all the info required under Schedule
14-A. However, now it is OK to use a Preliminary Proxy Statement
b/c a final proxy statement may take too long to get since
it involves haggling with the SEC
III. FILING REQUIREMENT
see Rule 14-A-6: pre-filing is only required of the Proxy
Statement, and Proxy Card
-the SEC doesn’t have the power to forbid you to disclose
your proxy statement if you disagree with their comments
IV. CONTENT OF PROXY STATEMENT:
-see Schedule 14-A, p. 1418: 22 items of disclosure requirements.
The first 6 items and Item 21 are always required, e.g.,
time of meeting, appraisal rights, info on solicitor, info
on my interest in soliciting, description of voting securities,
description of voting rules. The remaining items are transaction
specific, e.g. f there’s a merger, then Item 14 requires
V. ANAL REPORT RULE, or “The Glossy”
For decades the SEC was troubled with Form 10-K disclosure
requirements because no one read this document, only analysts
did. SEC looked at the other document corporations delivered
to Shs, i.e. the “Glossy” that contained little information
w/r to the info required under disclosure requirements of
the Form 10-K. SO, the SEC tried to include all the info
in the Form-10-K “ANAL” report by first, requiring that
all corporations send both the Glossy and the Anal report.
Since the SEC now had control of this, it was then able
to control the content of the sent documents. So, they required
corporations to Glossy to include certain information contained
in ANALYST report.
VI. FORM OF PROXY ITSELF:
See Rule 14-A-4: the Proxy Card must indicate in bold on
the top who is making the solicitation. It must also give
SH’ a choice on the issue, and there must indication of
how the solicitor intends to vote.
VII. Shareholder’s COMMUNICATIONS:
Rule 1: Rule 14-A-7: if issuer Company has either made or
is about to make solicitation at upcoming Director’s meeting,
then ANY Voting SH gets specific rights to do the same:
-e.g., if I as voting SH ask Management to tell me how many
Sh they’re soliciting, they must tell me promptly and also
estimate for me how much it’ll cost for me to do the same.
At that point, Management must make an election whether
to: a. do the mailing for me, or b. give me the SH list
(rare because Management wouldn’t want to disclose this
information and give me the opportunity to approach these
people on my own).
-SH bears these expenses
Rule 2: Rule 14-A-8: gives the SH the right to have his
own proposal included in CO’s solicitation of their proxy
-Company bears this expense!
-Eligibility: SH must own either 1% of outstanding shares,
or $2000 of such shares. Also, Sh must have owned these
shares for at least 1 year.
-Procedure: SH must give the Company reasonable notice of
his intention to include is his own proposal, and include
the text of argument, documents supporting his intention,
and some evidence of his eligibility.
-SH can only make one of these proposals per meeting, and
500 word limit
-Company can respond, no word limit
Can the Company exclude the SH’s proposal from their solicitations?
1. If PROPOSAL IS NOT A PROPER SUBJECT for SH action under
Federal law, e.g., SH proposes that management seek a merger
partner (this is manager’s prerogative). But, if you rephrase
your proposal to be a suggestion/recommendation then it
will be included
2. Yes, if the proposal is ILLEGAL
3. Proposal VIOLATES PROXY RULES: e.g., Rule 14-A-9 (Anti-fraud
Rule): if proposal is too vague…”I propose that the Company
shouldn’t spend its advertising funds on immoral behavior,
4. Proposal consists of SH’S PERSONAL GRIEVANCES: the proposal
merely benefits the SH, e.g. A former frustrated EE/SH proposes
to void entire current BOD
5. PROPOSAL IS TRIVIAL: If the proposal relates to less
than 5% of the company’s assets and sales, AND is otherwise
insignificant to the company’s operation
**Query: Must the proposal be “economically” related to
the company’s business, or can it also be “politically/socially”
-see Lovenheim v. Iroquois Brands: P was a SH in D’s company,
and also an animal lover who wanted to include in the Company’s
solicitations her proposal that the company should not buy
French Pate from the selling company that mistreats birds.
The BOD wanted to exclude the SH’s proposal b/c it related
to only a small percent of the company’s business.
HELD: proposal shall be included because it’s politically
6. PROPOSAL IS BEYOND THE COMPANY’S POWER TO EFFECTUATE
7. Proposal merely DEALS WITH ORDINARY BUSINESS CONDUCT
-see Phillip Morris: The SH proposal proposed that the company
should get out of the tobacco business. It was included
-see RJR Nabisco: The SH proposal proposed that the company
should separate from the tabacco business operation from
its general foods production. This was included
-see Crackerbarrel: The SH proposal proposed that the company
shouldn’t discriminate in employment based on sexual preferences.
The SEC held that it would review such cases on a case-by-case
8. PROPOSAL IS ABOUT DIRECTOR ELECTIONS: The decision of
picking directors is so important, SH’s should get full
disclosure on this issue??????????
9. Proposal is JUST A COUNTERPROPOSAL TO MANAGEMENT PROPOSAL:
This SH proposal will be excluded because it would have
already been voted on
10. Proposal CONCERNS SOMETHING THAT’S MOOT: If the SH’s
proposal contains matter that have already been substantially
11. Proposal is DUPLICATIVE of another proposal
12 Reproposal: If the SH deals with the SAME SUBJECT-MATTER
OF A PROPOSAL VOTED ON in the last 5 years, then it can
be excluded for 3 years from the time it was last voted
on, so long as when it was voted on, it didn’t get much
13. Proposal RELATES TO SPECIFIC AMOUNT OF $/DIVIDENDS:
Procedure to exclude proposal: If Management qualifies under
one of the above and is thus able to exclude the SH proposal,
it must: File with the SH proposer and the SEC certain documents
which include a copy of the proposal, a supporting statement,
Management’s reason for exclusion, and opinion of counsel
for its exclusion
IF the SEC agrees, does the SH have a remedy?
Yes, but the SH should sue the company, not the SEC, in
-see Rosewell and Wallmark case
Pros and Cons of PROXY RULES:
Cons: Expensive. All SH pay for the expenses of the on SH’s
proposal to be included if it’s eligible, and further, the
proposals rarely get implemented
-Chicagoan theory: Proxy rules impede attention to the market.
SH’s shouldn’t have to spend time and $ on this. IF SH’s
have a complaint, then just sell their shares.
Pros: After the vote, Management goes a long way to consider
the proposal anyway.
PROXY LITIGATION under RULE 14-A-9:
“Criminal Anti-Fraud Rule”
This rule penalizes false or material misrepresentations
of facts in the solicitation
5 ELEMENTS of a 14-A-9 Action:
Any SH has the right to bring suit?????
-See Virginia Bank Shares: Any VOTING SH has a right to
sue so long as the SEC can sue too.
-The Plaintiff can be: SEC, voting SH, Managers of Co.,
the Corporation itself
Suppose I’m a Sh in Corporation A and there a proposal
for merger at the BOD meeting. I’m convinced that the BOD
made false statements in its proposal to me. Do I alert
the SEC? Can I sue in a private action, or must it be through
-see **J.I.K. v. Borak, p237: Rule: SH can bring a private
action on behalf of the other SH
Facts: The proposal from the BOD did not adequately disclose
the fact that the Directors were manipulated with respect
to the merger activity.
HELD: 1. There is an implied cause of action for SH, not
just the SEC, and 2. There are many types of remedies, not
just prospective, or injunctive relief. It can include damages,
-Holding Criticized: There is no reference here to legislative
history, no mention that no where in the 1934 Act authorizes
a private cause of action for SH. This case seems to be
a result-oriented case.
-The Supreme Court however, clarifies that it won’t reexamine
whether the Act affords an implied cause of action to the
2. FALSE/MISLEADING STATEMENT or OMISSION
3. FALSITY or OMISSION RELATES TO A MATERIAL FACT
ISSUE No. 2: Whether the Misrepresentation or Omission was
RULE 1 (see TSC Industries v. Northway, p. 345:) Misrepresentation
or Omission is Material if a Reasonable SH “WOULD” (not
might) consider the fact important in deciding how to vote
(not that he’d change his vote, just only there be a substantial
likelihood he’d consider the fact important).
RULE 2: (see Virginia Bank Shares) the Misrepresentation
must NOT be one of merely opinion, but rather OPINION +
REASONS supporting the opinion (Director represents that
he thinks the merger would be good for the company, BECAUSE
4. CAUSATION--”Essential Link”
-see **Mills v. Electric: This case is often thought of
as an OMISSIONS case.
Facts: The SH’s claim that the company’s proxy statement
didn’t clearly state that . . .
In fact, the buying company had already 54% of the target
company’s assets. But the State Statute says that they need
at least a 66% share to complete the merger.
-ISSUE: CAUSATION (not omission)
-HELD: Causation is always a necessary element of the SH/plaintiff’s
case, see p. 341. But, the Court negates this requirement
of causation by stating: once the plaintiff in an omissions
case shows that the omission was material then the causation
requirement is satisfied. If the Proxy Statement as a WHOLE,
not the particular omitted fact, is an ESSENTIAL LINK in
the SH voting the way she did, then the SH has a cause of
-What is Causation?
But For causation?
Proximate Cause/substantial factor?
*3. Traditional Reliance or Transaction causation? Yes.
** Problem, though: If the case is an omissions case, then
how does the plaintiff/SH prove that she relied on something
she was never told?
4. see top half of p. 342: Once there’s a showing that the
omission was material, then there’s no need to show Reliance.
It’s enough that P shows that the proxy statement as a whole,
not specific defect, is a substantial link in SH voting
the way she did.
Rule: (Derived form the Mills case: even though the Mills
case refers to itself as an omissions case, subsequent cases,
such as TSE Industries--an Omissions case--, and Virginia
Bank Shares--a Misrepresentation case-- cite Mills as authority.
Once a P has shown that the misrepresentation or omission
was MATERIAL to the SH voting the way she did, then we’ll
dispense with her burden of showing RELIANCE. Now, the SH
only has to show that the PROXY STATEMENT as a WHOLE was
an “ESSENTIAL LINK” to her voting the way she did.
Harrington’s Conclusion of Mills case: Mills case applies
to both Misrepresentation and Omissions cases: CAUSATION
is an essential element in any action a SH brings in a proxy
litigation against the BOD, and therefore, we’ll dilute
the burden of proving causation ,but merely requiring a
showing that the misrepresentation/omission was MATERIAL.
NO need to show RELIANCE causation anymore. Instead, the
SH will prevail so long as she shows that the PROXY STATEMENT
as a WHOLE, not the mere fact in consequence, was an ESSENTIAL
LINK for the SH to vote the way she did.
ISSUE No. 1: What if the Company alone had enough votes
to complete the merger and yet it also makes a misrepresentation
in its solicitation to the SH?
-see Cole v. Schendley: This 2d Cir. case: the Parent Co.
already had 84% of the shares in the target Co. and told
the SH they could vote, but the majority of the SH would
vote in favour of the merger. A SH sued trying to enjoin
the Merger, and claiming that the BOD made a false statement
of material fact.
HELD: TRANSACTIONAL CAUSATION sufficiently shown in a proxy
statement so that SH would prevail.
R.D.: 1. If the BOD had told the truth, the Minority SH
could have had an APPRAISAL remedy
2. Minority SH could have also threatened an appraisal
3. They, could have got an injunction
-see Virginia Bank Shares: The parent co. FABV already
had 85% of the shares to guarantee them a merger. The Minority
SH votes weren’t needed to complete the merger. All the
SH’s voted, but the majority SH’s agreed to be bound by
the majority of the minority SH vote (so to free themselves
of liability for conflict in interests). Plaintiff/SH withheld
her proxy, and didn’t vote, and sued claiming that the directors
of FABV misrepresented their beliefs by stating that their
SH should vote in favour of a merger b/c the price of the
shares would increase.
ISSUES: 1. Causation: Whether the proxy statement, as a
whole, was an essential link in procuring SH’s vote?
HELD: NO. Ct. interpreted Essential Link doctrine literally:
R.D.: a. The Minority SH vote wasn’t legally necessary,
so they didn’t have a cause of action.
b. The right of the SH to bring a private action is merely
implied in the Rule 14-A-9. Since it’s not expressly provided,
the Ct won’t try so hard to enforce it.
c. If the Ct expands the reading of the essential link causation
cause of action, it may encourage more law suits.
PROBLEM: What if the Minority SH forfeited a state ct remedy
b/c the Majority SH’s made a misrepresentation?
-Supreme Court in Virginia Bank Shares case doesn’t address
-Circuits are split
Ordinary Negligence is the standard of care the plaintiff
must show in the DIR’s actions
-The literal reading of Supreme Court decisions leads us
to this standard of care.
-see SEC v. Aaron, p. 1496: the court here interpreted another
anti-fraud provision in the 1933 SEC CT and concluded that
based on the plain meaning, the standard of care was Ordinary
Negligence to prevent False or Misleading statements. The
Court then compared this with the anti-fraud provision in
the 1934 Act which also pointed to ordinary negligence to
prevent Mistrue & Misleading statements.
The Court can grant any type of remedy
-see JIK v. Borak case
INTRO to PROXY CONTESTS
-see p. 374
Generally, Proxy Contests are efforts by competing sides
to get SH’s to vote for one group of directors over another.
SH’s can also dispute over issues, but usually limited to
the issue of Director Elections for the purpose of cheaply
acquiring a corporation, as opposed to the expense of a
hostile tender offer (purchasing company BOD makes offer
directly to the target co. SH to pay them off in cash).
Although the Proxy Contest has a low success rate in these
types of acquisitions, there is a trend toward using both
the Proxy Contest and Hostile Tender Offer.
Rule 14-A-11: Although most of the rules of Proxy Litigation
applies here, there are a few differences. Rule 14-A-11
applies to Contested Election of Directors” and provides
that when this situation arises, then every PARTICIPANT
in the contest must FILE with the SEC a disclosure document
under Schedule 14-A, i.e. a PROXY STATEMENT. In the Statement,
the participant must DISCLOSE information about himself,
his interests, and his intentions. He must DELIVER to the
SH’s he wants to SOLICIT. The participant can use his preliminary
Proxy Statement for this.
“Participant”: defined as including the company itself,
the BOD, an insurgents who wants to vote for a certain person
on the BOD, any group who wants to solicit....
2. REIMBURSEMENT OF EXPENSES, p. 374
Old Rule: Only MANAGEMENT was permitted to use corporate
funds to wage a proxy contest, and only if the expenses
were INFORMATIONAL-related, not persuasive.
New Rule: see p. 381, Although still only MANAGEMENT can
get reimbursement, the expenses now must be related to POLICY,
not PERSONNEL ISSUES. (Query: Isn’t the election of directors
a personnel issue?)
-see Rosenfeld case
2a. Can Insurgents get reimbursed if:
I) they’re unsuccessful? (no case law on this)
ii) they’re successful? (only the N.Y. case, Rosenfeld v.
Fairchild, p. 374: Harrington says this case is incomprehensible.
Facts: Here, D founded a company and appointed Managers
to run the company, but they ended up turning on him by
waging a proxy contest, and won. Later, D started his own
proxy contest and HE won. Now, D’s new BOD paid the ousted
BOD reimbursement of funds, but also wanted to be reimbursed
for its own expenses. The new BOD proposed this to the SH
and they ratified their agreement to the proposal through
voting. SH brought suit.
HELD: Majority said that that the Old Management was entitled
to reimbursement b/c the expenses were related to POLICY.
Others held that the New BOD was entitled to reimbursement
because the SH’s Ratified their agreement. Dissent said
the distinction b/w POLICY and PERSONNEL was stupid. J.
Desmond said that the old rule was good, but he’s going
to agree with the majority anyway b/c there’s no evidence
3. RIGHT of SH to Inspect Corporate Records and SH List:
General Rule: Yes, there is a qualified right for SH to
do so if the SH proves PROPER PURPOSE.
**New York Sec. 624: New York provides the SH with a statutory
right to inspect and copy any corporate documents so long
as she shows the required AFFIDAVIT of GOOD FAITH PURPOSE,
and the burden of proof shifts to the corporation to prove
-see p. 310 Proper Purpose: “any purpose reasonable related
to the SH’s interest as a SH.”
DUTY OF CARE owed by Directors
I. Old Standard: The old standard of care required to show
that directors had breached their duty was GROSS NEGLIGENCE.
II. a. New Rule: Ordinary Negligence of a prudent person.
Since Hun v. Carey, where the Directors of a corporation
tried to keep their down-trodden company alive by buying
new things, which resulted in the corporation going bankrupt,
New York abolished the old rule. Now, New York standard:
“Directors acting in good faith with care that a prudent
person would take in similar circumstances.” (interpreted
to be the same as ordinary care).
b. Nonfeasance (didn’t do anything) v. Malfeasance (did
something, but stupidly): The Old rule in Huns v. Carey
was that if SH alleges Nonfeasance of the Director, then
the Director is not liable. But if the allegations are of
Malfeasance, then the Director was liable because he was
careless in what he did.
NONFEASANCE: Although it seems that the old rule “may” be
changing because 4 recent cases have held Dirs liable for
nonfeasance, the rule is:
-see 1. Bates v. Dressler, p. 587: President, not BOD, was
held liable for one of the bank’s EE stealing. This was
because the President was on actual and probably inquiry
notice of the EE’s activities, e.g. the EE’s extravagant
lifestyle, etc. The BOD however, really had no means to
suspect anything b/c all the books they were presented were
Comments: 1. In cases of pure Nonfeasance Directors are
2. ALI says that this case is the most infamous case for
diluting Director’s duty of care. They cited:
***2. Graham v. Allis Chalmers Corp: Directors have no
duty to FERRET OUT wrongdoing
(attitude toward this rule may be changing)
*** 3. Smith v. Brown Borheck: Directors aren’t liable for
pure nonfeasance because we don’t want to deter qualified
and competent from becoming directors.
MALFEASANCE: see 4. Litwin v. Allan,p. 576: The BOD of
a bank decided to lend money to one of its largest clients
even though the bank had exceeded its lending limit. The
bank got around this by having the client temporarily sell
the bank its bonds, and in exchange, the bank bought these
bonds, thus extending money to the client. This was a bad
decision b/c at this time, 1929, the stock market suddenly
crashed, and made the bonds worthless. The bank went bankrupt.
The SH’s sued the directors for negligence.
1. All 4 cases support the distinction b/w Malfeasance and
2. Bates case: Director’s reasonable reliance on others
is a defense if the Directors can bare the burden that he
reasonably relied on the other.
3. Aliss Chalmers case: Directors have NO DUTY TO INFORM
4. Smith v. Brown Borhek: Directors not liable for Nonfeasance
b/c it’ll DETER QUALIFIED PEOPLE FROM BEING DIRECTORS.
5. Sellheimer v. Manganese Corp,p. 567: If Directors were
self-dealing, then they’ll be held liable, but if director
DID ALL HE COULD DO, and NO SELF-DEALING, then not liable.
(BOD made a stupid decision to build a plant in the middle
of nowhere...the company went bankrupt shortly after. SH
sued. HELD: Directors held LIABLE! but the director that
“DID ALL HE COULD DO” to stop the madness and didn’t self-deal
wasn’t liable, even though there was no evidence that other
directors were engaged in self-dealing.)
6. (States no longer put in their statute “within their
own affairs” clause because it imposes a higher duty of
care on the directors.
7. “Reasonably Prudent Director Performs in the Best Interest
of the Corporation”: not contained in New York statute,
but in the Model. Does this impose a higher standard of
care on the director?
-see Schlensky v. Wrigley: BB club owner refused to allow
baseball games at night. SH sued him.
HELD: BJR protected his decision, and there’s no evidence
that Wrigley’s views were inconsistent with the statutory
requirement of acts in the best interest of the corporation.
-see Dodge v. Ford, p. 220: D thought he saw visions of
God, and did what he believed God wanted him to do, i.e.
produce more and more cars at cheaper price, and stop paying
dividends to SH so to use that money to reduce price of
HELD: Ford held liable b/c clearly, his charitable purpose
was not in the best interest of the corporation.
8. ILLEGALITY: if Directors make the corporation violate
the law then it’s per se breach of duty of care. NO defense
-see Miller case, p. 635: Director didn’t collect money
for bills people owed them.
9. New Cases suggesting old rule no good:
A. see Barnes v. Andrews, p. 535: Director breached his
duty of care because he FAILED TO INFORM HIMSELF of corporate
matters, but NOT LIABLE because plaintiff failed to prove
Director was solely liable.
-Bates and Allis Chalmers say that Directors just don’t
have the duty to inform themselves
B. ***TURNING POINT cases:***
1. see Francis v. United Jersey Bank, p. 557: (MAJOR TURNING
POINT!) Director held liable because of SHE HAD DUTY TO
INFORM HERSELF. (Old widow/director left the running of
the company to 2 delinquent boys who ran the company to
the ground. SH’s sued the Old widow b/c she did absolutely
nothing to inquire into sons’ performance).
-Court says this was a bad breach esp. b/c theses weren’t
ordinary funds that were squandered, they were people’s
trust funds! This point doesn’t seem important, but does
the court stress this b/c it’s making segway to new law?
-Ct says it wouldn’t have been enough for Widow to resign
or object, suggesting she needed to DO ALL YOU CAN DO (Sellheimer)
-this case is inconsistent with Barnes v. Andrews case,
above, where even though Dir breached duty of care by failing
to inform himself, he wasn’t held liable.
2. see Caremark case: Ct thinks the Allis Chalmers case
is not valid (i.e., no duty to ferret out wrongdoings, even
if on notice), and Ct re-interprets the duty of care to
be similar to duty to ferret and inform oneself: BOD must
attempt in good faith to install information & reporting
system that re reasonable in getting information to make
3. ALI Sec. 4.01-A: interprets duty of care to include Good
Faith, Prudent person, etc. AND:
-Directors must in a way they reasonable believe is in the
goodness of the corporation
-Duty to make inquiry
VII. Delaware has gone back to the old standard of director
liability: Gross Negligence
-see Aaronson and Smith case
VIII. Director Shield Statutes:
-see N.Y. Sec. 402b: This and other state statutes were
passed in response to strong lobby against directors’ liability
which makes directors insurance virtually impossible to
get. Statute says: the Corporation can insert or amend the
COI to provide a limit to Director’s liability, or eliminate
their liability completely, for damages (resulting from?)
any breach of fiduciary duty or duty of care, EXCEPT Where
facts are really bad (e.g., bad faith, intentional misconduct/price-fixing)
IX. BUSINESS JUDGMENT RULE
Basically, this rule provides protection to business decision
made by directors, with a few exceptions (conflict of interest,
illegality, fraud, lack of good faith, gross negligence).
The BJR protects the PROCEDURE of a decision. If P shows
that the process in making the decision was invalid, then
the Court will review the process using a “reasonableness
standard.” Also, the BURDEN SHIFTS then to the Directors
to show that the SUBSTANCE of the decision was valid. Courts
will review the substance of the decision using a lower
standard of review: RATIONAL BASIS. But courts are reluctant
to review the substance of business decisions.
The following are examples of the various ways in which
this rule is defined, or interpreted:
-see Kamin v. AMEX, p. 592: AMEX become the majority SH
in a stockbroker firm but it was a bad time in the market.
A few years later, the value of the shares plummeted. Directors
had the wise option of either selling the shares, or taking
the capital loss, but instead, Directors distributed their
shares to the SH which was beneficial for accounting principles.
HELD: Court won’t inquire into the SUBSTANCE OF A BUSINESS
DECISION made in GOOD FAITH (“Business Judgment Rule”) if
there’s no breach of fiduciary duty...
R.D.: Ct may feel that it doesn’t have the business knowledge
to make such decisions, and that it wouldn’t want to deter
competent people from joining the BOD of companies
VERSION 1 of BJR: Directors won’t be held liable for erroneous
decisions (no matter how stupid?) so long as they acted
on some reasonable basis in good faith, and without breach
of fiduciary duty obligations (including the exercise of
duty of care?)
Comments: 1. BJR doesn’t protect Director who make substantively
negligent decisions, but rather protects only PROCEDURAL
2. It is important to distinguish between SUBSTANTIVE v.
PROCEDURAL, see p. 631 for standard of review purposes:
REASONABLE review of Procedural decisions, and RATIONAL
BASIS review of Substantive decisions. (but it’s hard to
distinguish between Reasonable and Rational!)
3. p. 602, 631: Cts apply REASONABLENESS standard or review
to review of Conduct, whereas RATIONAL BASIS is used to
review legal aspect of the conduct.
4. ALI Sec. 4.01-A: agrees with #3
5. BJR may be redundant and doesn’t add very much tot the
basic rules. However, BJR Creates a presumption of validity
to Directors’ decisions. BOP first lies in SH.
VERSION 2 of BJR: “Professor Clark’s version:” (Virtually
the same as above:) A Director’s business judgment won’t
be questioned unless conflict of interest, illegality (AMEX
and Wriggley case), fraud, (same cases, and Auerback), lack
of good faith, Gross negligence.
VERSION 3: Delaware Rule: There’s a “presumption of validity”
in Director’s business decisions that Director fulfilled
his duty of care.
-this rule is troublesome b/c it doesn’t say whether the
presumption of validity is of the process of decisions,
or the substance of the decision
-see Technicolour case: “BJR is an allocation of burden
of proof. Once the P shows invalidity of process of the
decision making, the burden shifts to the BOD to show validity
of the substance of the decision
VERSION 4: ALI Rule: Director is deemed to have fulfilled
his duty of care if:
1. a decision was made, i.e. only in a case of Malfeasance
2. BODs informed themselves
3. Good Faith
4. NO conflict of interest
5. Directors “rationally” believed the judgment was in the
best interest of the corporation
VERSION 5: New York Rule: see Auerback case, p. 1042: SH’s
brought a derivative suit against a corporation that had
been investigated by SEC for accepting bribes. The BOD took
remedial measures by hiring a new and untainted BOD to make
HELD: The Court will not inquire into the SUBSTANCE of a
decision, but will only review PROCEDURE of decision, good
faith, and independence in decision making.
-see Smith v. Vangorham, p. 605 Here, the Supreme Court
held that the BJR didn’t protect the BOD!
F: The company in this case was profiting but had millions
in tax credit it couldn’t use. So, the BOD did a study of
what it could do.... The CEO, without consulting anyone,
finalized a deal with a buyer for a price per share that
was suggested by the CEO, not the buyer!. Anyway, the price
was profitable, at a 50% premium above the market value.
The buyer demanded that the deal be closed within a few
days. The CEO called an emergency board meeting and he told
the directors orally about the deal, and presented them
with a draft merger. None of the directors took the time
to read the agreement. The meeting lasted 2 hours and then
the BOD greed to the merger. SH sued.
HELD: BOD’s were grossly negligent (for reasons Harrington
think were just normal business judgments, especially given
the fact that the BOD and CEO were experienced business
men). Ct said directors breached their duty to inform themselves.
-this case, along with the list of others, including Technicolor,
may be interpreted to mean a new trend
Technicolour case: This case is regarded as the BURDEN ALLOCATION
case: Same case as above, but plus: 2 of 9 directors had
conflict of interest. But, they got a premium of 250% over
the market price of the shares, but still, the directors
were held liable for their business judgment.
BURDEN of PROOF:
1a. P has initial burden to show the Business Judgment Rule
doesn’t apply b/c of the invalidity of the process of decision
1b. P has burden by showing evidence of breach of fiduciary
duty of Care, Conflict of Interest, or Good Faith.
2. If P bares the burden, then D has the burden of showing
Substantive care, or entire fairness.
DUTY OF LOYALTY
If there is a CONFLICT of INTEREST in a Contract between
Corp. A & B, then the Contract will still be held VALID
(BJR will protect the decision) if the Corporation shows:
1. Full Disclosure of the conflict and the transaction,
2a. A Majority of the Disinterested Directors Voted, or
2b. A Majority of the Disinterested Shareholders vote.
BUT: If P proves unfairness, then the DUTY of LOYALTY has
been breached, and the BJR thus doesn’t protect.
I. Contracts of Corporations involving CONFLICT of INTEREST:
New Rule: A Conflicted Contract is presumed to be valid
(protected by BJR) if the Corporation proves that the Majority
of the DISINTERESTED BOD voted in favour of the K, or the
Majority of the SH voted in favour of the K, UNLESS P proves
that the K was unfair. (Thus, the initial burden is on P
to show unfairness)
1. Approval doesn’t insulate the K from attack
2. It is accurate to interpret such state statutes as BURDEN
of PROOF Statutes, i.e., who has the burden of proving unfairness:
If Corporation proves that it complied with procedure, then
P has the burden of proving unfairness.
-see Lewis, p. 652, and Cohen v. Blair
3. Most Statutes allow the vote of the Interested Director
to be included in the count
4. Most Statutes don’t use the term “disinterested SH.”
It is uncertain whether you include the vote of an interested
SH in the count.
5. There are 2 variations to the general rule:
a. The Model Act says that as soon as the Corp gets approval
from __, then they are COMPLETELY IMMUNE from any action
that P may bring. (BJR grants complete immunity in this
b. ALI says that even if the Corp shows they complied with
procedure, the Court can review the process using a REASONABLENESS
II. LOANS TO DIRECTORS:
New Rule: Loans to Directors are allowed as if it’s a business
III. EXECUTIVE COMPENSATION:
General Rule: 1. The compensation must be a REASONABLE amount,
and usually protected by BJR
2. There’s a contemporaneous benefit to the Corporation
3. Compensation cannot be a gift
-see Adams v. Smith
IV. CORPORATE OPPORTUNITY DOCTRINE:
This doctrine is derived from the rules of AGENCY. -see
General Rule: 1. Duty of Loyalty: Agent can’t compete with
his Principal without consent
2. Agent can’t use assets or information of the Principal
for his own personal gain
3. Agent must handover any profits he makes from the Corporate
transaction unconsented to
*simply, this just means that the Agent can’t take for
himself an opportunity that’s meant for the Corporation
Variations to the Doctrine:
A. LEGARD FORMULA: (see the Alabama case, p. 731): The Officer
or Director (agent) can’t acquire any business opportunity
or asset where the Corporation has a PRE-EXISTING INTEREST
or EXPECTANCY (e.g., if the Corporation has already started
negotiating on something, the agent can’t usurp that opportunity
from the corporation)
B. New York “Irving” Approach: (see Irving Trust v. Deutch,
p. 719): The Corporation had an opportunity to buy cheap
radio equipment and resale for a profit. They signed a Contract
to solidify the sale. Insiders in the Corporation took this
opportunity for themselves and made a bundle. Corp. sued.
HELD: This was an improper taking of a corporate opportunity.
Also, the CONTRACT was an essential element to show that
the insiders took the opportunity. (Harrington thinks the
K wasn’t a necessary element)
-this is a more strict formula than above
Defense: Financial Inability Defense: Insiders claimed
that their acts were justified because the corporation didn’t
have the financial capability to buy the equipment. Courts
won’t recognize this defense unless the Corporation is INSOLVENT.
C. LINE OF BUSINESS Formula: If the business opportunity
is within one of the Corporation’s existing line of businesses,
then the Corporate Opportunity Doctrine applies, and the
Agent will be held liable for taking the biz op.
-(this rule is too broad, especially if the corporation
is involved in a lot of businesses, thus making it impossible
for any agent to engage in other opportunities)
Defense: If the business opportunity came to the Agent’s
attention in his personal, not business capacity, then it’s
an ok taking.
D. Burg Approach, see case on p. 731: The Horns were the
Landlord of substandard housing buildings. Their friends,
the Burgs wanted to get into the business too, so they all
joined together to form a corporation that would buy up
old buildings and collect rent. There was a falling out,
however, and the Horns continued to buy up buildings in
the corporation’s name. They didn’t offer any of the opportunities
to the Burgs. Burgs sued.
HELD: The Burg’s reasonable expectation wasn’t sufficiently
Test: What was the reasonable expectation of the parties
at the time? (this standard is too loose)
E. Professor Ballantine’s Rule: Whether it was fair that
the Agent took the business opportunity (this test is also
F. Line of Business + Fairness Test: see Miller case, p.
721 (this formula is vague)
G. ALI Sec. 5.06: (see Northeast Harbor case, in Supp.)
A business opportunity is any business opportunity an executive
becomes aware of in his official or private capacity. The
Agent can’t take the opportunity unless he tenders the offer
to the BOD, and the BOD rejects the offer, and Consents
to the Agent taking it. If no tender and rejection, then
the Agent is automatically liable.
SUMMARY of Professor Clark’s position:
He says that It’s a good idea that here is a different body
of law for Closed Corporation than for Publicy held corporations
because of the active participation of SH is one and not
the other, etc.
1. Generally, Professor Clark accepts the Legard formula,
2. but rejects the Personal Capacity defense
3. rejects the Corporation’s Financial inability defense
4. accepts tender & rejection formula
5. but wouldn’t allow any corporate opportunity of any kind
because the SH’s can’t monitor the types opportunities that
arise, and also, there’s too much pressure among the BOD
to acquiesce to a director taking an opportunity.
Comments: The CORPORATE OPPORTUNITY doctrine, if agents
are held liable under this rule, would deter competent managers
from positions of directors. Also, there must be some great
compensation for a director to forfeit his chance to take
a corporate opportunity.
BJR & its application in HOSTILE TAKEOVERS
Most of the rules of Hostile Takeovers comes from Delaware
History: From the 1960’s to 1985, the BJR provided immunity
to Directors who took any defensive measures to thwart hostile
tender offers to the target corporation (such that Directors
were in danger of losing their jobs)
Examples of Defensive Measures (that may or may not be protected
by the BJR):
1. Greenmail: The Target Corp. would buy off the bidder
at a significant premium of what the shares are really worth
2. Make the Target Co. less attractive to the bidder, e.g.
Poison Pill (this is protected by BJR, see below)...
3. Target Corp would buy a subsidiary corp. to compete with
4. Target Corp. issues large blocks of shares to a friendly
corporation who agrees not to handover the shares in the
event of a hostile takeover
Poison Pill: (see Moran case): A Poison Pill is a defense
tactic the BOD can take before the hostile tender offer
is extended. It consists of the Target BOD offering its
SH a Right or Warrant or “option” to buy shares of the corporation’s
stock, in exchange for each share of common stock a Sh purchases
from the Corporation. They get this Right or Warrant in
the mail. The SH has a right to exercise this option in
the event of certain triggering events, such as a hostile
tender offer, etc. However, the Sh won’t want to exercise
this option because the purchase price per option share
is most likely gong to be some price forecasted to reflect
the shares higher value 10 years down the road. The poison
in this pill is where in the FLIPOVER provision: The Corporation
will most likely include a flipover provision in this Option
such that it is bound to pay the holder of this option 2x
the amount of the option price! That is, the corporation
is contractually bound to do this. SO, any bidding corporation
that wants to takeover the target, will be dissuaded from
taking it over b/c it wouldn’t want to honour the target
corporation’s contractual obligation and essentially give
away such amount of shares of their own corporation!
**Posion Pills are revocable at the will of the BOD for
very little money. So, in a hostile takeover situation,
a bidder who is aware of the poison pill will want to go
directly to the BOD to negotiate the takeover, and persuade
the BOD to remove the poison pill
**Dead Hand Poison Pill: The poison pill cannot be revoked
by the current existing BOD of the Target Co.. But 2 Delaware
cases invalidated this provision because Current BOD should
be the one managing the CO.
New Line of Cases: Courts now provide BJR protection, subject
to exceptions. There are 3 lines of cases that demonstrate
the development of new BJR interpretation in hostile takeover
1. Smith v. Vangorham -----> Technicolour case where
the standard of director negligence was GROSS NEGLIGENCE,
but the Directors had a duty to INFORM THEMSELVES
2. Unocal case, p. 1219
3. Revlon case,
2. UNOCAL Corp. v. Mesa Petroleum: Bidder Pickens was a
SH in Target Unocal, and extended a hostile tender offer
to buy off the target SHs of Unocal at a premium price.
Bidder said he’d pay cash for 51% of Unocal shares, and
once he’s done that, he intended to SQUEEZE-OUT the minority
SH’s buy buying them off at a substantially lower price.
By announcing this, Bidder essentially motivated all the
SH’s to get rid of their shares asap. Target Unocal BOD
tried to thwart the takeover attempt by purchasing the remaining
shares at a higher price than what bidder offered, and excluded
Bidder from this offer. Bidder brought suit seeking preliminary
injunction, and to invalidate certain actions by BOD.
HELD: Unocal bore its burden of the below test. But,
There an INHERENT CONFLICT OF INTEREST (where BOD is concerned
with keeping their jobs and thus engage in defensive measures
at the expense of the Target SH’s getting the best price
for their shares). Thus, there should be no presumption
of validity in BOD’s decision, and there should be a more
specific test, such as:
Unocal’s 2-prong “PROPORTIONALITY” Test: Because there is
“inherent conflict b/c BOD & Shs”:
1. BOD bares the initial burden to prove that their decision
was in Good Faith & there was a Rational Basis for perceiving
the threat (was the harm going to reasonably affect Corp/SH?),
2. The Defense Tactics were reasonable in relation to the
REVLON case, p. Ron Perleman of Pantry Pride Co. wanted
to takeover Revlon, run by Michael Bergerac. The two were
not on good terms. Revlon refused Perleman’s offers, and
adopted defense tactics such as: 1. Note Purchase Rights
Plan, and 2. Intentionally took on debt ....?????????????
Soon enough, the Revlon BOD realized that the breakup of
the corporation was inevitable and worried about losing
their jobs. So, the BOD negotiated with another bidder,
Forstman where they engaged in a lock-up option with him
where he’d pay an extra dollar per share and thus be entitled
to the income producing subsidiaries of Revlon. Revlon also
asked Forstman to indemnify them for the debt they owe the
note holders, worrying that they’d sue the BOD. Perleman
HELD: 1. Unocal case protects the initial defense measures
2. But, when break-up of the corporation is inevitable,
the BOD’s duties change from preserving the Corporation
to a role of an AUCTIONEER where they’ll try to get the
highest price for the SH’s shares.
-Revlon BOD failed this duty because they protected their
own interest, not the SH, by asking Forstman to indemnify
them for the debt to the Note Holders. Thus, they breached
their duty of loyalty.
Mills v. McMillen
Once it is inevitable that the corporation is going to break-up,
the BOD must conduct an auction that’s FAIR.
In this case, there were 2 bidders for the target. The BOD
of the target favoured one bidder in particular so he gave
the bidder insider tips. This was held to be a Breach of
Duty of Loyalty.
Paramount v. Time
Time wanted to expand its corporation so it negotiated with
Warner and reached an agreement where Warner would merge
into Time as a subsidiary. Warner SH would receive shares
of Time. At this time, Time shares were selling at $100/share.
Paramount tried to bid on Time as well at $200/share, but
Time BOD rejected the offer as grossly inadequate, considering
their SH’s longterm interests. With respect to Warner, Time
had to issue more shares to Warner SH’s and this would require
Time Shs vote, which Time BOD tried to avoid because they
knew that their SH’s would vote no. They avoided this by
restructuring the deal so that TIME would be the one buying
Warner! (this doesn’t require a shareholder vote b/c bidding
companies don’t have to get their SH’s vote to buy another
company). Paramount sued.
HELD: BUSINESS JUDGMENT RULE PROTECTS!
1. Revlon auction duties of the BOD didn’t apply because
Time was never put up for sale, nor was the break up inevitable.
2a. Unocal proportionality burdens were borne by Time BOD:
they proved that their business decision was in good faith
and they had a reasonable basis for perceiving the threat,
i.e. BOD considered its SH’s longterm interests.
2b. the Time BOD’s defense tactics were reasonable in relation
to the threats perceived
Paramount v. QVC
Paramount and Viacom negotiated a merger deal where Paramount
SH would get cash & non-voting stocks worth $70/share.
The merger agreement provided:
1. Paramount will revoke their Poison Pill
2. Paramount will be subject to termination fee if merger
didn’t go through
3. Paramount was subject to a lock-up option where if the
deal fell through, Viacom had the option to buy up to 20%
of Paramount stock at a favourable rate per share.
4. Paramount was subject to a no-shop clause
QVC made a hostile tender offer at $90/share, but Paramount
rejected it. QVC sued.
HELD: SURPRISE! Although the facts were the same as the
above case, here, the break up was inevitable! The break
up consisted of passing control of Paramount entirely to
ONE PERSON, unlike Time v. Paramount, where control was
passing from public Shs to another group of public Shs.
This difference is in the KIND of CHANGEOVER. Thus, since
the break-up of the corporation was inevitable, Revlon duties
applied, and were breached by the BOD refusing to accept
a higher bid for the SH’s shares.
Synopsis on “Takeover Defense” cases:
There are 2 schools of though. One school thinks that BJR
should protect BOD decisions about selling the corporation.
The other school thinks that the BOD should bud out of it,
not be able to adopt defensive measures, and leave the decision
whether to sell up to the SH’s.
Harrington: 1. BJR shouldn’t apply all the time, esp. when
there’s a conflict of interest
2. Burden of Proof of validity of business decision should
be on BOD to show compelling interest
3. BOD of the Target should be immune from suit if they
got the vote and ratification of the planned defense measure
4. A tender offer should be left open for a reasonable amount
of time over 20 days.
VI. Majority Shareholders Fiduciary Duty to Minority Shareholders
The following 4 cases show a trend toward imposing duty
upon a Majority SH to Minority SH:
Zahn v. TransAmerica
There was a publicly held corporation called Axton Fisher
whose largest asset was tobacco, that wasn’t generally known.
The corporation had 2 kinds of stock, each of which had
different rights. A 3dp SH called TransAmerica bought a
majority of both classes of stock, and thereby gained control
of the AxtonFisher and installed their own directors into
the BOD. The BOD’s then caused Class A SH to sell their
shares back to the company pursuant to a stipulation in
the initial Stock Certificate. The BOD then declared a liquidation
with the intent to get for themselves all of the valuable
tobacco by squeezing out the minority SH. Minority Sh’s
sued, but what else could the Majority have done? They could
2. Disclosed the plan to squeeze out, and say they’re going
to redeem Class A, but that would have induced Class A SH
to exercise their convertibility right to convert their
shares to Class B shares...
3. Liquidate the assets, but then, Class A gets two-thirds
of whatever’s left after liability paid off...
HELD: Managers???? violated their Fiduciary Duty to Minority
SH of Class A stock. They should have chosen Option 3.
This case is the first case to hold that Majority SH owe
duty to Minority duty
Jones v. Ahmanson & CO., p. 766
Ahmanson & CO. were majority SH in a Savings & Loan
Association in CA. They wanted to take advantage of the
high value of their shares, but there wasn’t a liquid market
for the shares. SO, the Majority formed a new Company but
didn’t invite the Minority Sh to participate. The Majority
then exchanged one share of the S & L company for shares
of the New Company. The new company went public and the
price of the shares went way up. Minority SH brought suit.
HELD: breach of Fiduciary Duty owed by Majority to Minority
R.D.: The Majority used their control to obtain special
advantages to create a liquid market for their illiquid
shares. They created this liquid market by exchanging their
shares of S&L for the new company, to the detriment
of the Minority Shs, and WITHOUT COMPELLING interest.
SINCLAIR case, p. 748
P is the majority SH in an oil company with a subsidiary
in Venezuela that wasn’t doing well. So, P .???????? Minority
brought suit: 1st allegation: ???????????? 2nd allegation
was that Sinclair breached his longtime supply K with the
subsidiary such that Sinclair had agreed to buy all that
it needed from the subsidiary, and Sinclair always paid
late and didn’t buy all it needed from the subsid.
HELD: Self-Dealing. The BJR won’t protect. Breach of Fiduciary
(GET THE FACTS)
Kahn v. Lynch, p. 755
Majority SH’s wanted to Squeezeout Minority. These are the
same facts as Weinberger (FACTS?) that said in Footnote
7 that had the parties negotiated at arms length, then there
wouldn’t have been a breach of fiduciary duty. Here, the
Majority suggested that the parties negotiate independently.
HELD: Breach of Fiduciary Duty: Majority’s negotiation attempt
was not independent. They went to the Minority SH and said,
“here’s our best offer, you better take it, or later we’ll
make a hostile tender offer.”
VII. Transfers of Control of the Corporation
“whether the Majority Has a duty to share in a premium it’s
Hypo: Suppose we start up a new biz and I contribute capital
of $60,000, you put in $40,000. I take 60 shares, and you
take 40. Business goes well and the business is now worth
$200,000! Sovern/3dp wants to buy the business but he doesn’t
have $200,000. He only has $150,000. He offers me that amount
for the control block shares I have, so to have control
of the board.
Issue; Do I have a duty to share the premium, i.e. Sovern
has to buy 60% of my shares, and 60% of your shares at the
premium price he offered?
-see Feldman case
Arguments FOR Sharing duty:
1. Cases that say there’s a duty based on analogous cases:
-p. 795: Corporate Action Analogy: The above set of facts
is like a merger, so merger law should apply, i.e., all
SH’s get to participate and get the best price for their
-see p. 796: this case involves a bidder asking a Director
of a Bank whether or not the bank is for sale. The Director
answers no, but then says his own block is for sale.
HELD: Breach of fiduciary duty
-Sale of Office Rule: see Geres case, p. 780: A naked sale
of officership/directorship is illegal. But the sale of
control block that has as a condition that the director
resign is LEGAL.
-Misrepresentation cases: see Goodwin and String cases,
p. 810, 815: Insider in a corporation finds out that there’s
a buyer willing to buy the corporation’s shares at a significant
premium. So, the insider goes and buys up all the shares,
and resells them to the buyer at a profit.
-Looting cases: see Gerdes case: Selling SH in a Sale of
Control should have foreseen that the bidder was a well
known looter. Thus, the Selling SH should be liable
-Perleman v. Feldman, p. 787: The holdings in the above
cases don’t seem to apply to this case here. The Court here
says there’s NO SHARING DUTY, but this case is a minority
Facts: During the Korean War there was a steel shortage.
Feldman and Insiders were directors of and owned controlling
shares of Newport Steel. They sold their control to another
Steel Company at a huge premium per share and the Minority
SH sued. The lawyers for the Minority SH didn’t want to
allege breach of Fiduciary Duty because that was not a developed
area of law at the time. So instead, the Minorities claimed
that the Majority took a corporate opportunity for themselves.
HELD: Feldman took 2 Corporate Opportunities:
1. Corporation’s opportunity to use the Feldman plan to
build additional plants to expand steel building capacity
by getting a loan and paying it back later,
2. Corporation’s opportunity to build up patronage in its
*The Court treats this case as analogous to the doctrine
of Corporate Opportunity, and even cites Irving v. Deutsch.
(see p. 48 of notes). Further, the Court felt that Feldman
is liable because he had 3 titles, as Shareholder, Director,
?. ALSO, the facts of this case were particularly bad in
that there was a Steel shortage at the time!
2d Circuit: Control is an asset that belongs to the Corporation,
not the SH. That means, that all SH’s (what makes up the
corporation) should share in the control,and shall share
in the premium offer.
-Professor Andrew: Across the board sharing should apply
to these facts
-Brown v. Talbert (California case): In favour of the sharing
rule: “when a Director acts in his legal capacity, he cannot
appropriate corporate opportunity for himself.”
**MAJORITY RULE: NO DUTY TO SHARE!
Support #9: Fairness
There’s a fairness argument: Minority SH’s put up real $
and that contribution may have been the last buck needed
to start the company (without them, the corporation wouldn’t
If there’s no duty to share, then that may deter minority
SH’s from investing their capital in the corporation
Minority SH’s assume big risks in that the buyer of Majority
block of shares may use the target company as a vehicle
so that it’ll assume debt and the bidder’s company merges
into the target??????
Argument Against Sharing:
1. Fairness Argument: Majority Sh’s took the largest risk
by paying more for
2. Javaras case, p. 779: If there’s a sharing rule, then
the bidder will be compelled to buy shares from all the
SH’s, and this will have the effect of reducing further
sales of control (good thing)
3. Sharing may result in no sale of shares
4. Chicagoan argument: If Transfers of Control are good,
then sharing rule is bad because it impedes sales
5. Contractarian argument: If there’s a Sharing rule, Minority
SH’s should have put in a provision in their stock certificate
agreement on day one that they wanted such bargaining power
6. Sharing rule would impede selling majority shares since
Majority wouldn’t want to share
7. Contemporary Finance Theory: There needs to be a natural
balance in the market reflecting those who take large risks,
those who take small risks. SO, if we allow sharing, then
the small risk takers (minority SH’s) will be over compensated,
and thus impedes diversification of portfolios.
DOES SH FIDUCIARY DUTY REALLY MATTER?
There are 2 arguments the court recognizes:
I. Yes, Fiduciary Duty matters between Majority and Minority
SH’s, and this authority can be found if you read the cases
II. No, Fiduciary Duty can actually be harmful to relationships.
I. SH Fiduciary Duty is GOOD!
Stockholder fiduciary duty can be read to be (i.e., can
hold Majority SH liable anyway) Directors Fiduciary Duty
so who really needs SH F.D.? Harrington thinks that the
doctrine of SH F.,D is superfluous and misleading. The Courts
talk the talk of this theory, but hey don’t’ really mean
Zahn v. TransAmerica
Recall the tobacco case where the acquiring Majority SH’s
squeezed out the minority.
HELD: Judge didn’t say that SH Fiduciary Duty was the issue
here, but rather just said that the DIRECTOR BREACHED HIS
The old man was bought out.
HELD: This was an act of the Directors, not SH’s.
The Directors fired him, not the SH’s.
Weinberger case & Kahn
BOD represented the interest of the Majority SH, squeezed
out the Minority without full disclosure.
HELD: Breach of DIRECTOR’S Duty, not SH.
Schwarz v. Marrion
IN this Close-Corporation, 50/50 shares between 2 families
HELD: Breach of Director’s Fiduciary Duty
**Cases that don’t fit into this hypothesis:
Perlman v. Feldman
This case doesn’t fit well with the above ones. But, we
can still look at it as a Corporate Opportunity case.
Smith case: This looks like a pure SH fiduciary Duty case,
but it can be read in a way that the SH assumed the position
of the Director and It was in the capacity as a director
that D breached his duty.
Jones v. Ahmanson: Every SH defendant was an officer or
director of the initial bank.
SH Fiduciary Duty is NOT GOOD!
a. The concept of Fiduciary Duty is an equity-based goal
and conflicts with the goals of Corporate Law, which are
economic-based. Even though equity should prevail at times,
the burden to prove a breach of duty should be on the parties
claiming a breach.
b. SH fiduciary duty is prevalent in Partnership Law which
shouldn’t apply in the realm of Corporate SH duties. Different
laws, different risks are taken.
c. SH Fiduciary Duty frustrates normal expectations of
all parties, in regard to one’s duties, profits…
d. Sh Fiduciary Duty creates a lot of unpredictability
in that it becomes very risky for Equity Investors, and
it will deter investors, and will raise the cost of capital
because investors will demand higher return for taking on
the risk of SH duties.
Some example of cases on insider-trading, and variation
Chiarella v. U.S., p. 884
P was an employee at Pandick Press, which was a company
that published public information on mergers an acquisitions.
P took advantage of this information and made his investments.
SEC sued him and he was held liable. (This case holding
was at the beginning of Insider-Trading law)
D is the son of a millionaire. The father was on the BOD
of the largest mining Co which was approached by another
company for a merger proposition. The father shared this
information with the son, but not for the purpose of tipping
him. However, the son used this information to by options
of common stock on the target company and then made millions.
SEC DIDN’T SUE HIM! Instead, the SEC asked for a consent
decree where the son agreed that he would never do anything
like this ever again.
Arguments For Insider Trading Arguments Against Insider
1. If you’re smarter & get better info, you should be
able to use it (but this may not fall w/i definition of
insider-trading) 1. Utilitarian Fairness argument: If Insider
trading thrives, it will result in deterring people from
investing and thus, dry up the investment markets
2. Government shouldn’t regulate business 2. If Insider
trading were prohibited, we’d better be able to protect
the customers by being able to narrow down who is responsible
3. Nobody gets hurt by insider trading. Buyer already made
his decision that day to bid, regardless of whether there’s
going to be insider-trading that day 3. Egalitarian fairness
argument: We should all have equal access to information.
(see the Texas Sulphur case, and Cady Roberts)
4. An implicit part of Manager’s employ package is insider
information 4. Prohibition of Insider trading promotes full
disclosure under the Securities Act
5. Insider-trading is efficient b/c it pushes the price
of stocks to its accurate and true value more quickly 5.
Misappropriation Theory: Insider information is proprietary
and belongs to the company for which EE works. The EE should
not be a thief
6. Insider trading is efficient b/c it creates a liquid
market and price economy, and prevents sudden large leaps
7. If insider trading was such an evil, firms would have
worked harder to prevent it, and outside Sh would have demanded
8. Insider trading doesn’t harm investors. They know that
this goes on, and thus, factors this into the price they’re
willing to pay. The market also discounts the price of shares
to reflect this benefit of insider trading anyway
State Common Law on Insider Trading
It is rare that insider trading would be tried in State
Court because this area of law is mostly regulated by Federal
Securities Act. but see p. 810, 989.
There are 4 Doctrines:
1. Goodwin case (Majority view): Insider has no Fiduciary
2. Minority view: Insider may never use insider information
3. Special facts Doctrine: see p. 814, the Strong case:
Generally follow the majority view, unless there are special
facts such as: Director is the actual insider tipper, and
has a special duty, or there’s face to face dealing.
4. New York rule: (unpopular rule): see Diamond case, p.
989: Insiders learned insider information that the corporation
wasn’t doing well. The Senior Execs sold their shares based
on this news.
HELD: This was insider-trading, based on the theory of Agency:
can’t appropriate confidential information for personal
gain. (Most court reject this argument. The Court here didn’t
explain how the Corporation was injured, but relied on the
importance of Fiduciary Duty to qualify their holding).
Federal Law on Insider Trading
“Insider Trading is:” Trading by any person on the basis
of material, non-public information in connection with sale
or transfer of the company or its securities
Insider Trading is governed by the 1934 Securities Act,
Sec. 10B, and Rule 10b5, see p. 820:
1. 1934 Act, Sec. 10b: is a general anti-fraud provision:
“it’s unlawful to use manipulative or deceptive devices
in connection with the purchase or sale of securities in
violation of SEC RULES.
2. Rule 10b5: (there must actually be a violation of this
rule before the party is held liable under the Act): The
rule provides that it is illegal to commit FRAUD or to speak
a mistruth/misrepresentation, or omit material facts, or
commit any conduct that operates as fraud.
1. Broad VENUE allowance: “any district where the violation
was committed, OR where the corporation does business
2. Interstate Commerce must be established in order for
Fed Court to have jurisdiction (mere calling on the phone
to another state can be interstate commerce!)
3. Act applies to CLOSE-CORPORATIONS
4. IMPLIED Private Cause of Action: Just like proxy litigation,
there is an implied private cause of action. The right to
bring suit is not limited to the SEC. If Congress wanted
to exclude a private action, it would have done so explicitly
when it had all its opportunities to amend the Act. Congress
also knew that the Court were ruling one way, that is, in
favour of a private cause of action, and thus, would have
amended the Act had they wanted to prevent this.
5. Who can sue? See Huddleston case, p. 1497: implied c/a
for private P’s
MODERN CASE LAW:
Insider-Trading liability is not limited to the tipper or
the tippee. Traditionally, any officers, directors, and
controlling stockholders with insider information must disclose
it, but this list is not exhaustive. Why?
1. Cannot abuse special relationship that gives the person
access to information intended only for corporate benefit,
not personal, and
2. Inherent unfairness where party takes advantage of info
others don’t have
Rule: Duty to Disclose or Abstain from trading.
(Harrington thinks this rule is phrased wrong because other
courts are going to use it literally, that is, you EITHER
disclose, OR you abstain from trading until the information
has been disclosed. This isn’t the intent of this holding.)
SEC v. Texas Gulf Sulphur, p. 822
Senior officers at Texas Gulf Sulphur learned that the Company
had made a major profitable mineral find up in Ontario.
While the Company was conducting tests over the months to
determine the extent of their find, the Senior officers
tipped their friends and families, and along with the officers,
bought lots of shares in the company, and the price of the
HELD: Insider Trading violation.
R.D.: 1. Cady Roberts: “any person who comes to know of
information that may affect SH’s ... must disclose”
2.. Duty to Disclose New Information: p. 950: The court
also said that
a. If corporation makes a misstatement in the information
affecting the way one trades, then the corporation is liable
b. There is no further duty to report more so long as the
corporation has made the appropriate disclosures as required
in SEC filing, except:
-Duty to correct prior misstatements
-Duty to update prior statements that are no longer true
-Duty to correct rumours created by the corporation, but
not those created by newspaper
-INTERTWINING DOCTRINE: Duty to correct misstatements made
by senior officers who are so INTERTWINED with the statement
Vinny Chiarella v. U.S., p. 884
Chiarella was alleged to have committed “FRAUD BY SILENCE
(failure to disclose).” He was convicted, but conviction
was later overturned because:
Rule: No DUTY TO DISCLOSE unless, you have DUTY TO SPEAK,
and there’s no duty to speak unless, there’s CONFIDENTIAL
RELATIONSHIP. (Chiarella’s mere possession of non-public
market information didn’t impose a duty to disclose, b/c
there’s no special confidential relationship to begin with.)
Dissent: J. Burger would have convicted Chiarrella on the
theory of steeling/Misappropriation.
1. What is the impact of Chiarella on “Scalping:” Scalping
involves a broker-dealer firm who recommends a stock to
customers, but first buys the stocks for himself. This is
illegal because it’d be a breach of fiduciary duty.
-Financial Columnists: No fiduciary duty to readers who
follow what the columnists advises, even if the columnists
-Professor Calfman: famous speaker on bond market worked
at a firm and was also a great speaker. He used to always
disclose the contents of his speech to the firm first. The
firm probably wont be held liable because there’s no special
relationship of confidence with those who listen to the
professor’s advice. Also, one should be able to use to his
advantage his smarts.
2. What is the impact of Chiarella on the area of Hostile
Bidders can also use their researched information to buy
for themselves stocks of the target company at its lower
price, before it publicly announces its hostile tender offer
which will raise the price of shares.
-probably OK b/c no special relationship with any person.
3. What about Frontrunning: a. Customers, and b. Research?
a. SEC thinks that frontrunning a customer is a breach of
a fiduciary duty
b. It’s not sure whether frontrunning research is illegal,
i.e., if broker-dealer firm does research and trades according
to what it’ s found. This can be seen as using your own
smarts, or contrastly, a duty owed to all customers to disclose.
4. What about Selective Diclosure?
SEC thinks there’s Tippee liability when someone trades
on information obtained from an analyst who received a tip
from a conference call with a company’s BOD, and the analyst
then calls the customer who trades on this information.
The case law on this is uncertain.
Narrowing the Rule on Tippee liability:
Dirks v. SEC, p. 896
EE, Seacrest (Tipper) was employed at an insurance company
that was committing fraud by underwriting insurance policies
that were non-existent, and then sold then to re-insurers.
EE, probably threatened to disclose this scam, was fired.
In angst, EE tipped Dirks (Tippee) who’s an analyst. Dirks
confirmed the fraud and then tipped some favoured brokerage
firms he worked for. The insurance company suffered huge
SEC didn’t sue Dirks for tippee liability, instead, wanted
to censure him. Dirks refused to settle.
HELD: There’s no Tippee liability if the Tipper didn’t breach
Rule: Tippee is liable if:
1. Tipper must have breached a Fiduciary Duty by tipping,
2. Tippee must have known this.
*There should be an objective test for this, i.e.: Whether
the Tipper would have benefited from the tipping in any
way, e.g. his reputation, gift, $...
Comments: What’s the impact of this case on:
1. Paul Fayer’s case: Paul Fayer was the Secretary of Defense
under President Carter. When he stepped down, he became
a professional director on 10-15 boards of companies. He
then developed a close relationship with a woman and the
two of them used insider information. The both defended
by citing Dirks v. SEC and that they had no fiduciary duty...
They ended up settling.
2. Coach Schwitzer’s case:
D took his son to a track meet and in the stands, he overheard
the CEO of Pfizer, Mr. Platt talk about the details of a
pending Acquisition to his wife. D took this information
and made millions on his investment. Is this OK?
HELD: Mr. Platt cannot be held liable for tipper liability
b/c no breach of fiduciary duty by talking to his wife.
3. Innocent overhears: the shoeshine guy, the cleaning crew...
If the speaker wasn’t breaching a fiduciary duty, then the
tippee not liable.
4. Favoured Analyst: Can the SEC sue the analyst (tippee)
for information he received form an insider tipper? The
tipper probably wasn’t breaching a fiduciary duty at the
5. “Footnote 14s Insiders” or “Outside-Insiders”: In footnote
14 of the Dirks case, the court says that, “we should treat
as Insiders those persons who are temporarily employed at
the firm and who learn of insider information, eg. lawyers...
Rule on Hostile Tender Offers: Rule 14e3
1. Rule 14 e 3
2. Possession v. Use
3. Actual Knowledge
1. Rule 14-e-3:
History: After Dirks and Chiarella, the SEC felt that it
couldn’t successfully go after bidders in tender offer situations
who used their research to buy stocks of the target company
before they publicized their tender offer. SO, the SEC passed
Rule 14e3: It’s illegal or fraudulent for any person in
connection with a tender offer who’s in possession of material
and non-privileged information regarding the offer to purchase
or sell an affected security to trade prior to public disclosure
of the tender offer.
*This rule essentially overrules part of the Chiarella test
that required fiduciary duty to speak. Here, F.D. to speak
is not required.
1934 Act, Sec. 14e: This is a general broad anti-fraud provision
just like 14b, except: The Commission shall by Rule-making
define & design means reasonably designed to prevent
fraud.” (this is an express grant by Congress.)
U.S. v. Chestman, p. 896
Old man Waldbaum wanted to sell his majority interest in
the stores. He told his wife in confidence, who told her
daughter, who then told her husband, who used the information
to tip the broker. The broker appropriated the information
and bought many shares for himself. Did tipper/husband breach
any fiduciary duty to Old man Waldbaum? And did the tippee/broker
know he was breaching his F.D.?
HELD: Even though the Dirks test is no satisfied, the court
held the broker liable.
2. Possession v. Use of Insider Info:
When a P alleges illegal Insider Trading, must he show that
not only did D possess the info, but also, he used the info?
Courts are Split.
Majority: Possession of Insider Trading Info is enough to
hold him liable
-see Adler case, supp. p. 199: P’s burden is to merely show
knowing possession and at that point, the burden then shifts
to D if he chooses to claim an affirmative defense that
he possessed it, but didn’t use it.
3. Actual Knowledge not Required:
-see U.S. v. Lebira: a small group of Insider Traders contacted
EE’s at a printing plant for an influential business magazine.
They asked the EE’s to tip them with the information in
the magazine before it was published. EE’s were caught.
HELD: No ACTUAL knowledge required that insider-information
would be used for improper purpose. GENERAL KNOWLEDGE is
4. Misappropriation Theory:
Recall, in Chiarella, J. Burger & other justices said
that D was a thief of the corporation’s insider info? Now
what’s the law?
-in the early years, Circuit cts followed this theory, e.g.
U.S. v. Newman, and SEC v. Matera, p. 909.
-The Supreme Court had a chance to clarify whether misappropriation
is the law in the Carpenter case, p. 910 (a famous &
influential financial columnist had as a lover, a person
that unfortunately contracted AIDS. So, in order to make
$ to pay for treatment, the columnist tipped the lover,
and they then invested according tot he information).
HELD: All were convicted, but there was no breach of any
law! Only a breach of the newspaper’s internal policies.
(The court here was split 4-4, and no opinion was written.
SO, it’s uncertain whether misappropriation doctrine is
valid, however, 2 Ct. of Apps. have rejected this doctrine.)
O’Hagan case, supp.
O’Hagan is a partner in a law firm that was retained to
represent a bidding company in a hostile takeover situation.
O’H heard this news and then went out and bought many share
of this company before the takeover was announced to the
public. The Dep’t of Justice and the SEC couldn’t go after
him because of Chiarella (No DUTY TO DISCLOSE unless, you
have DUTY TO SPEAK, and there’s no duty to speak unless,
there’s CONFIDENTIAL RELATIONSHIP). O’H did not have any
of these duties to the TARGET company, only to the client
of the firm for which he worked.
-Lower Court held: Misappropriation is an invalid theory,
1. It doesn’t require deceit, which is required under 10b
actions. All that is required under misappropriation doctrine
is that one take something so to breach a duty.
2. Misappropriation is inconsistent with the requirement
in 10b that actions deceit be in connection with the sale
of securities. This isn’t the case here because deceit didn’t
induce anyone to sell or trade.
3. This theory is also inconsistent with Rule 14e3 because
the rule merely redefines Fraud.
-Supreme Court reversed on every above point:
1. There is sufficient Deceit (of the source) here, even
though O’H didn’t deceive other traders or the target Company.
He did deceive the firm’s client with respect to a fiduciary
duty he owed.
2. Deception was sufficiently in connection with the sale
of securities, namely that O’Hagan’s own trade or purchase!
3. Sustained rule 14e3 on the basis of language in 14e.
**Harrington thinks that the Lower Court’s reasoning is
more powerful but he’s happy that misappropriation theory
lives on, even though it only gives private P’s a limited
cause of action. But this doctrine really only gives the
SEC a cause of action.
**Harrington thinks that Dirks and Chiarella should have
decided differently, by:
1. The Courts should have used a different policy analysis.
They should have harped on how broad the statute is, in
that it includes “any person”, not necessarily those who
have a duty to speak, may be liable. Also, on the policy
of “Equal Access to Info”, the SEC should require companies
to make annual disclosures on information.
2. Courts should rule in favour of granting the remedy prescribed
by remedial legislation, such as in 14e3, when there is
an honest question of doubt.
3. When Congress wrote the Act, the specific motivation
was a remedial one, in that State Common Law was insufficient.
Congress stepped in. So, now, the last place the Supreme
Court should look to decide fraud in common law cases, is
to look at common law. This is what the Supreme Court didn’t
do in the above case in deciding whether DECEIT element
4. DISCLOSE or ABSTAIN clause in Cady Roberts case used
by Supreme Court to decide the case, i.e., they looked to
common law! What was really meant by this clause was that
anyone with insider-information must ABSTAIN from trading
until the information was disclosed. The rule DOES NOT MEAN
that insider has a duty to disclose.
5. ITSFEA: (Insider Trading Securities Fraud Enforcement
This embodied amendments to the 1934 Act to address abuses
of Insider-Trading that weren’t properly punished, and also
to address the Supreme Court’s rule on this. ITSFEA embodies:
a. Increased Penalties: for insider-trading, e.g. jail sentences,
b. Civil Penalty: Congress gave the SEC the power to impose
a civil penalty against Insider Traders (see Sec. 21a of
the 1934 Act which authorizes Federal Courts to impose the
penalty against any person who’s violated the 1934 Act by
trading or tipping)
1. Does ITSFEA penalties first require a violation of Rule
14e3, or the possession or use doctrine, or misappropriation
doctrine (based on old 14e3 or 10b5 cases)
2. What’s the penalty? It’s up to the discretion of the
judges, but there’s a ceiling of up to 3 times the gains
made or losses avoided by having insider information.
3. The U.S. Treasury gets the money from the penalties
c. Sec. 20-a: this creates a private cause of action for
damages in favour of contemporaneous traders in the market
against traders who use insider information, so long as
P can show there’s a violation (of disclose or abstain rule,
Chiarella or Dirks rule, or 14e3, or Misappropriation theory).
-Private P’s haven’t used this remedy much
-The SEC has.
1934 Act, Sec. 10b, generally
Insider-Trading is only a small part of the 10b Anti-Fraud
litigation. Let’s look at the act, generally, and what must
a plaintiff plead & prove to have a cause of action.
In a 10b action, Plaintiff must PLEAD & PROVE each of
the 7 elements below:
1. Fraud: a. Misrepresentation
b. Omission (Chiarella, or Dirks, etc)
-see Deceit (Santa Fe case)
-Sue Fact doctrine
-Sec. 21D Pleading
-see TSC/Basic cases
-BeSpeaks Caution doctrine
-Sec. 21E Projections
3. Causation: a. Relevance -see Ute, Wilson, and Fraud
on the Market
c. Loss Causation, Sec. 21D
d. “In Connection With”
4. Standing (Blue Chips)
5. Culpability, Sec. 21D
7. Statute of Limitations
P must show Fraud, either 1. Misrepresentation of the truth,
or 2. Omission of the truth when trading with that person
**State of the law: before Santa Fe Industries, the lower
Federal Courts read the Fraud provision loosely, i.e. allowing
all sorts of claims to qualify as legitimate Fraud c/a???????????????
Supreme Court felt that the Fraud provision in the 1934
Act, Sec. 10b should be read more narrowly, requiring deceit.
However, after Santa Fe, the issue left unresolved was whether
what looks more like a breach of Fiduciary Duty can qualify
as a Fraud action under 10b?
a. Deceit: see Santa Fe Industries v. Green, p. 938: This
involved a short-form merger (recall Weinberger, where minority’s
only remedy is an appraisal...). Here, the minorities of
the subsidiary company sued the majority SH in the parent
company, but didn’t pursue an appraisal remedy. Instead,
they claimed Fraud. An unfair price was paid by Majority,
and there was no pre-announcement by the parent company
that there were going to short-form merge.
HELD: insufficient pleading b/c a claim of Fraud falls under
Sec. 10b, which requires showing of DECEIT. Further, the
parent company didn’t violate any state law by not pre-disclosing.
Also, there wasn’t any unfair price found.
*The Courts here felt that this looked more like a breach
of Fiduciary Duty, which is governed by State law, thus
the Fed Ct has no jurisdiction over this case. Sec. 10b
DOES NOT address breach of Fiduciary Duty in SE Act. Court
felt that Federalism should be preserved here.
“Breach of Fiduciary Duty” constitutes Fraud c/a under
Below, is the Sue Fact Doctrine, which is non-deferential
to the above holding in Santa Fe which requires a pleading
of deceit in order to have a cause of action under 10b.
Although the Sue Fact doctrine probably wouldn’t withstand
review if it ever came before the Supreme Court on appeal,
but considering the O’Hagan case, it may....
b. Sue Fact Doctrine: “A Material Omission/Fraud/Deceit
in connection with a sale of securities by a SH or a Corporation
for the Corporation to no to pre-disclose facts which are
material not to SH’s decision whether to buy or sell securities
(sec. 10b) but rather, material to his decision whether
to sue in STATE COURT. If Plaintiff can prove that it would
have been more probable than not that he would have sued,
and would have won
-This doctrine tries to get around the requirement that
P show deceit when there seems to be a case of Breach of
Fiduciary Duty, so that P can have a Fraud c/a under 10b.
In Goldberg v. Maridor, Federal Judge, J. Friendly hones
in on FN 14 of Santa Fe Indus. case (failure of Parent Co.
to pre-disclose didn’t violate Sec. 10b because State law
didn’t require it, and even if they did, it wouldn’t be
necessary because the only available remedy to minorities
is Appraisal). J. Friendly asked, “Suppose there was another
State Remedy? If there was another remedy, then full disclosure
of the planned merger would have been required because P
may have sought this remedy had they known all the facts).
Judge Friendly, in essence, turned the whole doctrine around.
Goldberg v. Maridor: 2 Panamanian Companies, one parent,
one subsidiary, and P was a SH of the Subsid.. P sued on
the ground that it was unfair for the Parent Co. to transfer
worthless assets to the subsid in exchange for the subsid’s
valuable stock. SH’s of the Subsid were damaged.
HELD: Given these facts, a New York justice may enjoin this
(a state law remedy). If facts had been disclosed, P would
have sought this remedy. Thus, there is FRAUD!
c. Sec. 21D Pleading: see the PLSRA (“Private Securities
Litigation Reform Act, or “1995 Act) that amended the 1934
Act, esp. w/r to Sec. 10b Fraud claims
History: This was in response to a strong lobby by accounting
firms and Silicon Valley managers to raise the bar to make
it more difficult for plaintiffs to bring 10b cases. Sec.
21D Pleadings was added.
Sec. 21D Pleadings raised the pleading requirement in damages
actions under 10b, in that:
-P must specify in his complaint each statement alleged
to be misleading, and
-the reason it’s misleading.
*This helps get cases dismissed much earlier.
II. MATERIALITY: “the fact that was omitted or misrepresented
had to be material” (recall this from Proxy Litigation material)
a. Basic v. Levinson, p. 848: (The test used here is the
test for all Securities Fraud cases):
We adopt the TSC Industries test on “materiality:” Misrepresentation
or Omission is Material if a Reasonable SH “WOULD” (not
might) consider the fact important in deciding whether to
buy or sell securities.
Facts: A Publicly traded corporation offered to buy another,
but it was agreed that this must remain secret in fear of
the price of shares skyrocketing. But word leaked out and
insiders tipped others. Price of the shares shot up and
it was noticed. Management issued a No Corporate Development
Statement (public statement that says that there is no knowledge
of corporate development). But this statement was a lie!
The corporation did in fact know about the potential acquisition!
ISSUE: Is this misstatement MATERIAL?
Lower Court HELD: No. It’s not material until negotiations
are started, and an agreement on price is established, and
the form of a deal is established. Before that, it is uncertain.)
Supreme Court HELD: Rev’d and Rejected this definition of
materiality, and adopted the TSC Industries standard.
R.D.: If the corporate officers chose a “No Comment Response”
to the rumours, then there’s no liability. But, if corporate
officers speak, it must be truthful because what they say
b. BeSpeaks Caution Doctrine: When a corporation makes projections
about its future performance they inherently won’t be accurate
because it’s impossible to predict. If the corporation gave
sufficient warning that the projections may not be accurate,
then as a matter of law, the disparity between the actual
market price and the projected price is not material.
General version of the Doctrine: When projections are accompanied
by meaningful, cautionary statements about risks involved
which are substantive and tailored to the specific projections
themselves, that cautionary language renders the alleged
deceit/misstatement immaterial as a matter of law.
c. Sec. 21E Projection Doctrine: This is Congress’ version
of the BeSpeak Caution Doctrine. Basically, there is no
liability for a forward looking statement if:
1. it’s a projection accompanied by a meaningful cautionary
statement (i.e., identifying the risk factors), or
2. Plaintiff suing fails to prove that the statement was
made with actual knowledge of the falsity.
*Does Congress really mean that even if Defendant has the
specific intent to cheat you he’ll get away with it so long
as he accompanies his statement with a cautionary statement?
*Oral Projections? If you make an oral projection statement,
you must caution that it’s only a projection and say that
the actual results may differ, and must identify a writing
that a listener may have
III. CAUSATION: (If P flunks in pleading/proving any one
of these elements in causation, then case dismissed)
a. RELIANCE: “D’s misrepresentation/omission caused me to
rely to my detriment!” The same Omissions case problem arises,
as in Mills in proxy litigation: How does a plaintiff prove
that she relied to her detriment on something she was never
told? see below:
Ute Affiliated case, p. 868:
Supreme Court here acknowledge the proof problem in an omissions
case and said that the Reliance standard still stands, and
P won’t have to prove causation, so long as she shows MATERIALITY
of the Omission, because the Court will grant P a REBUTTABLE
PRESUMPTION that there was in fact reliance! (How generous
of the Court!)
-the Supreme Court delegated the duty to Trial Courts to
determine whether the case before them is either an omissions
or a misrepresentation case. This causes controversy, of
course, since in once case the burden of proof is higher.
-in Mills, the Supreme Court wasn’t so generous. It just
said that so long as the P shows materiality of the omission,
the P will only be required to show that the Proxy Statement
as a whole was an essential link in causing reliance to
Is proof of Reliance really that important?:
Wilson v. Comtek
Wilson went to an analysts meeting where the president of
Comtek forecasted that his company won’t be making any profits
next year. Wilson went back home and didn’t do anything
until his broker told him 6 months later that it would be
profitable to invest in Comtek. Wilson did just that, but
2 days later, Comtek disclosed millions of $ in losses,
and thus, Wilson suffered losses too. Wilson sued under
Sec. 10b for reliance on President of Comtek’s speech.
ISSUE: Whether this a case of Omissions or Misrepresentation?
(Wilson said it’s an omissions case because Comtek failed
to correct its president’s misstatement as it was underinclusory.
If Wilson succeeded on this argument, he wouldn’t be required
to prove reliance, since a showing of materiality suffices.
Defendants disagreed, and said that this case was a misrepresentation
case, and P should be required then, to prove reliance.)
HELD: Judge Friendly held for plaintiff, and remarked, “You
shouldn’t read Ute Affiliated case so narrowly. The proper
interpretation is: A REBUTTABLE presumption will be granted
to Plaintiff when it’s an unreasonable burden for P to prove
Fraud on the Market Doctrine:
If a stock is public traded on the efficient capital market
and Defendant makes an affirmative misrepresentation, and
if plaintiff traded during the interval between the misrepresentation
and when the true facts were revealed, then the Court will
grant plaintiff a REBUTTABLE presumption of reliance reflecting
her implicit reliance on an efficient market which impounds
the new but false information and reprices the security
accordingly (the market relied on the misrepresentations
and was fooled, and plaintiff relied on the market thereafter!)
(see p. 861 for explanation of efficient capital market
-see Panzer v. Wolf (2d Cir.): Plaintiff was an elder widow
left with millions of $. She read the financial column advice
in a magazine that stated that Company X is a company that
was once doing horribly, but is predicted to do very well.
Plaintiff bought this and invested lots of $ on this company.
Little did she know that Company X just recently filed their
report with the SEC which said it was doing really well.
But this was a complete FABRICATION! In actuality, the company
was doing worse than ever. A few months later, the Fraud
was revealed to the public, and Plaintiff then lost millions,
and sued on Reliance theory. The only problem was that she
didn’t rely on Company X’s financial statements per se,
but rather, on the financial magazine article!
HELD: under Ute Affiliated there is a sufficient showing
of Reliance here, since there was fraud on the market: chain
of reliance on the fraudulent SEC reports led to plaintiff
relying on them, down the road. Essentially, plaintiff relied
on an efficient capital market.
*Class Actions: Plaintiffs must prove by preponderance of
the evidence that the reliance was common to all in the
Comments on Panzer v. Wolf:
1. The Second Circuit wrote this opinion a mere few months
after the stock market crash, and which essential contradicts
the theory of efficient capital markets.
2. The decision was handed down without examining the significant
writings on the INEFFICIENCY of the market
3. There’s a policy anomaly here: the court goes to of its
way to give a remedy to a plaintiff that didn’t bother to
read what the SEC reports that are made public
4. Fraud on the Market effectively nullifies Sec. 18 (express
grants cause of actions to private plaintiffs who are defrauded
by financial statements filed with the SEC, but here, you
must prove reliance). So, now, Sec. 10b allows remedy without
invoking Sec. 18.
Summary on Reliance requirement:
Although the Supreme Court in Ute Affiliated says proof
of reliance is required, it “seems” like proof of reliance
is no longer required in both omissions or misrepresentation
cases. Under Ute Affiliated, in an omissions case, plaintiff
needn’t prove reliance, only materiality. Under Panzer,
in a misrepresentation case (of financial statements filed
with the SEC?????????????), plaintiff needn’t show reliance
because the Fraud on the Market theory will suffice, thus
invoking the Efficient Capital Market hypothesis.
*Note, Proof of Reliance is required when:
1. Closed Corporations, and
2. Affirmative Misrepresentations???????????????
b. Damages: “How was plaintiff hurt?” There is no case law
on this element of Causation because all parties settle
before going to trial. There’s just too much uncertainty
on either side of how damages will be awarded.
-see p.870 on the various theories of calculating damages
c. Loss Causation:
This element of causation is vexing, mostly because Courts
interpret the phrase in different ways. The origin of the
term is in Tort law: Loss causation mirrors proximate causation,
that is, even though there may be multiple causes to the
injury, it is sufficient if there is proof that the fraud
is a “substantial factor” in causing the injury.
-some courts require that fraud be the sole factor in causing
-see Roofa Hanover case: Scam artists went to wealthy people
and said they’ve found a gold mine, but need their money
to get it out. The wealthy people believed the scam artists
and handed over lots of $. The scammers ran with the money,
and the wealthy people sued the law firm that represented
HELD: Plaintiff failed to prove loss causation b/c the immediate
source of harm was not the LIE, but the THEFT.
-see Bastion case, p. 867: Scam artists approached certain
investors to get their money exploit an alleged oil mine.
The venture went bankrupt because there was actually no
gas or oil. P sued under 10b.
HELD: P’s failed to prove loss causation because the plaintiffs
would have lost money anyway since they intended on investing
in the oil industry, and all oil ventures failed during
d. “In Connection With” (the sale or purchase of securities):
This requirement is expressly stated in Sec. 10b. But there
has been 2 interpretations of it:
1. Narrow: The Fraud must have induced the buyers/plaintiffs
to enter into the transaction
2. Broad: The Fraud just need to have had “something to
do with the sale or purchase”
-see Superintendent v. Bankers Life, p. 928: An pro Con
Artist wanted to buy an insurance company that had huge
certificates of deposits, with the intent to cash them after
he bought the company. He did just that and plaintiffs/minority
SH’s sued everyone in the company.
ISSUE: Was there sufficient showing of Fraud in connection
with the sale or purchase of securities?
HELD: Yes. The securities, here, were the certificate of
deposits! The Fraud need only touch upon the purchase or
-see O’Hagan case (also a broad reading of “in connection
-see Aames case
-see U.S. v. Livieratoss: Scam artist approached wealthy
people, claiming to be a Phd student from MIT, to get them
to invest in what he purported to be the best money making
invention he was about to patent: a self-heating can. The
wealthy people bought it. But they got nervous, and the
scam artist held a party to reassure them, but also got
them to invest in his “self-chilling can” invention too!
He took off with their money!
ISSUE: Was there sufficient ‘in connection with” causation
HELD: Yes, even if he merely retained funds in connection
with the second invention, the first transaction constituted
Fraud in connection with sale or purchase of securities
(in his self-heating can).
-see Blue Chips Stamps case: Supreme Court held in this
close case that a private plaintiff must be a purchaser
or seller of securities, not a mere offerree, nor holder
of shares. The court’s decision was based on policy analysis:
R.D.: this deters vexatious strike suits that have no merit,
and avoids the proof problems if plaintiff is not this kind
??????????????????what’s an example of seller of securities???????????????
1. It is rare to see the Supreme Court in such a close case
use policy to decide the case!
2. The court seems to imply that even though there may be
plaintiffs who have been in fact defrauded, they won’t have
a cause of action because of these policy reasons
3. With respect to the comment on proof problems, the court
seems to imply that lower federal court judges won’t be
able to weed out cases that are non-meritorious
4. Most lawyers think that Fed Judges are good at weeding
out non-meritorious Sec. 10b cases on the docket
V. CULPABILITY: What state of mind is required?
-see Earnst & Earnst v. Hochfeller: P must plead &
prove SCIENTER, or Specific Intent to deceive or manipulate
in committing a fraud.
-although the court held that this was the standard, the
opinion refers to “knowing or intentional conduct” may constitute
the mens rea requirement. This was stated in the opinion
because the court wanted to dodge the issue of recklessness,
and whether it suffices as the requisite mens rea.
*Most Federal courts say recklessness suffices as adequate
*What is recklessness? see Sunstrand case, p. 932: “an extreme
departure from reasonable care”
*Does the SEC also have to show Scienter like a private
plaintiff? YES. see Aaron v. SEC
a. Sec. 21D Pleading requirement: This section seems to
require new pleading requirements of scienter by a private
plaintiff in a damages action only, though. P must specify
the facts giving rise to a strong inference that Defendant
acted with the reqpired st`te of m`nd.
*spill, a showing of recklessness suffices, according to
the 2d Circuit. But some say that Congress intended the
pleading requirement be a showing of “conscious recklessness”
VI. DILIGENCE, p. 935
Plaintiff must show that not only was Defendant negligent,
but also Plaintiff was free from negligence!
*Most courts hold that it’s OK for Plaintiff to show that
she was free from recklessness
-see Malice case, p. 936: P no longer has to plead diligence,
unless D makes it an issue and shows evidence that P was
??????????????????????so what is the standard?????????????????????????
VII. STATUTE of LIMITATIONS:
Usually Statute of Limitation issues come up when D pleads
it as an affirmative defense.
Plaintiff must plead & prove that the suit was brought
within the Statue of Limitations of Securities Litigation
a. Borrowing/Absorption Doctrine: Since private plaintiffs
only have an “IMPLIED” cause of action under the Securities
Act, Congress never thought plaintiffs would bring suit,
and didn’t state what the SOL would be for private plaintiffs.
So, it looked to the state’s anti-fraud laws, and their
SOL’s, thus, borrowing and absorbing their SOL. However,
this resulted in nationwide disparities, and a lot of forum
shopping for the longest SOL.
-Lampf v. Pleva case, p. 952: Supreme Court addressed
this issue and said: If there’s an implied c/a for a private
plaintiff under a large statute that expressly states a
SOL for expressed c/a, then use that, not state law. So,
in this case, the court looked to Sec. 9e of the 1934 Act
and found that the SOL is 1 yr from discovery, but no later
than 3 yrs after the fraud was allegedly committed.
*************CONSTITUTIONAL ISSUE: the above holding resulted
in the dismissal of approx. 20 pending cases that were filed
beyond the SOL. Congress responded by enacting Sec. 20A
to reinstate those cases. But, in Plout case, p. 953: The
Supreme Court addressed a SEPARATION OF POWERS issue in
that Congress cannot demand that the Supreme Court reopen
those cases, and thus, dismissed all 20.
Remaining Loose ends to Sec. 10b Securities Fraud Litigation
1. Contribution & Proportionate Liability Theory:
(The issue of “contribution” is discussed on p. 952.)
ISSUE: IN regard to “contribution”, is liability for multiple
Defendants was Joint & Several? YES!
ISSUE 2: Does any of the D have a right of contribution
to pay off the entire liability?
(The statute is silent on this, but it’s interpreted to
mean yes!) see below:
Music Peeler case
HELD: 1. We can’t investigate Congress’ intent because a
private cause of action is implied
2. So, we should look to what Congress said when it carved
out express causes of action: see Sec. 9 & Sec. 18,
both of which involve SCIENTER, ANTI-FRAUD, & CONTRIBUTION!
So, yes, there’s a right to contribution in Sec. 10b litigation.
*Proportionate Liability Theory: This was a proposal that
debuted in 1995 that generally suggested replacing Joint
& Several liability with PROPORTIONATE LIABILITY. This
means an Individual Defendant will be liable only for the
proportion of the total damages of his percentage of responsibility,
based on the Court’s finding of facts, EXCEPT: when the
defendant is a KNOWING VIOLATOR who intentional bad, not
mere reckless (this theory was meant to give reckless persons
a break, but there is very little case law on this)
2. Aiding & Abetting Liability:
Persons who weren’t primary violators but AIDED & ABETTED
in the primary violation will be held JOINTLY & SEVERALLY
LIABLE in all 10b violations..
-Definition of Aiding & Abetting: 1. Existence of a
primary violation, e.g. Corporation lies in its prosepctus
2. Aider & Abetter knows about the primary violation
3. Aider & Abetter knowingly and substantially assists
in the violation
-typically, accountants may be liable if they reckelessly
conducted an audit; or outside lawyers; bankers
-see Central Bank v. Denver, p. 937:Bank was the Trustee
for public investors in bonds. The Bank had to make sure
that the value of the collateral was a certain %. However,
the bank was reckless, and the value of the collateral dropped
HELD: Although the Bank aided and abetted in the violation...
?????????????? NO A & A LIABILITY IMPOSED!
R.D.: Aiding & Abetting liability would hold persons
liable that Congress would not have intended to hold liable
in 10b actions. When the Statute was drafted in 1934, A
& A was only a criminal law concept, and hadn’t extended
into private tort law yet, so it’s likely that Congress
didn’t intent for it to reach aiders and abetters in 10b
litigation. BUT: there is A &A liability in actions
brought by SEC, evident in Sec. 20 where Congress restored
this liability for this situation only.
-(Now, Private P’s are trying to frame their complaints
alleging that P was the PRIMARY VIOLATOR because otherwise,
10b wouldn’t impose liability on an A & A’er.
-Primary Liability: the 9th & 3rd Cir. impose liability
if D played a significant role as the primary violator,
or if D actually authored the fraud
3. SEC’s cause of action & pleading requirements:
a. SEC doesn’t have to be a purchaser or seller (like a
b. SEC doesn’t have to show that it was diligent ???????????????
c. SEC ONLY needs to show that the FRAUD WAS IN CONNECTION
WITH the sale or purchase of securities
4. Can Insider-trading be a defense?
Bateman Eichler Inc. v. Berner, p. 934
This is one of the “Gold in Surinam” cases: Scammer approached
wealthy people to get them to invest in their venture. The
scammer sold them a ‘secret tip,’ and of course, the venture
ended up being a scam. Investors sue on the theory that
fraud, and tried to use D’s Insider-trading as a defense!
HELD: Although there are some cases where we’ll accept Insider-trading
as a defense, THIS IS NOT ONE OF THEM.
R.D: An insider who tips is more blameworthy than a tippee
who voluntary trades on the basis of the information (he
later finds out to be false)
5. “SLUSA” (Securities Litigation Uniform Standards Act):
This is an addition to the 1934 Act, but there hasn’t been
much case law on it yet. One of the main purposes of the
1995 Act amendments was to cut back on Securities fraud
Class Action suits because too many were being brought (remember,
Congress created all thoses pleading and proof requirements
so to weed out all those cases). After the 1995 Act, it
was the perception that plaintiff’s alternative remedy was
in STATE COURT! Congress enacted SLUSA to address this situation
and tired to REDIRECT LITIGATION BACK INTO FEDERAL COURT.
Sec. 28F provides: it bars from State Courts covered class
actions alleging Fraud in connection with the purchase or
sale of securities, except: DERIVATIVE SUITS (courts are
already very tough on these suits).
-”Covered securities:” securities which are traded in any
of the major Stock exchanges, or NASDAQ
-”Covered class actions:” any action involving 50 or more
Sec. 16 of 1934 Securities Act
(see p. 953. Sec. 16 is the original statute for Fraud)
Section 16 has 2 main purposes:
1. 16-A: Disclosure
2. 16-B: Liability
Generally, there was a perception after the 1929 Market
crash that ther was a lot of corporate violators, like who
manipulated securities short-term. Congress wanted to stop
1. DISCLOSURE: Sec. 16-A: if we have a corporation and it
has stock (equity securities) whch is publicly traded (registered
under Sec. 12), then there are 3 DIFFERENT CLASSES of INSIDERS
who are required to MAKE 3 KINDS OF FILINGS/DISCLOSURES
with the SEC.
a. Form 3: within 10 days of becoming an Insider, one must
make this filing which details all my holdings
b. Form 4: within 10 days of the end of the month, whenever
my holdings change, one must make this filing
c. Form 5: year-end filing
(a secret trading strategy is to follow Insider-Traders,
especially if they’re senior officers and get access to
these 16 b filings. You then do a calculation of all he
bought and sold--formula shown below--then, with the final
figure, call the president of the company for whom the Insider
works, and tell him about the insider and how much he owes
the company, and then demand your lawyer’s fee.)
-”Insiders”: Any Director or similar role; or Senior Officer;,
or Any SH who owns more than 10% of outstanding stock
-If an Insider engages in short-term insider-trader, and
gains profits, he must return those profits to the corporation
2. LIABILITY: this implies automatic liabity. The Insider
Director, Officer, or any SH with 10% of the outstanding
stock must disgorge to the Corporation any profits on any
purchase and sale or sale and purchase of any equity security
of the corporation WITHIN A 6 MONTH period (before or after
the transaction date).
*How to calculate the total disgorgement sum of all the
profits the Insider ever made? See Harrington’s 6 Simple
Sillies for Interpreting Sec. 16 to maximize damages owed
by the Insider:
Silly #1: Take each Sale price at which an Insider sells.
Look 6 mos forward, 6 mos back for the LOWEST PRICE at which
he BOUGHT. Substract High Sale Price - Low Buy Price, then
caculate the profit on that matched transaction. Take that
Sum x # of Shares Sold.
Silly #2: If there is more than one Purchase of Sale within
a 6 month period, pair off the transactions by matching
the HIGHEST SALE PRICE with the LOWEST PURCHASE PRICE, and
then, the next highest sale price with the next lowest purchase
-But, this can lead to problems, see #3
Silly #3: If the pairing and calculation of that pair results
in a loss, don’t count it, ignore it!
Silly #4: Rule of Convenience: 1. Focus on SALES TRANSACTIONS
first, and look for the highest sale price. LOOK 6 mos.
ahead and backwards from that date. Then, pair it with the
LOWEST PURCHASE PRICE. Calculate profits by multiply by
# of shares *sold (*in actuality, you should use as the
multiplier, the lower # of shares in the pairing, not necessarily
the shares sold, see #6)
Silly #5: Carry-over rule: Once you’ve used the transactions
in a pairing, strike them out. But, what if there’s an UNEVEN
# of SHARES Sold & Bought? Match them as usual, but
carry-over the excess no yet paired, and use it as the first
leg of the next transaction because the excess represents
an unused transaction price.
Silly #6: When there’s an uneven # of shares, USE THE LOWER
# of SHARES as the multiplier for that pairing calculation
e.g.: 3/1 buy 200 shares $40/share
4/1 sell 100 $20
5/1 buy 100 $35
6/1 sell 200 $50
7/1 buy 100 $45
8/1 sell 100 $40
1. Look for highest sell price: June 1 at $50/share. Lowest
buy price is May 1 at $35/share:
$50 - $35 =$15/share x 100 shares = $1500 (but excess of
100 sold shares, so find the next lowest buy price)
2. Remaining 100 shares of June 1 at $50. Next lowest buy
price is March 1 at $40/share:
$50 - $40 = $10/share x 100 shares = $1000 (but excess of
100 bought shares, so find next highest sale price)
3. Next highest sale price is August 1 at $40/share. Remaining
100 shares of March 1 at $40/share:
$40 - $40 = $0
4. Next highest sale price is April 1 at $20/share. Next
lowest buy price is July 1 at $45/share:
$20 -$45 = LOSS. OMIT this from total caculation.
Result: $1500 + $1000 = $2500, the maximum damages the insider
The Corporation is the only party who recovers, not a plaintiff-shareholder
who may be forced to commence a 16b action. Any security
holder must make demand on the BOD to enforce a 16 b action,
and if they don’t, then the security holder has a private
cause of action.
*Why bother then, if you don’t recover the profits?
B/c attorney fees. Lawyers look for violators of 16b and
they get 1/3 contingency fees for catching them.
1. Does a gift constitute a Purchase or sale of a security?
2. What if there’s a stock dividend, and SH gets additional
shares in the mail as a bonus? No.
3. True involuntary transactions where the actor had no
choice in the matter are also excluded: see Kern City v.
Oxy, p. 966: Occidenta started a hostile offer on on May
8th and Oxy already had some shares in Kern City. On May
19th, Kern tried to preserve the corporation by a defense
tactict that involved merging with Teneco. Kern would propose
to sell all of its common stock in exchange for Teneco’s
preferred stock, and this transaction would be effective
August 30th. However, this deal would also compel Oxy to
give up their common shares in exchange for Teneco shares
too. So, Oxy tried to prevent this by enterring negotiations
diretly with Teneco, and they agreed that Oxy would get
a call option on its future shares in Teneco, that Oxy could
exercise on December 9th. Since this date was over 6months
after Occidental’s last purchase on May 8th, Occidental
could not be liable.
ISSUES: Was Occidental liable for the August 30th forced
exchangd of shares? No, it was purely involuntary. Was it
liable for its handover of Teneco shares on the Call option?
SH Derivative Suits
Each year, about 400 suits against Directors of Publicly
traded corporations are filed, about 200 of which are class
actions started by one Sh claiming to represent all SH’s
harmed by fraud/10b action, (see p. 1124). The other 200
suits are SH DERIVATIVE SUITS where the SH sues on behalf
of the Corporation as a whole against the Director. These
suits are adopted by Statute or judicially.
a. SH Derivative actions are good b/c other remedies are
hard to succeed on, e.g.: Private c/a may be defeated by
BJR protection of Directors’ actions; 10b actions have hard
pleading & proof requirements (and disclosure requirements
of SEC Proxy statements don’t help much either); Proxy contests
b. SH Derivate suits are bad b/c they’re merely “Strike
suits”, i.e. non-meritorious, lack substance, and brought
only for its settlement value. These suits are wasteful
of SH $ to defend. The only persons who benefit are law
firms (usually, the lawfirm seeks out the plaintiff). Only
1% of all that survive procedural requirements. 2/3 of all
suits and 95% of all that survive procedural requirements
end up settling anyway. When they’re litigating, 95% of
them the Directors win. Only ½ of the settlement suits result
in monetary recovery.
1. What is a SH DERIVATIVE SUIT? 2 kinds:
a. Direct c/a: Director breached duty mainly owed to SH
or the Class bringing suit. Injury was specific to her,
or them, and the breach relates to the fundamental K b/w
SH and Corp.
-e.g., SH’s suit to enforce their right to inspect books;
right to vote; pre-emptive rights; allegations of fraud…
**Usually P wants his suit to be characterized as “Direct”
so to avoid the difficult procedural requirements of a SH
b. Derivative c/a: Directors breached FIDUCIARY duty owed
to Corporation, and injury was to Corporation (see p 1014).
The standard of Director care is ordinary negligence.
-e.g.: breach of loyalty, Director took corporate opportunity
Sax case, p. 905
Majority Rule: where essence of claim is injury to Corporation
as a whole, and not to P himself, then this is a DERIVATIVE
Schumacher case, p. 1009
*Special Injury Cases: (minority rule) Even though there
was a breach of Fiduciary Duty, P was ESPECIALLY HARMED
b/c this was a close corporation, and thus, Minority P-SH
can bring a DIRECT C/A. This rule applies to:
a. Close Corporations, or
b. if P presents a good argument
2. STANDING: P must be a SH at 3 different critical times:
a. When he brings suit
b. remain a SH until end of litigation
c. when injury happened to the Corporation
-see Banghor case, p. 1021: A new owner of almost 100% of
the shares in a Corporation wanted the Corporation to sue
the past owners for self-dealing.
HELD: New owner had no standing b/c he wasn’t a SH when
alleged injury happened to the Corporation.
Comments: I) the TRADITIONAL purpose of SH Derivative suits
is COMPENSATORY for Director’s breach of Fiduciary Duty.
Today, the purpose is DETERENCE.
ii) New Owner would get a windfall if we compensated him
with losses he didn’t sustain
Exception to 3 rules:
a. Inheritance: If P inherited the shares from a predecessor
SH who owned shares at the time of harm
b. Continuing Wrong: if P didn’t own shares when the injury
occurred, but the harm now continues when he’s a SH
c. Beneficial SH: P need not be a SH of record. A Beneficial
SH will suffice
3. DAMAGES: Who gets them?
-see Glen v. Hoteltron: (Majority rule): all damages go
to Corporation, even if SH brought the suit
R.D.: a. Fear of jeopardizing Creditor’s rights, who have
rights to Corporation’s assets, but not the individual’s
b. Consistency: the suit was brought on behalf of the CORPORATION,
not the individual
c. Awarding Full damages to corporation may scare off non-meritorious
*new theory: “Pro Rata Recovery”: (only applies to Close
Corporations): Suppose the wrongdoer is a majority SH. If
the Court awards full damages for his breach of F.D., then
he also benefits b/c he has control over the corporate funds.
Soooooo…., the P-SH should recover her pro-rata share from
the Wrongdoer, instead of it all going into the Corporate
4. JURY TRIAL: (p. 1032): NO
5. ATTORNEY’S FEES: (p. 1071): P-SH is entitled to recover
REIMBURSEMENT by the corporation for the costs of litigation
& ATTORNEY’S FEES when the derivative suit is successful,
RESULTING IN PECUNIARY DAMAGES. (but for this rule, no one
would bring these suits).
-What if no pecuniary damages awarded? Then, so long as
the judgement resulted in some substantial benefit to corporation,
then lawyer will be awarded the value of that benefit.
-e.g., Substantial benefit: cessation of the Director’s
-*How to calculate fees:
a. LODESTAR: Total billable hrs. x lawyer’s billing rate
x Multiplier (1.1-.9) reflecting based on experience difficulty
of the case
in that area in that
-criticism: the lodestar drains judicial time, and creates
an incentive for attorneys to stall the case to jack up
the billable hours
b. % of RECOVERY: 25 –30 % of the value of the recovery
6. BOND POSTING: (rule in 18 states): in order to deter
suits, the Corporation can elect to demand that the SH bringing
suit POST A BOND securing reimbursement of the corporation’s
expenses, e.g, attorney’s fees in the event the Corporation
loses the suit (this doesn’t mean the SH has to pay for
it at the end though. This just puts pressure on SH to bring
a meritorious suit).
**P’s lawyers try to avoid posting a bond by framing the
case as a DIRECT ACTION, or as a FEDERAL action where there’s
no bond posting requirement, OR
**(see Baker v. McFadden): if a Corporation elects to have
SH post a bond, the Court will halt the proceedings to give
P-SH a chance to find other SH’s totalling 5% of the Corporation’s
SH, whom together, will then be excepted from posting a
7. SETTLEMENT & DISMISSAL:
a. NO SETTLEMENT WITHOUT COURT APPROVAL (but in reality,
Judges accept settlements w/o judgment all the time)
b. COURT MUST GIVE NOTICE OF SETTLEMENT TO SH’s so they
have chance to object
-Comments: CONFLICT OF INTEREST b/w SH’s and Attorney who
just wants his lawyer’s fees, and favours settlement if
it’s for a decent amount. So, a judge’s role in requirng
that he review the settlement first doesn’t really deter
this attorney abuse b/c the judges like settlement, and
further, then don’t’ have all the information to make a
decision. Hearings are like joint pep rallies.
a. Corporation treated like a D
b. Must have Personal Jurisdiction over Corporation
9. INDEMNIFICATION & INSURANCE: Must a corporation indemnify
a Director who’s sued? State statutes address this, and
there’s room in it to expand.
a. Yes, if win the case
b. Yes, if lose the case, but only expenses, if Court finds
the Director acted in Good Faith & in a manner he reasonably
felt was in the best interests of the corporation.
c. if 3dp (not SH) v. Director, Yes, even if lose the case,
if Court finds same as above. Director gets indemnified
for judgment, settlements, expenses…
**Insurance: b/c Director liability insurance is so expensive
and not readily available, Indemnification is very important.
****10. P-SH Demand on the BOD 1st:
1. Generally: EVERY P-SH MUST PLEAD WITH PARTICULARITY
SPECIFIC FACTS HER ATTEMPT TO MAKE DEMAND ON BOD. IF SHE
DIDN’T MAKE DEMAND SHE MUST EXPLAIN WHY NOT.
*Exception: DEMAND IS EXCUSED IF P CAN SHOW THAT IT WOULD
BE “FUTILE” TO DO SO.
2. “Futility”: a) when a Majority of the BOD is “interested”
in the underlying transaction in
-“interested”: I) when BOD approved & participated
in the transaction in
question (Barr v. Wackman) (liberal view), or
II) when Majority of the BOD must get some kind of
“PECUNIARY GAIN or equivalent (Aronson v. Lewis)
b) when the Majority of the BOD is under he domination
& control of the wrongdoing minority such that they
can’t exercise independent control (Aronson v. Lewis)
3. But, the BJR protects:
a. in both Demand-Excused and Demand-Refused case so long
as there is an SLC (N.Y. Rule), or
b. in Demand-Excused cases if
I) Directors bare 1st burden of proving the SLC conducted
II) the Court in using its own BJR finds it in the best
interests of the corporation to dismiss the suit. (Zapata),
c. in cases where there’s no “egregious” facts (Aronson—narrowing
of the rule on which cases are demand-excused cases)
RULE: IN EVERY STATE STATUTE, A P-SH MUST SET FORTH WITH
PARTICULARITY IN HER COMPLAINT HER EFFORTS TO DEMAND THE
BOD TO TAKE ACTION. IF SHE DIDN’T DEMAND THIS, SHE MUST
STATE THE REASONS WHY NOT.
-Why require this?
a. Management ____ to bring a suit
b. Judicial economy
c. Protection of Directors from harassment
d. Deter non-meritorious strike suits
**EXCEPTION: DEMAND IS EXCLUDED IF P SHOWS IT WOULD BE
“FUTILE” (if P gets demand excused, the Corporation no longer
has control over the suit, but P does
*In reality, in demand required cases, the BOD never proceeds
with the litigation anyway.
*Issue: What is “FUTILE?” ????????????????!!!!!!!!!!!!!!!!
Rule 1: IT IS FUTILE WHEN A MAJORITY OF THE BOD IS “INTERESTED”
IN THE UNDERLYING TRANSACTION IN QUESTION.
*Issue: So, when is a Director “interested?”
a. -Barr v. Wackman: (liberal view): if BOD approved &
participated in the transaction in question there is sufficient
Director “interest” so that SH’s demand would be futile
(A wanted to buy B and they negotiated for $20/share. But,
the deal broke down, and in the new negotiations, the parties
agreed on $10/share. 3 of the new BOD got good K’s as did
CEO (self-dealing). This was held to be sufficient ‘interest’
of the Directors, even though the Majority didn’t do so).
b. Majority/Delaware Rule: Majority of the BOD must get
some kind of “PECUNIARY GAIN or equivalent in order for
there to be sufficient “interest.”
-see Aronson case
Rule 2: IT IS FUTILE WHEN THE MAJORITY OF THE BOD IS UNDER
HE DOMINATION & CONTROL OF THE WRONGDOING MINORITY SUCH
THAT THEY CAN’T EXERCISE INDEPENDENT CONTROL
-see Aronson v. Lewis, p. 1060: (recall this case in the
BJR Gross Negligence Standard of care in Delaware). Old
man Fink retained 47% stock interest in a public corporation.
Right after he retired, the BOD generously gave him a consulting
K that didn’t require him to do anything back in return.
Lewis, SH, didn’t like this K so brought a SH Derivative
HELD: P-SH failed to show futility as an excuse for not
demanding the BOD to bring suit; he failed to show that
the Majority of the BOD got pecuniary gain, or that they
were under complete domination of the Minority.
What kind of case is a Demand-Excused case?
1. If Demand was made against an unrelated 3dp (e.g., former
customer for breach of K), & BOD refused the demand
of the SH, the refusal is protected by BJR.
1a. If Corporation has a major customer who’s on the verge
of bankruptcy, and instead of the BOD suing him, the Majority
of the BOD let the client tough it out. This decision protected
2. If P-Sh alleges wrongdoing by the minority of the BOD,
Demand must be made (b/c FUTILE exception only applies when
the Majority of the BOD is interested). BJR protects here,
3a. If P-SH sues Majority of the BOD but fails to specifically
allege pecuniary gain, DEMAND is required, but BJR protects.
**3b. (Turning Point): If P-SH alleges ACTUAL Wrongdoing
& Pecuniary benefit by the Majority of the BOD, then
DEMAND SHOULD BE EXCUSED b/c if P makes Demand, he’s conceded
that the Majority of the BOD made a decision, which is protected
by BJR ??????????????????????????
4. Is there any way that the Corporation can convert what
could have been a Demand-Refuse case into a Demand-Excuse/BJR
protection case? Yes, by Special Litigation Committees (SLC):
SLC’s: In order for the Directors to claim BJR protection
in demand-refuse cases, it will appoint new Directors, who
will then form a supposedly independent SLC to investigate
P-SH’s claim. The SLC then reports back to the Directors
on whether to pursue the cause of action. (Not 1 SLC has
ever recommended the BOD to sue).
-see Back v. Bennet: (this is NY’s version of the BJR) GTE
was alleged to have participated in foreign bribery scandal
to get new busienss. P-Sh alleged that 4 Directors out of
15 participated. P wanted this to be a demand-excuse case
and the BOD acquiesced. GTE then asked the Court for a stay,
and appointed an SLC. They reported back to the corporation
that it would be in the corporatio’s best interest not to
pursue the litigation.
HELD: case dismissed b/c BJR protection.
Court’s Role: The Court will only review the “Process”
of the decision, e.g, external formalities, method of the
decision-making, but t won’t review the wisdom of the decision,
thus, giving BJR protection.
New York Rule: Give BJR protection to both demand-excuse
cases and demand-refuse cases when there’s a SLC. (Auerbach)
Delaware Rule: see Zapata v. Meldonado case, p. 1051: P-Sh
alleged self-dealing by directors when they accelerated
the exercise date of their stock options & arranged
for the corporation to give them interest free loans. This
is a classic DEMAND-EXCUSE case. The BOD appointed a SLC,
but even so,
HELD: No BJR protection!
R.D.: a. BJR is not strictly applicable when there’s an
inherent bias in the members of the new BOD, (or SLC), to
conform, to edit facts…they’re not truly an independent
body. Also, the decision to terminate litigation is not
an ordinary business decision.
b. Instead of the BJR, Delaware Courts should adopt 2-step
1. Corporation has the first burden to show INDEPENDENT,
GOOD FAITH, REASONABLE INVESTIGATION.
2. If Corporation bares this burden, then Court should determine
whether motion should be granted, using its own Court BJR,
e.g. whether Directors acted in the best interests of the
The states are split on whether to adopt the Delaware 2-prong
Zapata rule, or the New York Auerbach rule.
Narrowing the Rule on Demand-Excused cases:
Aronson v. Lewis
If you use the Zapata rule, the BJR won’t protect decisions
made by the majority of BOD only if they’re EGREGIOUS. This
is because a presumption of validity is given to business
judgments. Aronson attempts to narrow the rule, so that
more cases won’t qualify for demand-excused.
General Rule: Only when particularized facts are alleged
in the complaint that create in the Court a reasonable doubt
1. either the Director are disinterested* and independent,
2. the transaction was otherwise the product of valid Business
then, should the Court characterize the case as a demand-excused
-Examples of interested: tangible benefit to a majority
of BOD, NOT mere approval of the transaction
Marx v. Acres (Supp)
The New York court here says it rejects the 2-prong test
in Aronson but it looks like it really adopts it! P-SH alleged
the Majority of the BOD wasted the Corporation’s assets
by giving excessive compensation to Senior Execs and Senior
Members of the BOD.
Court announces new 3-prong test (but probably doesn’t overrule
Barr v. Wackman)
Demand is excused if P alleges with particularity:
1. Majority of BOD is interested in underlying transaction
2. BOD didn’t fully inform themselves
3. the challenged transaction was so “egregious” (Aronson)
on its face that it couldn’t have been the produce of valid
HELD: NO cause of action against Senior Executives, but
demand-excused with respect to Senior BOD.
The compromise is so convoluted:
1. If it’s a Duty of Care case, then apply BJR & give
the Court should give the business decision deference
2. If Duty of Loyalty case, then use something like Zapata
The ALI demands 2 levels of pleading & 2 steps of review:
1. Validity of pleadings in complaint: P must plead particularized
facts which raise significant prospect of 2 things: a. underlying
conduct breached a duty of care or loyalty, and
b. Rejection of demand was not because the decision was
disinterested, informed, or reasonable in the best interest
of the Corporation
2. BOD”s motion to dismiss:
a. If the transaction being challenged is a breach of duty
of care, then the Court MUST DISMISS, unless the Court finds
that the decision is not protected by the BJR (Auerbach
b. If the transaction in question is a breach of duty of
loyalty then use something like the Zapata rule: Court can
dismiss ONLY if it finds that the BOD was informed, reasonably
found dismissal to be in the best interest of the corporation,
based on grounds the COURT believes warrants reliance
1. How much serious Manager misconduct goes on in real life?
2. Do these suits really deter future suits?
3. Are SLC’s really objective…is the structural bias argument
valid in Zapata?
-see p. 1066-67
4. What role should BJR play?
5. Is the distinction b/w Duty of Care and Duty of Loyalty
too attenuated b/c it’s such a novel issue?
6. Are costs overstated for a derivative suit?