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Business Law Notes - Agency Partnership Corporations


Forms of Business Organization

1. General Partnership
2. Limited Partnership
3. Limited Liability Companies
4. Limited Liability Partnerships
5. Corporations

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 control
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 an agreement
-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:
a. Master-Servant
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 contract if:
a. Agent acts without authority, or
b. Agent acts in excess of authority given.

***Exception to No Authority/No liability rule: i) Inherent authority
ii) Ratification
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 given

1. Expressed
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 accompany it.
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 authority
-P is liable if no actual authority, but there's apparent authority
-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

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 was forbidden)

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
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 of P"

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 to P.
-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 P is.
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 liable.
-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 authority
August 26, 1999

2 Main concepts: 1. AUTHORITY
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 of clients.

-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 allowed.
-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 disclose.
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 action.
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.)


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 into ....

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 of biz
4. For profit
5. as Co-owners of the firm: a. Joint-control
b. Profit-sharing

-ISSUE: Under what circumstances is a Court going to call it a partnership, and apply general partnership law when sued?

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 J!!!!!
-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?
-Held: No.
-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.

Net Profit-Sharing
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?
Held: No.
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 state.
-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.

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”
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 and Committee.
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

e.g. Tenant has lease in shopping center. Landlord put provision in lease that he’d acquire X% of tenant’s profits annually.

e.g. Martin v. Peyton

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.
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, repairs, maintenance?”

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 rights.
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.


A. Look at POSSESSION: UPA Sec. 25: Each partner has equal right to possess other’s right to use firm’s assets to promote firm’s business
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 property
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 in agreement

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
5. AE has no right to GO TO MEETINGS

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

-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 encrusted.


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 partnership interest.
(New York doesn’t require judgment.)
-”CHARGING ORDER” Not much case law. Very few rights in this order:
1. A ct can appoint a receiver to sit as a mere AE, but lacks many rights. He’ll just collect profits and surplus if dissolution.
2. Once order is granted, all non-charged partners can dissolve partnership immediately.
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
-Exceptions: 1.
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 law
7. DUTY TO KEEP ACCURATE BOOKS & RECORDS: of accounts and transactions. Partner has absolute right to inspect them
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 in deal.


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 for contractarians.

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


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
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…)

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 RP
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.
Requirements: 1. Actual Reliance
2. Representation
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 in fact.
-If liability is Several, then each obligor is liable.


“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
4. Liquidation
5. Continuation

1. TRIGGERING EVENTS-Causes of Dissolution:
a. Non-Judicial: dissolution w/o judicial intervention
b. Judicial: judicial declaration of dissolution required


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 sight.
-Narrow holding.

iii) Dissolution at the Express Will of all partners who have not assigned interests to a mere AE, or have ....charging order
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.
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.

(most judicial dissolution’s are litigable)
B1. Incompetence
B2. Incapability of partner to carry on duties, e.g. sickness
B3. Misconduct of partner--must materially interfere w/ firms conduct
B4. Willful or persistent (material) breach of partnership K
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 is equitable.
(consequences on the normal, 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 partner
-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 to CONTRIBUTE.
-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 if:
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, AND
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 notice.

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 creditor.

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.
2. CLAIMS BY PARTNERS, other than for capital or surplus profits on assets, e.g., partners advances, any indemnification payments owed
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 creditors
5. CONTINUATION: What are the universe of possibilities in which a firm can continue?
b. AGREEMENT IS SILENT< but all partners unanimously agree to continue: this is unusual. Each partner alone can force dissolution
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 goodwill, or
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.

(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

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 has formalities:
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.

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

ii) Rights
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 interest

iii) Assignments
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

(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” become blurry?
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.

-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 liability:
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,

Unanswered Questions:
a. We form a LP and we put in a provision that only Lpartners make 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 limited liability.
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.

RULPA Sec. 401-405
Main points:
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 agreement)
-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 purposes?”
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.

-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 (see )
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

Typical LLC:
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 agreement
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 contribution)
-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.
-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

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

-see handout
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 theory.
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 role
-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 develop:
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 and SH.
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 filing
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 the biz.
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

There’s a presumption that a corporation will incorporate locally unless:
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 incorporate elsewhere

Delaware: “laxity”
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

-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”
3. Lawyer:
. 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 located.
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. 102, 103)
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 issue dividends.
-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 dividends.
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 financial security

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 severally liable

3. PROMOTER’s LIABILITY with respect to pre-incorporation liability:
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 K.

(this is the most litigated issue in corporate law)
General Rule: There is no personal liability for SH, except specific circumstances
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 the veil...
3. Never Pierce Corporate Veil of Public Traded Corp: perhaps Ct not willing to hold passive rather than actively participating SH liable.

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 Veil?
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 system
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, p. 174

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 TEST
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 foreseeable risks?
-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 personally liable.
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 challenge this.
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 formalities followed
-see Kinney Shoe case: undercapitalization AND No corporate formalities followed
-see Sealand case: undercapitalization AND multiple bad facts: No corporate formalities, shuttled assets, co-mingled funds

**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 is required?

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 closely held)
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 cases
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 piercing.
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 individually significant.
11. Multiple Bad Facts If Fraud is proven, 1 bad fact is enough to pierce. If no fraud, then multiple bad facts must be shown.

Another SYNOPSIS: based on a survey:
1. Courts tend to pierce corporate veil more often than we think
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 persons

“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 pierced.
*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 says otherwise.

-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 another SH.
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 the COI
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 SH power.
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 the COI.
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 assets...????????????????)
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 them out.)

******Issue: Whether to Add more or deduct from the list?!

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 call
3. Informal Board Action (see p. 294)
1. Meeting:
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 they take?
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 be bound

What about the BOD delegating authority to COMMITTEES & OFFICERS?
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.

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.
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 “No.”
-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 majority.
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 work?

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)
------------------------------------------------------------------------------------------------------------- +1(vote)
N (# of total Directors to be elected) +1

1000 outstanding voting shares x 1 Director the minority wish to elect
-------------------------------------------------------------------------------------------- +1
4 vacancies + 1

equals 201 total voting shares required by minorities to elect their 1 director in a board of 4.
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 Directors.
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 voting SH.
-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. ?????????????????????????

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 occur.

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 & Consolidation.
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 him remedy.
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)

-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

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 market value.
-Other states never had this exclusion. New York adopts this exclusion.

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 price

2. Factors Judge considers when he values shares: Should the judge exclude elements of value arising from the transaction itself?
-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 merger

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 SH

*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 shares
-Parties should be treated equally: if Minority gets favourable treatment, then majority is mistreated

If available, must the Minority SH take it, or can he choose another remedy?
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 public held?
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 Fair Value.
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 prove:
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 a farce

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 and appraisal
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 the merger.
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 self-dealing?
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 to Majority.
3. Shallowness of opinion writing in New York, in the last 20yrs.

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
II. Deadlock & Dissolution problems, Corporate paralysis!
III. Freezeout and Freezein problem
IV. Fiduciary Duty


Different theories:
#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 TO MINORITIES.
-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 SLOPPY here.

#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, and
2. the Purpose couldn’t be achieved by any less unequal means

#4: Alpert case: You can squeeze-out the Minority SH if Majority proves independent business purpose but there’s no mention

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
7. Mandatory

1. VOTING AGREEMENT: An agreement between all or some of the SH on how they’re going to vote, but no transfer of shares.
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 requirement
-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
What happens when the managers don’t comply with State Statutes governing this agreement? See 4 N.Y. cases on the Corporate Norm.:

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 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 be Unanimous
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 of management
5. Any SH who agrees to this are deemed to inherit Director’s liabilities

Issue: What happens if the SH Agreement doesn’t comply with the Statute?
-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.

(This is like “Delectus Personi” no one can be made a partner if objection)
A. Consent Restraint: a provision that provides, “No SH can transfer her shares without permission of the other SH.”
-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 on notice)
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 certificate.

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 shows:
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.

What happens when things just don’t go well and the majority still wants to squeeze out the minority, or the 2 factions are deadlocked?
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, no directorship.
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 means
-see MAROLA case (Massachusetts): HARD-CORE RADICAL EQUALITY is not the rule in Mass anymore!

-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
III. Custodian/Receiver
IV. Arbitration
V. Dissolution: a. Non-Judicial
b. 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 the corporation
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 there’s Oppression.
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 agreement?
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 going concern
c. The Minority SH should not be given an incentive to unfairly impede the Majority’s right to buy them out by petitioning for dissolution

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 buy-out.”
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!

I. Scope
II. Core Rules
III. Filing Requirement
IV. Content of Proxy Statement
V. Annual Report & Rules
VI. Form of Proxy
VII. Shareholder’s Communication Rules

-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 of information

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 itself...
-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 bio)
-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, not federal.

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 analysis
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, p. 333

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 be “Opted-Out.”
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 7.22:
-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 himself
-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 rules.”

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 makes.
-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.

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
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

-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 disclosure

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.
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.
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 statement.
-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, products”
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” related?
-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 significant
-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 basis
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 implemented
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 support

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 district court
-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.

“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 the SEC?
-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, recision…
-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 SH’s.



ISSUE No. 2: Whether the Misrepresentation or Omission was MATERIAL?
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 OF ....)
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 action.

-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 this
-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

-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....
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 otherwise.)
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 IMPROPER PURPOSE.
-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 balanced.

Comments: 1. In cases of pure Nonfeasance Directors are not liable
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.
HELD: liable.
Common Themes:
1. All 4 cases support the distinction b/w Malfeasance and Nonfeasance.
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 THEMSELVES
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 cars.
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 recognized.
-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 information.
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)

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. SH sued
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 mistakes.
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 decisions. ????????
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.
1a. P has initial burden to show the Business Judgment Rule doesn’t apply b/c of the invalidity of the process of decision making
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.


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, and
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 case)
b. ALI says that even if the Corp shows they complied with procedure, the Court can review the process using a REASONABLENESS standard.

New Rule: Loans to Directors are allowed as if it’s a business decision.
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

This doctrine is derived from the rules of AGENCY. -see Hawaiian case
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 tangible.
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 lacking)
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 law.
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 the bidder
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 situations:
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?), and
2. The Defense Tactics were reasonable in relation to the threat perceived

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 sued.
HELD: 1. Unocal case protects the initial defense measures against Revlon
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.
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 have:
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 SH.
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 Duty.


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 been offered?”
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 shares
-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.
HELD: Illegal
-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 view.
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 geographical area

*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.”

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 exist)

Support #10
If there’s no duty to share, then that may deter minority SH’s from investing their capital in the corporation
Support #11
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.

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 narrowly.
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 it.
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 FIDUCIARY DUTY
Donahue case
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 in law:
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)
Thomas Reed
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 Trading
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 for fraud
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 in price
7. If insider trading was such an evil, firms would have worked harder to prevent it, and outside Sh would have demanded it ceased
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 Duty
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


Cady Roberts
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 shares tripled.
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 scalps.
-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 Tender offers?
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 losses.
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 a duty.
Rule: Tippee is liable if:
1. Tipper must have breached a Fiduciary Duty by tipping, and
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 time.
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
4. Misappropriation

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 enough.
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, b/c:
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 was satisfied.
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 Act):
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, fine...
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

2. Materiality:
-see TSC/Basic cases
-BeSpeaks Caution doctrine
-Sec. 21E Projections

3. Causation: a. Relevance -see Ute, Wilson, and Fraud on the Market
b. Damages
c. Loss Causation, Sec. 21D
d. “In Connection With”

4. Standing (Blue Chips)

5. Culpability, Sec. 21D

6. Diligence
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 Sec. 10b?:
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 is material.
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 plaintiff’s detriment.

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 reliance.
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 hypothesis)
-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 class.
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 the injury
-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 the scammers.
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 that time.
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 sale.
-see O’Hagan case (also a broad reading of “in connection with” clause)
-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 here?
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 of plaintiff
??????????????????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 Scienter.
*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”

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 reckless...
??????????????????????so what is the standard?????????????????????????

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 considerably.
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 privat P)
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 persons

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 this.
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 price.
-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 of profit.
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 trader owes.

*Who Recovers?
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.
*Unorthodox Transactions:
1. Does a gift constitute a Purchase or sale of a security? No.
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? No, involuntary.

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.
ive actions:
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 are expensive.
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 DERIVATIVE suit.
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 SUIT.
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 cases

*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 pot.
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 obnoxious activity

-*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
geographical area

-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 bond

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:



2. “Futility”: a) when a Majority of the BOD is “interested” in the underlying transaction in
question., or

-“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 an Independent/Reasonable
investigation, AND
II) the Court in using its own BJR finds it in the best interests of the corporation to dismiss the suit. (Zapata), or
c. in cases where there’s no “egregious” facts (Aronson—narrowing of the rule on which cases are demand-excused cases)

-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?” ????????????????!!!!!!!!!!!!!!!!
*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

-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 suit.
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 by BJR.

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, too.

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 test:
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 corporation..
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 that
1. either the Director are disinterested* and independent, or
2. the transaction was otherwise the product of valid Business Judgement
then, should the Court characterize the case as a demand-excused (FUTILE).

-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 in question
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 business judgment

HELD: NO cause of action against Senior Executives, but demand-excused with respect to Senior BOD.

ALI Compromise
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 rule

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 case)
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?


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