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Chapter 29: Management of the Corporate Business

Introduction: SHs are known as the owners of the corp, they affect the way business is run thru their power to elect
directors and amend articles. They do not have power to make mgmt decisions. No right to instruct the directors/officers
on operating decisions. Directors make the day-to-day operating decisions to the officers. MBCA require SHs to get
approval for special actions (merger, sale/lease of substantially all assets, dissolution) from the BOD.
The Board of Directors

Powers & Duties: Directors tend to ratify mgmt decisions made by top execs rather than
to take the initiative in making the decisions. MBCA now says: All corp powers shall be exercised by or
under the authority of, and the business and affairs of a corp shall be managed under the direction of, a BOD.
MBCA used to say the business of the corp shall be managed by a BOD.

General Powers of the Board: MBCA permits the board to take the following actions by itself:
1. Declaring a dividend.
2. Establishing the price for the sale of shares
3. Electing and removing officers
4. Filling vacancies on the BOD
5. Selling, leasing, and mortgaging assets of the corp outside normal course of business.

Actions Requiring Board Initiative: Initiative process requires that the BOD propose the
matter to SHs, who then must approve the actions. Required for fundamental changes in the corp:
1. Amendment of articles of incorp
2. Merger of the corp
3. Sale of all or substantially all assets
4. Voluntary dissolution of the corp.
Online Communications: Directors can now legally communicate official business by email.
Electronic Communications Includes form of comm that dont involve the physical transmission of
paper if the comm. Creates a record that can be retained, retrieved, or reviewed by the recipient and can
be reproduced in paper form.
- BOD meetings cant take place electronically
- Permits director resignations to be transmitted electronically.
- Director actions taken by unanimous consent may be taken electronically.

Powers & Rights of a Director as an Individual: Directors are NOT agents of the corp
by virtue of that office. They have power to act for the corp only as part of the board, not as individuals. A
director can become an agent if she is also serving as an employee of the corp.
o Director has right to inspect the corp books & records. Necessary to carrying out the directors duty of
overseeing mgmt. Right to inspect can be denied where I can be shown that the director has an interest
that conflicts w/ that of the corp.

Election of Directors
Number of Directors: MBCA requires only one, some states require 3. MBCA allows the # of directors to be fixed in
either the articles or bylaws. Not necessary to amend articles when a director dies or resigns and the directors arent ready
to nominate a successor.
Qualifications: A few states require directors to be SHs, some require that a certain percentage of directors be citizens of
the state of incorp or of the US. Qualifications set in articles if desired.
Nomination: Elected by SHs at annual meeting. Nominated by current directors, but can be nominated from the floor
during the SHs meeting. Candidates nominated from the floor seldom are elected in large corps.
Term of Office: Directors hold office only until the next annual meeting, or until a successor has been elected and
qualified. MBCA permits corps to provide for staggered (longer) terms in their articles. A corp that has a board of 9+
members may establish either 2 or 3 nearly equal classes of directors. Then only one class of directors is elected at each

annual meeting unless there are vacancies. Staggered terms are to ensure that experienced directors remain on board;
however, they are usually adopted to make a corp takeover more difficult.
Vacancies: Can be filled only by a vote of the SHs unless the state statute, the articles, or bylaws give this power to the
board itself. MBCA permits a majority of the remaining directors, even tho less than a quorum, to elected directors to
serve out unexpired terms. Permits the board to increase the size of the board then to elect a director to the vacancy

Removal of Directors: Director may not be removed w/out cause unless this is permitted
by statute or by articles or bylaws adopted prior to the directors election. MBCA permits SHs to remove
directors w/ or w/out cause. A director who has failed to/unable to attend and participate in directors meetings
or who has acted contrary to the interests of the corp (mismgmt, conflict of interest) can be removed for cause.
SHs can remove a director for cause at any time even though the power of removal has been given by the
articles or bylaws to directors. Before being removed for cause, a director must be given notice and a hearing.

Directors Meetings
Frequency: Usually schedule regular meetings. Large corps meet monthly or quarterly. Small corps where
directors are active in business meet formally just once a year. The directors other meetings are informal w/ no minutes
Notice: Reasonable notice must be given for special meetings. If all directors attend a meeting, this cures any
defect in or failure to give notice. A director who has not received a proper notice may attend solely to complain of the
notice, and he would not be held to have been in attendance. Directors may also cure a defect in the notice by signing a
waiving notice before or at meeting.
Formality: MBCA permits directors to act w/out a meeting if all directors consent in writing to the action taken,
and permits a director to attend a meeting thru telephone. Only requirement is directors must be able to hear one another
Quorum: Each director only has one vote, regardless of his shareholdings. Actions taken by a board are
ineffective unless a quorum is present (majority of the # of directors fixed by the articles/bylaws). Articles may set
quorum at a higher figure.
Compensation of Directors: MBCA permits directors to fix their compensation unless this is prohibited by articles of
incorp. Outside directors (not employees of corp) are paid rather modest fees even in the largest corps, but fees are rising
Compensation committees are now expected to practice real oversight, including meeting w/
compensation consultants and their firms HR dept independent of top mgmt.
Officers of the Corp

Powers: MBCA provides that a corp shall have a president, 1+ VP, a secretary, and
treasurer. Any 2+ offices may be held by the same person except the offices of president and secretary
(permits dual signatures on corp docs).

President of Chairman: Power of officers to bind the corp on contracts is the same of
any agent. In addition to express authority, they have implied and apparent authority, and certain officers
(president and CEO) may have ex officio authority (authority by virtue of their offices). President or chairman
has no power to bind the corp solely bc of his position. Officer liable on losses if he acts beyond his authority.

Vice President: No authority by virtue of that office. However, if title indicates the
person is the principal officer of some area of the business, he has considerable implied authority (for
example, the VP of mktg has implied authority to do those acts normally done by a manager of sales).

Corp Secretary: aka clerk. Keeps the minutes of meetings of SHs and directors and
other general corp records (stockholder records). Office gives the secretary no authority to bind the corp on
contracts, but there is a presumption that a doc to which the secretary has affixed the corp seal is properly

Treasurer: In charge of funds. Has power to pay out corp funds for proper purposes and
receives pmts to the corp. Binds the corp on receipts, checks, and endorsements. Does not have authority by
virtue of the office alone to borrow $ or issue negotiable instruments.

Duties of Directors and Officers: Unlike directors, the corp officers are agents of the corp. The directors share w/ the
officers the same fiduciary duties that an agent owes the principal. Fiduciary duties include:

Duty to act w/in ones authority and w/in the powers of the corp: Authority
given by statute, articles, bylaws. Directors/officers may be liable to corp if it is damaged by an act
exceeding authority or outside scope of corps authority. If they enter an ultra vires trxn, justifiable
believing it to be w/in scop of corps business, they arent held liable.
Ratification: a corp may ratify an unauthorized act by officers/agents thru a resolution of the
BOD or the SHs. Implied from acceptance of benefits from unauthorized act. Releases
officer/director from liability.

Duty to act diligently and w/ due care in conducting the affairs of the corp:

Prudent Person Standard: MBCA requires that a director/officer discharge his duties
w/ such care as an ordinarily prudent person in a like position would use under similar
circumstances (common sense, practical wisdom, and informed judgment). Greater actual
qualifications of individual = greater level of duty.

Officer/Director will have discharged her duty of care if she acts:

1.) In good faith
2.) As would an ordinary prudent person under like circumstances.
3.) Under reasonable belief she is acting in best interests of corp.

MBCA permits directors/officers to rely on opinions, reports, and statements of

persons who reasonably appear to be competent and reliable. Duty of care requires making a
reasonable investigation before any corp decision.

Business Judgment Rule: Directors/officers arent liable for mere errors of

judgment when they act w/ care & good faith (honest mistakes in judgment).
Must meet 3 requirements in arriving at their decision:
1.) An Informed Decision
2.) No Conflict of Interest
3.) Rational Basis: decision cant be manifestly unreasonable or gross negligence.

Deal Protection Devices adopted by the board to protect the original merger trxn
must withstand judicial scrutiny under an enhanced std of review. implicate
1.) Judicial determination regarding the adequacy of the decision-making process employed by
the directors, including the info on which the directors based decisions.
2.) Judicial examination of the reasonableness of the directors action in light of the
3.) Directors have burden of proving they were adequately informed and acted reasonably.

Legislative Responses to Increased Director Liability: Legislations (amendment)

to limit directors liability for breach of the duty of care:
Charter Option Statutes: authorizes any corp to adopt a specific amendment to its articles of incorp that removes breach
of duty as a cause of action for monetary damages against directors. BOD and SHs would have to approve limitation, but
officers/directors still would be liable for intentional misconduct, failure to act in good faith, self-interest, knowing
violations, breach of loyalty of duty.
o Self-Executing Statutes: Directors will have no liability for breach of the duty of care in
the absence of willful misconduct or recklessness. Automatically effective, no board or
SH action is necessary to trigger their applicability.
Cap On Monetary Damages Statute: Adopted by VA. The max liability that may be imposed on directors is the greater
of $100,000 or the amt of cash compensation that the director received from the corp during the previous 12 months. Can
amend articles to reduce the cap, but cant increase it.

Duty to act w/ loyalty and good faith for benefit of corp: Must act in best
interest of corp, breach this duty if they try to profit personally at expense of the corp.

Self-Dealing: A director/officer must fully disclose his interest if he enters a contract

w/ the corp. Contracts only voidable if unfair to corp. After full disclosure, the disinterested
members of the board or the SHs themselves must approve the trxn. Approval doesnt

automatically relieve the self-dealing director/officer from liability to corp. MBCA says the
initial burden of proving the fairness of the trxn lies w/ the self-dealing director/officer. After
proper approval from board/SHs, the burden of establishing unfairness shifts to corp.

Usurping Corporate Opportunities: Directors/officers cant usurp (seize) a corp

opportunity. (Ex: Directors cant buy the right to sell a product that would fit into the corps
line of goods. If the corp is financially unable to pursue the opportunity, a director or officer
may take it). 3 Elements must be met to have usurped an opportunity:
1.) Opportunity must have come to them in their corp capacity.
2.) Opportunity must be related to the corp business.
3.) Corp must have been able to take advantage of the opportunity.
*The director may still avoid liability if she can show that the corp waived its rights to the opportunity
(director offered the opportunity in full disclosure to the corp but the corp rejected it) May be implied
waiver if corp knew of opportunity and failed to act timely.
Freeze-Outs, Oppression, & Bad Faith:
Freeze-Out: Occurs when the corp is merged w/ a newly formed corp under terms by which the minority SHs receive
cash or other securities for their shares, rather an receiving stock in the new corp. Usu involve close corps.
Oppression: Frequently occurs when the majority SHs refuse to pay dividends even though the corp is able to.
- Others claim that the corp wont hire minority SHs while unreasonably high salaries have
been paid to controlling SHs and their friends.
- Others involve purchases by or sales of assets to controlling SHs where the price is said to
be unfair.
- Minority SHs only win such suits where the acts of directors have been clearly been in bad
faith or abused discretion given to directors under judgment rule.



Trading on Inside Info: Federal SEC laws prohibit insiders (those

w/ confidential material info about corp) from buying or selling its stock. Violates fiduciary
Directors Right to Dissent: A director who agrees to the actions of
the BOD may be held liable if the board has failed to abide by its duties to the corp. Any
director who attends a BOD meeting is held to have assented to the boards actions unless he
specifically dissents. Under MBCA, a director will not have dissented unless he refused to
vote for the proposed course of action and makes this dissent clear to the other board
members by having it appear in the minutes or by giving a written notice to the chairman or
secretary immediately following the meeting.

Liability for Torts & Crimes

Corporate Liability
Tort Liability: Corp is liable for all torts committed by its employees while acting in the course of and w/in the scope of
their employment, in some cases even when the corp has instructed the employee to avoid the act (respondeat superior).
Crimes: Many criminal statutes clearly are intended to apply to corps (securities act, antitrust laws, employment
relationship laws). Tradition view: corp couldnt be held guilty of a crime involving intent. Today, courts are likely to find
criminal liability when a crime is committed, requested, or authorized by the BOD, officer, of high-level mgr.
Liability of Officers and Directors
Torts: Modern courts much more willing to find negligence on the part of corp directors/officers. Where corp activities
cause injury/economic damage to others, the officer/director in charge may be held liable. Officer/director may be held
liable for torts of employees of corp if he authorizes/participates in the commission of the tort.
Crimes: Directors/officers may be held criminally liable for failing in their supervisory duties, requested, authorized, or
assisted in commission of crime and when the officer:
1.) Knew of or should have known of the illegal conduct and
2.) Failed to take reasonable measures to prevent it.

Indemnification: To encourage people to become officers/directors, corps often pays them for expenses in
defending/settling a suit or criminal charge brought against them.
- Mandatory: Director/officer prevails on suit or guilty but in good faith w/ preexisting
indemnification agreement.
- Voluntary Indemnification: When the officer/director is found guilty, he still may be
indemnified if he acted in good faith, believed he was acting in corp interest, unaware action was
illegal, and disinterested board, legal counsel, or SHs agree to indemnify.
- Impermissible: Officer/director who acted in bad faith or liable to corp may not be
indemnified under any circumstances, including damages sustained as a result of violating Fed
SEC laws.

Chapter 30: Financing the Corp and the Role of SHs

Financing the Corp

Sources of Corp Financing: Sale of corp securities in the form of shares, debentures,
bonds, long-term notes, short-term bank loans (A/R financing and inventory financing). Two types of corporate
funding are equity (c.stk) and debt (bonds) securities.

Equity Securities: Corp security, arises thru the sale of ownership interests in the business in the
form of sales of corp stock. Evidence of ownership by certificates to represent shares, but they are not the stock.
Ownership interest in corp.

o Common Stock: If a corp only has one class of stock, its common. If there is more than one, common SHs bear
the major risks and benefit most from success by receiving whats left over after the other classes have been
satisfied (for both dividends and net assets on liquidation). Usually carries voting rights, but may have more
than one class.
o Preferred Stock: Any stock that has preference over another class of stock. May be made convertible into
common stock, sometimes given voting rights (right to vote usually only granted if dividends due are not
paid) (preference in dividends)
May be redeemed even if the SHs dont want to sell. (paid off and canceled by corp if articles
permit and redemption price must be stated).

Consideration for Shares: Money, property, or services already performed for corp. BOD
has authority to decide what is proper amt and form of consideration. Corp statutes may place limitations on
discretion of BOD to protect SHs.
o Old MBCA Approach: (Most states). The promoters preincorp services arent considered proper
considerations b/c the services werent technically rendered to the corp since it wasnt in existence at the
time. Promissory notes or pledges of future service dont count either (may overstate value of corp since
they may never be performed).
o Revised MBCA Approach: Permits promises of future services and promissory notes to be exchanged for
shares since they do have value to the corp (value may not be as great as value of services already rendered
due to risk of non-performance). Also permits corp to issue shares to promoters in preincop efforts b/c the
corp benefited from services.

Value of Shares
Par Value: Arbitrary amount assigned to value the shares of stock.
Stated Value: If stock has no par value, the BOD may assign a stated value.
o Stated Capital: Calculated as ( # of outstanding shares) X (the par or stated value of each share). Par value and
stated value reflect the minimum amt of consideration the shares can be issued. If shares were issued for less
than par/stated value, stated capital would exaggerate actual value of corp. BOD and purchasers of shares are
liable to the corp when shares have been issued for less than par value.
o Capital Surplus: When shares sell for more than their par/stated value. BOD must, in good faith, determine the amt
of appropriate consideration (duty to receive the fair value of the stock). Calculated as (Amount received per
share MINUS par value) X (# shares outstanding).
Options, Warrants, & Rights:


Options: MBCA allows directors to issue options to purchase shares in connection w/ other securities or
issued to employees as an incentive to increase profitability to maximize the mkt value. SH approval is
Warrants: Options represented by certificates. Sometimes part of a unit being sold.
Right: Applies to short-term and often nonnegotiable options. Gives present security holders

a right to subscribe to some proportional quantity of the same/different security of a corp.

Often given in connection w/ a preemptive right requirement.

Treasury Stock: A corp may buy its securities from any willing seller, doesnt need to state specific
authority in its articles. MBCA permits this only out of unrestricted earning surplus (when a corp retains
all/part of its operating profit rather than paying out dividends).
- Capital surplus may only be used on t 2/3 vote of SHs.
- Capital surplus arises when sales of shares is above par value.
- Treasury shares cant be voted in elections.
- Treasury shares can be resold w/out regard to par value/original price.
Debt Securities: Borrowing $$ for operations. Power is inherent, need not
appear in articles. They do not transfer an ownership interest in the corp. Creates a debtor-creditor relationship.
Corp/debtor obligated to pay periodic interest.
o Notes: Short-term debt instruments (less than 5 yrs). Secured (creditor may force the sale of collateral if debt
isnt paid according to terms or unsecured).
o Debentures: Long-term unsecured debt instruments. Can be for 30+ years.
Indenture: A contract protecting rights of debenture holder (defines what acts constitute default by
the corp and stipulates rights of holder on default.
o Bonds: Long-term, secured debt securites. Generally have indentures. Security may be real (building) or
personal property (machinery, raw materials, accounts due from customers). Bondholders and secured notes
holders have priority to assets securing the debt.

Becoming a Shareholder (SHs mostly interested in the right to share profits, even tho they have many rights).
Functions of SHs: Few functions, exercise little influence.
Principal function: Election of SHs, but in large corps SHs vote following the recommendations of mgmt.
Also required to approve unusual or extraordinary corp trxns (merger, sale of substantially all corp assets, or
voluntary dissolution).
Favorable vote necessary to amend the corp articles or stock option plans for corp officers/managers.
Approval of loans to officers by corporation.
Means of Acquiring Stock
o Subscribing to shares in a new corp being formed. Usually treated as offers until incorporation is
completed. Such subscriptions irrevocable for six months. Acceptance occurs by action of BOD after
incorporation, subscriber comes SH.
o Subscribing to shares that are being issued by existing corp. Treated as an offer, corp must accept. Issuing Stock:
Making of the subscription contract. Certificate cant be issued til shares are paid in full.
o Buy newly issued shares that have been underwritten by an investment banker and sold thru
Stockbroker. (underwrite: agrees to mkt it to investors and usu guarantees to sell entire issue at
agreed-on price).
o Most common: buying previously issued shares from former owner (directly or thru broker).
Shareholders Meeting
Annual Meeting: Required by all states except Delaware (which can use a mail ballot instead). Main purpose is the
election of directors. Ask the SHs to approve selection of public auditors, or executive stock option/profitsharing plan, or amendment to articles of incorp. CEO or other officers give brief reports on operations and
prospects for current year.

Special Meetings: Rare, called when SH approval of corp action is necessary b/w annual meetings. May be called by the
president, BODs, or the holders of 1/10th or more of the shares entitled to vote at the meeting. Other officers
or persons (chairman of the board) sometimes may call meeting.
Notice of Meetings: MBCA requires note of meetings to be given not less than 10 or more than 50 days before meeting.
Must give place, day, and hour. For special meetings, purpose must be given. If extraordinary corp trxn
(merger), notice of proposal must be given to ALL SHs, regardless of the SHs class of stock.
*If required notice isnt given, actions taken at meeting are of no effect. SHs who didnt give proper notice
may waive notice. Attendance at meeting is automatic waiver. No waiver if SH attends only to object the
holding of the meeting. Waiver is effective only if all SHs who didnt get proper notice either attend or
waive in writing.
Remote Participation: If a SH meeting is to be conducted remotely: (modern comm. Tech)
1.) the corp must have implemented some reasonable means for ensuing that those participating are indeed SHs.
2.) Those participating SHs and proxy holders must be afforded a reasonable opportunity to both participate and
3.) Some means must be provided so that participants have the opportunity to read/hear ongoing proceedings.
4.) The corp must keep a record of any remote votes or other actions taken at meeting.
Rules governing remote participation by SHs dont have to meet same retention, retrieval, review, and
reproduction requirements imposed on directors actions. A directors action by remote transmission
wouldnt be valid unless it could be reproduced in paper form, and a SH meeting may now be conducted
by conference call.
Shareholders Entitled to Vote
o Sources of the Right to Vote: Depends on incorp statute, articles and bylaws of corp. Most common
stock listed in your name gives right to vote.
o Determining Who May Vote: The person who has legal title to the stock. Those who are owners of
shares held in the name of another (stock broker) may obtain a proxy from record holder.
o Non-voting Stock: Nonvoting class of stock holders have right to vote only under certain
circumstances, such as extraordinary corp trxns. Neither a corp nor its subsidiary may vote treasury shares.

Proxy Voting: As a SH, you may appoint another person (proxy) to vote for you.
MBCA requires written document, also called a proxy. Some states permit oral proxy. Generally can be
revoked at any time. Automatically revoked if you later give another proxy on the same shares of stock.
- Modern statutes permit creation of irrevocable proxies which define when a proxy may be irrevocable
(MBCA allows for this if it so states and if it is coupled with an interest
- Coupled w/ an Interest: Proxy holder is a party to a SH voting agreement or has agreed to purchase the
shares under a buy-and-sell agreement.

Solicitation of Proxies: In publicly held corps, only a small proportion of the shares are owned by persons who
attend the meetings. Mgmt then solicits proxies, it asks the SHs who dont expect to attend to appoint, as their
proxy, one or more of the directors or some other person friendly to mgmt.

Regulation of Proxies: SEC has power under the 1934 act to make rules about proxies. Must give certain

info, such as info about any employment contract and pension or stock option benefits and any material
trxns. An annual statement must be mailed w/ or before the proxy statement for an annual meeting.

The proxy doc (under SEC rules) must permit SHs a choice of voting for or withholding their vote from all
of mgmts slate of directors. May also exempt one or more directors from their favorable vote. Must be
permitted to abstain or vote for or against any proposed resolutions.
SEC rules require corps subject to them to furnish a SH list to any SH who wants to solicit proxies. Corp
may main the proxy material for soliciting SH.

Expenses: Corp pays for the prep and mailing of a proxy on behalf of mgmt. If someone else wants to

nominate directors, that group must bear the expense of soliciting proxies. Proxy battles are very expensive and
few challengers win. If they do, they are entitled to be reimbursed by the corp b/c its assumed from SH support
the corp has benefited.

Effect: SHs usually follow recommendation of mgmt in their voting or just sign the proxy w/out voting. Proxy
usually gives mgmt authority to vote the shares on any matter. The effect is to determine the outcome of the meeting
before its held. Argument made for or against a resolution at the meeting can affect only the votes of those present.
A resolution made from the floor has no chance of passing unless the mgmt votes its proxies in favor of it. Through
proxy system, mgmt is able to control the corp w/out owning many shares.

Shareholder Proposals and Right to Speak

Sources of SH Rights:
1.) An owner is to be informed about his investment, ask questions to discover economic conditions or corp social
2.) An owner can participate in establishing the framework w/in which the directors exercise their powers of mgmt
(right to govern property interest) and propose resolutions to
Protect investment: Proposals to amend the corp articles to put ceilings on salaries of top execs
and limit corp gifts to charitable and educations orgs.
Maintain social values: Proposals with goals of social/political change that oppose certain corp
activities. Shares may be purchased solely to permit making the proposal. Ex: Asking directors
or corps to withdraw from S. Africa until apartheid ended, or publicizing certain info withheld as

Cumulative Voting: To give minority SHs an opportunity to be represented on the board.

Each share is entitled to one vote, but many corps permit SHs to cumulate their votes to support one director.
Opponents say it is likely to be troublesome and cause friction among BOD members. States that require
corps to allow SHs to cumulate votes have few large publicly held corps.
X = (S/D+1) + 1
X = # of shares required to elect one director under cumulate voting.
S = # of shares voting
D = Total # of directors to be elected.

Rights of Inspection & Preemptive Right

MBCA requires a corp to send its latest financial statements to any SH on request, and to
permit a SH (on written request) to examine in person, or thru an agent such as a lawyer, its relevant books
and records of account, minutes, and record of SHs. May make extracts from these records.
o Proper Purpose: SH must have proper purpose for examining records, such as to determine the value of
ones shares or identify fellow SHs to communicate w/ them concerning corp affairs, or to make a copy of
the SH list to wage a proxy contest to unseat present mgmt. Not proper cause: To learn business secrets or
gain a competitive advantage.
o Denials: MBCA makes a corp official who denies a proper demand liable for penalty of 10% of

the value of the shares of the demanding SH. Many states dont have such penalties, so denials
are common.

Preemptive Rights: Many states require corps domiciled there to give their current SHs an option
to purchase their proportionate share of any new issue of stock. Enables SH to maintain the same relative interest in
the corp as before. Creates difficult problems in large corps that have several classes of stock. Doesnt apply to
treasury shares, shares issued in connection w/ a merger/consolidation, or shares issued in exchange for property/past
services. No preemptive right unless the articles create such a right.


Directors Discretion to Pay Dividends: SH have a right to share in NE, but the declaration of
dividends is subject to business judgment of BOD. They cant pile up unneeded cash in the treasury or pay it out in
unreasonable high salaries to mgmt. Burden of proof is on SH to show that the directors have abused their


Legal Limits on Dividends: MBCA permits paying dividends only out of RE. Prohibits pmt of a
dividend that would make the corp insolvent (cant pay its debts as they become due).

Stock Split: Not a dividend, it changes the par/stated value of the shares and increases the # of
shares outstanding, not the retained earnings account. Reverse stock split: reduces the # of shares outstanding.
Reason: To adjust the price of the stock to one that mgmt believes is more appropriate. Stock prices too high may
discourage investors from buying, prices too low appear less desirable.
- If articles have not previously authorized a share split, it cant be made until a favorable vote of SH. Only
vote of directors is necessary for a stock dividend unless addl shares must be authorized (an amendment to
increase the # of authorized shares).


Types of Dividends
Cash and Property Dividends: Usually cash, may be property dividends in form of
shares of stock the corp owns in another corp or any other non-cash asset.
Stock Dividends: Distributions of share in the corp itself. Usu paid when mgmt wants to
retain all or an unusually high proportion of earnings for reinvestment. Main purpose may be a reduction
in the mkt price per share to encourage greater investor interest. Stock dividends payable in the same class
of shares do not change a SHs stake in the corp, the proportion of shares owned remains the same, just a
high # or shares.

Dividends on Preferred Stock: Preference in dividends over common Shs.

Dividends on cumulative preferred stock, if not paid in any year, will be payable later
when funds are available.
Dividends on non-cumulative preferred stock need not be paid later if they are not
earned and paid in the year due.
Participating Preferred: Holders get their usual dividend, then, after the common SHs
receive a prescribed normal dividend, the preferred SHs participate w/ the common SHs in income
available for dividends.
If the preference is cumulative to the extent earned, the preferred SH has a right, before
common SHs receive any dividends, to be paid all dividends that were not declared when earned in prior

Effect of Dividend Declaration: Once directors have voted to pay a lawful dividend, it becomes a
debt of the corp. Directors usually set a record date. If a sale is made on a stock exchange, the purchaser is entitled
to the dividend unless the sale occurs on or after the ex dividend date, which is two business days before the record
date for the dividend.

Shareholder Rights in Extraordinary Corp Transactions

Amendment of Articles: MBCA requires approval by majority of shares entitled to vote but
permits the articles of incorp to impose a higher requirement. If amendment would affect the rights of a class
of shares, SHs of that class have a right to vote as a class even though those SHs normally have no vote (ex:
proposal to eliminate a provision for cumulative dividends on a class of preferred stock).
Other Extraordinary Transactions
o Mergers/Consolidation: Approval of all classes of shares is required.
o Sale of most of the corp assets or a voluntary dissolution also requires favorable vote.
Appraisal Rights: Given to SHs who vote against certain trxns (such as a merger) when the majority are in favor, you
may demand that the corp pay you the fair value of your shares.
Actions Covered: Under MBCA, the right of appraisal applies in cases of mergers or a
sale of most of the corp assets. Also applies to amendments to the articles that would materially
affect liquidation, dividend, redemption, preemptive, or voting right.
Procedures: SHs can only exercise the right only if they did not vote in favor of the trxn.
Most statutes insist that the dissenting SHs notify the corp of their intent to exercise the right before
the actual vote has taken pace.

Must actually demand payment. If cant agree on amount, ask a court to appraise value.
Exclusions: Most states deny the right of appraisal to shares that are traded on a recognized securities
exchange, b/c of the belief that the securities mkt is the best determinant of the value of shares.

Lawsuits by Shareholders

Individual Actions: SHs may sue the corp for a breach of their SH contract. Contract is a product
of the corp articles/bylaws and any BOD resolution is applicable to the particular stock issue, as well as the corp
statute. Its not a doc signed by the SH and the corp.

Class Actions: When a # of people have a right/claim against the same defendant growing out of
the same set of facts. Ex: If the corp didnt pay a preferred dividend that was due. If you win, you can collect the
dividends and recover from the corp the expenses in bringing suit.

Derivative Action: SHs not usu able to sue to enforce a right of the corp. Ex: Suppose an officer
of the corp has breached his duty by setting up a business to compete w/ the corp and has made $1 mil at
expense of the corp. A SH couldnt sue b/c a corp is a legal entity separate from SHs.
o A SH is permitted to sue as a representative of the corp when these requirements are met:
1.) SH must have owned shares at the time of the wrong.
2.) The SH must urge the directors and, if appropriate, the other SHs to direct that such a suit be brought by
the corp.
*SH only permitted to bring suit if the directors refuse of have conflict of interest that is likely to keep
them from suing. If the SH wins, the damages go to the corp, but the SH will be reimbursed for her expenses
in bringing the suit.

Special Litigation Committees: When SHs file a derivative lawsuit, corps may establish
a SLC to determine if the claim should be pursued, settled, or otherwise terminated. If SLC recommends that
a derivative suit be terminated, the SLC persuade it that:
1.) Its members were independent
2.) They acted in good faith.
3.) They had a reasonable bases for their recommendations.
*Permit a corp to terminate a derivative suit if its board is comprised of directors who can impartially
consider a demand. Primary means which corp defendants may obtain a dismissal of a derivative suit if they
conclude that the plaintiffs have not met their pleading burden.

Shareholder Liability

Liability on Shares: If a person buys stock that was fully paid for when issued, or subsequent
buyers of stock regardless of price paid, he normally has no further liability to the corp or its creditors.
- A SH who didnt pay the full subscription price for newly issued shares is liable for the balance due.
(includes watered stock situations where property exchanged for shares is overvalued.
- SH is also liable if the consideration given for the shares is not lawful payment under the incorp statute.
Liability for Illegal Dividends: A dividend that was paid illegally may be recovered from a SH who received it
knowing it was illegal. If the corp was insolvent that the time, the SH is liable even if he was
unaware of the illegality.
Transfer & Redemption of Shares

Restrictions: SH has right to sell/give away her shares unless there is a valid restriction. Under
SEC rules, selling may be restricted b/c the shares were part of a private offering.
- In close corps, the original SHs may not want to have to deal w/ strangers.
- An agreement by all of them to require any SH who desires to sell to give the corp or other SHs a first
right to purchase the shares would be upheld by courts.
- Notice of a restriction on the right of sale must be conspicuously placed on the stock certificate to be
effective against a purchaser who is unaware of it.

Transfer Procedures: To transfer the stock, the owner endorses the assignment form usu printed
on the back of the stock cert. An assignment may also be made by a separate doc called a stock power. Banks usu

use stock power when stock is put up as collateral. If no transferee is named, the certificate and the shares it
represents are transferable by mere delivery.
Duty to Record: Corp has a duty to record the transfer of its stock and its other registered securities. It is liable to the
transferee if it fails to do so.

Chapter 31: Securities Regulation

Introduction: Federal securities laws provide investors w/ more info to help them make buying and selling

decisions, and prohibit some of the unfair, deceptive, and manipulative practices that caused substantial losses to
the less informed and loess powerful investors during the stock market crash at end of 1920s.
Overview of the Federal Legislation:

Securities Act of 1933: Concerned primarily w/ public distributions of securities. Regulates

the sale of securities while they are passing from hands of issuer to hands of public investors. A one-time
disclosure statute, issuers selling securities publicly must make necessary disclosures at the time issuer sells to

Securities Act of 1934: Requires periodic disclosures from issuers of securities. An issuer
w/ publicly traded equity securities must report annually and quarterly to its SHs. Any other material info about the
issuer must be disclosed as it is obtained by the issuer, unless the issuer has a valid business purpose for
withholding disclosure.

Securities and Exchange Commission: Created by 1934 Act. Administers the 1933 and
1934 Acts and 5 other security statutes. Has legislative (promulgates rules and regs), executive (brings enforcement
actions against alleged violators), and judicial (decides whether a person has violated security statutes) functions.

What is a Security? 1933 Act states: Any note, stockbond, debenture, evidence of
indebtedness, cert of interest of participation in any profit-sharing agreement,preorganization cert or
subscription,investment contract, voting trust cert,fractional undivided interest in oil, gas, or mineral rights,
or, in general, any interest or instrument commonly known as a security.
1934 Act: Same, excludes notes and drafts that mature not more than 9 months from date of issuance.

Investment Contracts: Investment of money in a common enterprise with an expectation of

profits from efforts of others. Fact that theres no cert or that what is being offered for sale is labeled tangible
property is immaterial. Device that is specifically included in the definition of a security. Examples: Sales of ltd
partnerships, Scotch whisky receipts, live animals w/ contract to care for them, restaurant properties and citrus
groves w/ mgmt contract, and franchises have all been held to be securities.
Securities Act of 1933: Two regulatory components:
1.) Registration Provisions: Designed to give investors the info they need to make intelligent decisions about
whether to purchase securities. Issuer required to file a registration statement w/ SEC and make a prospectus
available to prospective purchasers.
2.) Antifraud Provisions: Impose liability on sellers of securities for mistaking or omitting facts of material
significance to investors.
Registration Requirements: Issuer of securities must register securities / SEC prior to their offer/sale to public.
Registration Statement: Prepared by issuer, include historical & current data about the issuer and its business (incl
certified F/S), full details about the securities, use of the proceeds of issuance, and more.
Registration stmt becomes effective after it has been reviewed by SEC (checks completeness of reg stmt and whether it
contains per se fraudulent stmts usu lasts 20 days).
o Per se fraudulent stmts: tout the securities (Best securities you can buy) and forecasts that arent reasonably
based (new company promising 35% annual ROI on common stock.

Prospectus: Basic selling doc of 1933 Act registered offering, most info in registration stmt
must be included also. Must be furnished to every purchaser of the registered security prior to or
concurrently w/ the delivery of the security to the purchaser. Allows an investor to make his investment
decision based on all relevant data concerning the issuer, not just the favorable info the issuer is inclined
to disclose voluntarily.

Exemptions from the Registration Requirements: Every trxn in securities must be

registered w/ SEC or be exempt from registration (which is very costly and time-consuming).
1.) Exempt Securities: Never need to be registered, regardless of who sells them, how they are sold, or to
a. The character of the issuer makes registration unnecessary.
b. The issuance of such securities is subject to regulation under another statutory scheme
c. The purchasers of securities can adequately protect themselves.
Most important security exemptions*:
a. Govt issued or guaranteed securities.
b. Short-term notes & drafts.
d. Securities of nonprofit issuers.
e. Financial institution securities.
f. ICC-regulated issuers.
g. Insurance policies and annuity contracts.
*Not exempt from antifraud provisions of the act. Any fraud committed in the course of selling these
securities can be attacked by SEC and by those involved.
2.) Transaction Exemptions: (most important) Securities are exempt from the registration requirements for
those particular trxns only. Each trnx stands by itself, a security sale may be exempt today b/c it is sold
pursuant to a trxn exemption, yet tomorrow it may have to be registered when the security is offered or
sold again in a trxn for which there isnt an exemption.
*Not exempt from antifraud provisions of the act.
a. Several exemptions for non-issuers (average investors). One provision exempts trxns by any
person other than an issuer, underwriter, or dealer, used my most investors when they sell
securities (ex: buy GMC common shares on NYSE, you are not an issuer (GM is), you arent an
underwriter (youre not helping GM distribute shares, and you arent a dealer (youre not in
business of selling securities).
b. Several exemptions for issuers: Private offering, the intrastate offering, and small offering.
Antifraud Provisions of the 1933 Act: Preventing fraud and deceptive practices and providing remedies to victims.

Liability for Improper Offers & Sales: Imposes liability on any person who has
violated the timing, manner, and content restrictions on offers and sales of new issues.
- Purchasers remedy is rescission or damages. Occur when a person offers or sells unregistered and
nonexempt securities in violation of 1933 Act.

Liability for Defective Registration Statements: Section 11. Provides civil liabilities
for damages resulting to an investor who finds, after purchasing the security, that the registration stmt for the
security contained an untrue stmt or omitted a material fact.
- Potentially liable are all of it signers, all directors (whether or not they signed), all experts who cave
consent to be named in the reg stmt as having prepared/certified part of it (auditors, lawyers, geologists,
engineers), and the underwriters of the distribution of the security.
- Purchasers remedy is for damages caused by misstatement/omission.
- Section 11 is radical for 3 reasons:
1. Reliance on misstatement or omission in reg stmt is not usually required.
2. Privity is not required, a purchaser doesnt need to prove she purchased the securities
from the defendant.
3. Purchaser need not prove that the defendant negligently or intentionally misstated
or omitted a material fact. Defendant has the burden of proving that he exercised due
Other Liability Provisions:
Section 12(2) prohibits misstatements/omissions of material fact made in a
prospectus or in an oral comm. Related to the prospectus or an initial offering (except govt-issued
or guaranteed securities). Mere negligence, rather than scienter (intent to deceive, manipulate), is
enough to trigger liability.

- Has a privity requirement, the purchaser may only sue those person from who she purchased
the security, and must show she relied on the misstatement/omission and didnt know of the
- Defendant may escape liability by proving he didnt know and count have reasonable known
of the untruth/omission.
- Purchasers remedy is rescission or damages; recoveries are available to purchasers of initial
distributions, not to those trading in secondary mkt.

Section 17(a): Broadly prohibits use of any device/artifice to defraud and the
use of any untrue/misleading stmt in connection w/ the offer/sale of any security. 2 subsections
require that the defendant merely act negligently, 3 rd subsection requires proof of scienter.

Securities Exchange Act of 1934: Concerned w/ disclosing material

info to investors, requires periodic disclosure by issuers w/ publicly held equity securities. Regulates insiders trxn
in securities, proxy solicitations, tender offers, brokers and dealers, and securities exchanges. Several sections
prohibiting fraud and manipulation.

Registration of Securities under 1934 Act: 2 types of securities must be registered:

1.) Issuer must register a class of equity securities w/ at least 500 SHs if the issuers total assets exceed 3 mil.
Securities must be traded in interstate commerce.
2.) Issuer must register any security traded on a natl security exchange (common shares on ASE).
Periodic Reports: Issuers required to register under 1934 Act and any issuer who has made a registered offering under
the 1933 Act must file periodic reports w/ SEC.
10-K Annual Report: Must include audited F/Ss for the fiscal year plus current
info about the conduct of business, its mgmt, and the status of its securities. Intended to update the info
required in the 1934 registration stmt.
10-Q Quarterly Report: Requires only a summarized, unaudited operating
stmt and unaudited figures on capitalization and SHs equity.
8-K Monthly Report: Required w/in 15 days of the end of any month in which
any specified event occurs (change in amt of securities, a default under the terms of an issue of
securities, acquisition or disposition of assets, a change in control of corp, or other materially important
Section 906 of Sarbanes Oxley: requires CEOs and CFOs to certify in writing the accuracy of the companys periodic
financial reports reqd by SEC Act of 1934. Specifically, the statement must certify that the information fairly presents, in all
material respects, the financial conditions and result of operations of the issuer. A fine up to 5 million and/or imprisonment
for up to 20 years is the punishment for whoever willfully certifies and statement knowing that the financial report does NOT
comport with all the statutory req.


Short-Swing Trading by Insiders:

not insider trading
Requires that insiders (officer of a corp w/ equity securities registered under the act; a director of such a corp
or an owner of 10+% of a class of equity securities registered under 1934 Act) individually file a stmt
disclosing their holdings of any class of equity securities of the issuer. Insiders also must report any trxn in
such securities w/in 10 days following the end of the month in which the trxn occurs. Purchases & sales
made 6 months before and six months after one becomes an officer, director, or 10% holder must also be
Any profit made by an insider is recoverable by the issuer if the profit resulted from the purchase and sale
(or sale and purchase) w/in less than a 6-month period of any class of the issuers equity securities. This
regulation of short-swing profits is designed to stop speculative insider trading on the basis of info that
may have been obtained by such owner, director, or officer by reason of his relationship to the issuer.
Application is w/out regard to intent or actual use of insider info.

Regulation of Proxy Solicitations: SEC rules require that any person soliciting proxies from
holders of securities registered under 1934 Act furnish each SH w/ a proxy stmt w/ info to be able to
determine whether to give proxy to another person and how to direct that person to vote. Usually the only
party soliciting proxies is the corps mgmt in order to reelect itself to BOD. If the mgmt of the corp doesnt
solicit proxies, it must nevertheless inform the SHs of material info affecting matters to be put to a voite of
SHs. This info stmt, which contains about the same info as proxy stmt, must be sent to all SHs entitled to
*SHs of public corps rarely attend SH meetings so they vote through proxies.
Liability Provisions of the 1934 Act: Provide remedies to victims of fraudulent/deceptive practices.

Manipulation of a Securities Price: Sec. 9 prohibits a # of deceptive practices that cause

security prices to rise or fall by fraudulently stimulating mkt activity (when a person simultaneously buys
and sells the same stock in order to stimulate substantial trading activity wash sale).

Liability for False Statements in Filed Documents: Sec. 18 imposes liability on any
person responsible for false/misleading stmts of material fact in any doc filed w/ SEC (10-K, 10-Q, proxy
- Any person who relies on fasle/misleading stmt may sue for damages, he need not prove that the
defendant was negligent or acted w/ scienter (bad motive).
- Defendant has a defense that he acted in good faith and had no knowledge that the stmt was false.

Section 10(b) and Rule 10b-5: Most important. Extremely broad provision, prohibiting the
use of any manipulative/deceptive device in breaking any rules the SEC may prescribe as necessary or
appropriate in the public interest or for protection of investors.
o Rule 10b-5 misstatement/omission of material fact, scienter, and reliance. Securities need not be registered
under 1933 or 1934 Acts for Rule 10-b5 to apply, on a securities exchange or face-to-face. The wrongful
action must be accomplished by the mails, an instrument of interstate commerce (telephone) or securities
Misstatement: Fraud, deception, manipulation. Liability on person who misstate material facts.
Example: A manager induces SHs to sell their stock to him by saying the business will fail, but
knows the business has become potentially profitable.
Omission: Nondisclosure when there is duty to speak. Liability on person who omits material
facts, there must be a duty of trust or confidence breached by a nondisclosure or by the selective
disclosure of confidential info.
Materiality: Info that is likely to have impact on price of security in the mkt. Mergers, tender offers
for the corps stock, plans to introduce important new product, or indications of abrupt changes in the
expectations of the company.
Scienter: Intent to deceive, manipulate, or defraud. Recklessness may constitute scienter, but mere
negligence is not enough under Rule 10b-5.
Purchaser or Seller: In order to seek damages, plaintiff must be actual purchaser or seller of
Reliance: Private plaintiffs must prove they relied on a misstatement of material fact. But, reliance
isnt usually required in omission cases; the investor need merely prove the omitted fact was
material. Reliance element might be met where material misreps were avail to public. Under this
fraud-on-the-mkt theory the investors reliance on the integrity of the mkt was found to justify a
presumption of reliance on the misrep.
Statute of Limitations: Uniform federal statute litigation must be commenced w/in one year after
discovery of the facts constituting the violation and no more than three years after the violation
Conduct Covered by Rule 10b-5
o Continuous Disclosure of Material Info: Rule 10b-5 requires a corp to immediately and accurately
disclose material info unless is has a valid business purpose for withholding disclosure b/c it ensures that
investors have the info to make intelligent investment decisions at all times.

Insider Trading: A person w/ inside info must either disclose the info before trading or refrain from trading.
Applies to almost anyone, not just those who are actually viewed as insiders, such as directors, officers, and
owners of a major interest in the company. Includes secretaries, employees such as researchers or geologists,
and their supervisors, outside consultants, lawyers, engineers, financial and PR advisors, news reporters, and
personnel of govt agencies.
- Tippies: Those who are given or acquired the info w/out the need to know, such as stockbrokers or
financial analysts and even relatives or friends of those w/ access to inside info, are forbidden to trade on this
- For violation of insider trading rules, the SEC may seek a civil penalty of 3x the profit gained or loss
avoided. (Treble penalty) Also can be punished criminally (ex: $1 mil fine, 10 yrs prison).
-EX: Martha Stewarts arrest after receiving insider information regarding a pharmaceutical company not
getting a drug approved by the FDA. She could have just been fined but she lied to officials and ended up
with jail time.
- Statute of Limitations: 5 years after the violations occurred.

Safe Harbor Legislation: End of 1995, Congress passed new legislation to curb lawsuits
against companies whose stock performance fails to live up to expectations. The law discourages the filing of
lawsuits by requiring that plaintiffs plead specific facts that corp insiders knew they were committing fraud when
they made stmts projecting a companys future performance.
o New law erects a safe harbor for companies that make optimistic forecasts about future earnings or new
products. As long as companies warn the public about factors that might undermine their corecasts, they will
be immune from liability if the predictions prove false. Legislation is vague about how specific the warning
must be and fails to define exactly what types of factors must be identified.

International Cooperation: SEC pursued 2 strategies to protect US investors throughout the world.
1.) Asserted broad extraterritorial jurisdiction over global trxns that affect US commerce.
2.) Formation of mutual legal assistance treaties and memoranda of understanding b/w the US and its trading
*Seeks cooperation b/w the SEC and securities regulators from other countries.
Tender Offer Regulation

History: Until early 1960s, one corp acquired another through the merger, which required
the cooperation of the acquired corps mgmt.
Since the 1960s, tender offer has become an often-used acquisition device.
Tender Offer: Public offer by a bidder to purchase a target companys equity
securities directly from its SHs at a specified price for a fixed period of time. Offering price
is usually well above mkt price of shares.
- Hostile Tender Offer: Offers made despite the opposition from target cos mgmt.

The Williams Act: 1968 Amendments to 1934 Act to provide investors w/ more info to
make tender offer decisions. Gives the bidder (usually a corp) and the target company equal opportunities to
present their cases to the SHs. Strict requirements for both parties. Only applies when the target companys
equity securities are registered under 1934 Act.
- Bidder making a tender offer must file a statement w/ the SEC before offer is made. Info included: terms of
offer (price), background of bidder, and the purpose of the tender offer (including whether the bidder intends to
control the subject company).
- SEC rule requires bidder to keep tender offer open for at least 20 business days and prohibits any purchase of
shares during that time. Give SHs adequate time to make informed decisions to tender their shares.
- If bidder increases the offering price during term of offer, all SHs must be paid the higher price even if they
tendered their shares at a lower price.
- If more shares are tendered than the bidder offered to buy, the bidder must prorate purchases among all shares
tendered. Designed to foster careful SH decisions about whether to sell shares.
State Regulation of Tender Offers: Most states have statutes regulating tender offers to protect local corps from
hostile takeovers, requiring long periods of advance notice to the target co and long minimum offering periods.

State Securities Legislation: aka blue-sky laws since the early statutes were designed to protect investors from promoters
and security salespersons who offered stock in companies organized to pursue visionary schemes. All states provide penalties
for fraudulent sales and permit the issuance of injunctions to protect investors from addtl or anticipated fraudulent acts.
Most states grant broad power to investigate fraud to some state official usu Attorney General.
State security laws also called blue sky laws

Broker-Dealer Registration: Most state securities statutes regulate prof sellers of securities
(securities brokers and dealers). Must register securities brokers and require proof of the financial
responsibility of dealers. Dealers must disclose pertinent facts about the securities they are selling and avoid
sales of fraudulent securities.

Uniform Securities Act: In 1985, the Natl Conference of Commissioners on Uniform State
Laws adopted a new Uniform Securities Act (replaced 1965 Act). Contains antifraud provisions, require
registration of securities, and demand broker-dealer registration.
- Permit an issuer to register its securities by coordination. Instead of filing a registration stmt under the 1933
Act and a different one as required by state law, registration by coordination allows issuer to file the 1933 Act
registration stmt w/ the state securities admin. Decreases the issuers expense of complying w/ state law when
making an interstate offering of securities.

Chapter 32: Legal Liability of Accountants

Bases for Liability: Basis of accountants liability is the duty to exercise ordinary skill and care. Breach of this duty
could lead to tort of negligence, or breach of contract b/w accountant and client. Sometimes violation is
fraudulent or even criminal. If a partner in a public firm is responsible for wrongdoing, the law of
partnership will be involved, prob resulting in liability for all partners in firm. (if acct is an employee and not
partner, firm may still be held liable under respondeat superior). Can be both civil or criminal.
Common Law Liability to Clients

Contractual Liability: If an acctg firm agrees to complete an audit for a prospective lender
by 2/15 (an informed deadline) and doesnt finished until March and the lender runs out of funds, the acct
would be liable for the clients resulting loss. The acctg firms other deadlines arent a defense, but the firm
wouldnt be liable if the client obstructed performance by refusing access to records.
o No Delegation Rule: Ordinarily, an accountant cant delegate his duties w/out consent of client b/c the contract is
personal, based on the skill, training, and personality of the acct.
Tort Liability
o Negligence: An accts failure to follow instructions of firm or duty of care for an acct may lead to

negligence if the client suffers damages.

Failure of an acct to discover fraud by client is not in itself proof of negligence by acct.
Notifying an appropriate person is necessary when fraud is suspected, but never to the person suspected
of fraud.
Contributory Negligence and Comparative Negligence are traditional defenses that may apply to a
negligence action. More likely to succeed when the client failed to follow accts advice.
Client is limited to recovering compensatory damages.

Fraud: Intentional misrep of material facts or intentional failure to disclose such info. Acting w/ scienter
(knowledge of an untruth or reckless disregard for truth).
Client may recover compensatory damages (amount that will repleace the actuall loss caused by
accts wrong. May be able to recover punitive damages as well (amt in excess of actual loss to punish

Common Law Liability to 3rd Persons: such as creditors, SHs, or other investors who rely on audited F/Ss.

Privity Doctrine: Limits recovery to those w/ a direct contractual relationship to acct.

historically, 3rd party suits against accts were generally barred by this.

Contract (past approach): At common law, recovery by a creditor was possible b/c the
creditor was considered a 3rd party beneficiary of the contract employing the acct. Required showing
that the acct was aware that the audit was ordered to satisfy creditor. Contract law has not been widely
used by 3rd persons suffering damages b/c of accts.
Negligence (past approach): Many courts carried privity doctrine to negligence suits by 3 rd
persons. These non-clients (creditors, SHs, etc) were prevented from recovering damages caused by
accts negligence. Accts did not owe a duty of care and skill to non-clients.
Current Approaches to 3rd Party Negligence Actions: Many courts today refuse to apply
privity doctrine to 3rd party negligence suits against accountants. They use:

1.) The Ultramares Approach: 3rd Party cant recover unless in privity. Ultramares vs. Touche; auditor not told
that Ultramares Corp was to receive 1 of 32 signed certified B/S, yet auditors were clearly negligent in making
their audit. They accepted w/out question as $700,000 in fake sales, although these and other entries should
have aroused their suspicions. Jdg Cardozo refused to hold acctg firm liable If liability for negligence
exists, a thoughtless slip or blunder, the failure to detect a theft/forgery beneath the cover of deceptive entries,
may expose accts to a liability in an indeterminate amt for an indeterminate time to an indeterminate class.
2.) The Near Privity Approach: From case where a seller employed a weightier to certify weight of beans and
provide a copy of certification to buyers. Jdg Cardozo held for the buyer in a suit against the weightier for
inaccurately certifying the weight of beans. Accts may be liable in negligence to 3 rd parties when:
a. The accts must have been aware that the F/Ss were to be used for a particular purpose.
b. The acct must have known the identity of the 3rd parties that they would rely on reports.
c. Evidence that acct knew reliance would occur.
3.) The Restatement (2nd) Approach: Acct is liable only to those 3rd parties who are specifically foreseeable,
greater liability on accts than Ultramares. Requires the acct be aware that audited material would be used
by 3rd parties. Does not protect the typical investor who was unknown to acct and her client when F/S were
prepared. States who abandon Ultramares use this approach.
4.) The Reasonably Foreseeable Users Approach: Exposes a negligent acct to greater liability than Ultramares
and Restatement. Acct could be held liable to unknown but reasonably foreseeable users if:
a. User must have received the F/S from the accts client for a proper business purpose.
b. The 3rd person must have reasonably relied on accuracy of F/S.
c. The damages suffered by 3rd party must be a foreseeable result of accts negligence.
5.) The Balancing Approach: More flexible/equitable standard for resolving 3rd party negligence suits against
accts. 3rd party may recover if they meet the six-factor balancing test that examines:
a. The extent to which the trxn was intended to affect the plaintiff.
b. The foresee-ability of harm to plaintiff.
c. The degree of certainty that the plaintiff suffered injury.
d. The closeness of the connection b/w the defendants conduct and the injury suffered.
e. The moral blame attached to the defendants conduct.
f. The policy of preventing future harm.

Fraud: Courts have extended an accts liability for fraudulent conduct to all foreseeable
users of her work product who suffered damages that were proximately cause by accts fraud. To prove
fraud, must be shown acct acted w/ scienter (intent). Ex: rather than examining current figures in a clients
books, an acct relies on last years figures, or recognizing obvious evidence of embezzlement yet failing to
notify client of it.
Duty to Disclose New Info: Duty of care of accts extends beyond their actions during

the audit itself, they have a duty to disclose the unreliability of the earlier report to anyone who
they knew was relying on it. Could be negligence or fraud.
Statutory Liability of Accountants

Federal Securities Act

o Civil Actions under the 1933 Act: Section 11(a) explicitly imposes liability on accts for misstatements/omissions
of material facts in info they furnish for registration stmts required by 1933 Act. Also applies to
lawyers/other experts. Liable to any purchaser of securities issued pursuant to a defected registration stmt.
Purchaser need not prove reliance
Burden is on accountant (must prove he exercised due diligence, GAAS, GAAP)
Acct not liable if he can prove the purchaser was aware of the misstatement.
Accts duty is to have a reasonable belief in accuracy of figures at time the registration stmt
becomes effective (usu several months after audit was completed), so the acct has continuing duty
to review the audited stmts until effective date and correct any material changes.
Statute of Limitations: Purchaser must sue acct w/in one year after time the
misstatement/omission was or should have been discovered. However, a suit may not be brought
more than 3 years after the securities were offered to the public.

Civil Actions under the 1934 Act: Section 10(b) prohibits any person from making a
misstatement or omission of a material fact in connection w/ the purchase or sale of any security.
Purchaser or seller must rely on the misstatement/omission, but sometimes courts allowed plaintiffs to
recover even though they hadnt read the report containing omissions.
Popularity of this rule among plaintiffs is somewhat diminished by the requirement that something
more than negligence must be shown to make defendant liable (scienter, intentional or knowing
misrep, reckless disregard of facts).
Section 18(a) imposes liability on accts who furnish false or misleading info in any report/doc
filed w/ SEC. While privity is not a defense in Sec 18, it is still not widely used b/c it contains a
stringent reliance requirement (purchaser/seller must have actually read the false info investors
seldom read many docs filed w/ SEC).
Accts may be liable for assisting (aiding and abetting) others in violating SEC laws, even if info
was prepared by others. Accts must report any illegal activities uncovered in audit.
New legislation shields accts from the joint-and-several liability system (an acctg firm could be
held liable for the full amt of a judgment if the defendant corp became insolvent). New regulations
limits the acctg firms liability to the proportion of the fraud for which the accts were responsible,
plus a 50% premium when main defendant is insolvent.

Criminal Liability: 1933: A willful (intentional) misrep/omission in a registration stmt is criminal.

1934: To willfully make a fast or misleading stmt in reports that are required to be filed with
SEC. Willful violation of Rule 10b-5 is also a crime.

State Securities Acts: All states have statutes that contain liability provisions, some that specifically
impose criminal penalties on accts for willful falsification of F/S, but few actions have been brought against
accts under these statutes, but this might change as plaintiffs recognize difficulty of proving scienter under
Rule 10-b.

Liability for Tax Work: Accts may be held liable for negligence in preparing tax returns and giving tax
advice. Example: An acct may be required to reimburse a client for a penalty imposed for the late filing if the
delay is caused by acct. Or an acct who erroneously tells a client a trxn is nontaxable when it actually is.

Administrative Proceedings: An acct who violates the fed securities acts may be subjected to an admin
hearing conducted by SEC, where an admin law judge will first hear the case and make a determination. The
SEC commissioners will then issue a final order. SEC possesses the authority to temporarily or permanently
bar an acct from practicing before it. Final order of SEC may be appealed to a fed court of appeals.

Professional Conduct: Most states have licensing boards that regulate the ethical conduct of acct prof.
State agencies may suspend or revoke accts license to practice in that state if she commits illegal/unethical
acts. Strict regulation of advertising in acctg prof is now a thing of the past.

Qualified Opinions and Disclaimers: After audit completed, acct must issue an opinion letter.
- Unqualified Opinion: In accts opinion, there has been compliance w/ GAAP and GAAS.
Qualified Opinion: When there is some kind of issue, for example, a pending litigation against the client.
Uncertainty over how the litigation will be decided may cast a cloud of doubt over financial condition of company.
Relieves acct of any responsibility for major changes in the clients financial position due to an unfavorable verdict.
Disclaimer: When an acct may have conducted such a limited audit that she doesnt feel able to offer an opinion as
to the accuracy of the clients F/S. She would still be liable for any irregulatirites that her limited audit should have
Adverse Opinion: To avoid liabilities for any irregularities discovered, accts issue an adverse opinion.
- Merely issuing an unaudited stmt does not create a disclaimer as to the F/S accuracy. It just lowers the level
of inquiry for which the acct will be responsible.
Protection of Accountants Papers

Working Papers: Working papers from audit belong to acct, not client, b/c the acct may
need to justify his work before the IRS or a court. May include notes, plans for audit, results of testing to
determine reliability or accounts, comments about clients IC. Acct must get clients permission before they
can be transferred to another acct. Client has a right of access to working papers for any reasonable purpose
(use of papers by an attorney defending client in a tax case).

Accountant-Client Privilege: Many states have statutes that grand protection to accts
working papers and also to conversations, letters, and memos b/w accts and their clients. However, federal
courts dont always recognize such state statutes.
o Example: A privilege of confidentiality has not, in the past, been recognized in fed tax cases. An acct may
be forced by a subpoena to make available to the IRS working papers involving a client who is being
investigated. Acct may also be forced to testify about the clients records and about convos that the acct
had w/ client (same w/ SEC investigations).
- Differs from lawyers and clients, their communication is treated as privileged.
- In 1998, fed statute extended attorney-client privilege to a federally authorized tax practitioner. Does
not protect work product.
-Work Product Privilege: broad privilege against compelled disclosure of an attorneys work product.
Today protection is extended to braider class of professionals. It now protects from discovery any documents
and tangible things prepared in anticipation of litigation by or a party. Party asserting WPP bears burden of
establishing that docs he seeks to protect were prepared in anticipation of litigation.

Chapter 44- Bankruptcy

The Federal Bankruptcy Act
- The Bankruptcy Act is a Federal Law that provides an organized procedure under the supervision of a
federal court for dealing with insolvent debtors. Debtors are considered insolvent if they are unable or fail
to pay theirs debts as they become due.
-Most recent revision to the bankruptcy law was passed on 4/20/2005 by Pres. Bush called the
Bankruptcy Abuse, Prevention and Consumer Protection Act of 2005. (valid for cased filed after
-Several Major purposes:
1) to ensure that the debtors property is fairly distributed to the creditors and that
some of the creditors do not obtain unfair advantage over the others
2) The act is designed to protect all of the creditors against actions by the debtor that
would unreasonably diminish the debtors assets to which they are entitled
3) Provides the honest debtor with a measure of protection against the demands for
payment by creditors (in some cases, the debtor is given additional time to pay the
creditors free of pressures the creditors might otherwise exert.)
Bankruptcy Proceedings
Bankruptcy Act covers several types of bankruptcy proceedings:
1) Straight Bankruptcy (liquidation)

2) Reorganizations
3) Consumer debt adjustments
Liquidations (Chapter 7)
- A liquidation proceeding, traditionally called strait bankruptcy, is brought under Chapter 7 of the
Bankruptcy Act. The debtor must disclose all property show owns (the bankruptcy estate) and surrender it
to the bankruptcy trustee. The trustee separates out certain property that the debtor is permitted to keep
and then administers, liquidates, and distributes the remainder of the bankrupt debtors estate. If the
bankrupt person has been honest in her business transactions and in the bankruptcy proceeding, she is
usually given a discharge (relieved) of her debts.
Reorganizations (Chapter 11)
- Chapter 11 of the Bankruptcy Act provides a proceeding whereby a debtor who is engaged in business
can work out a plan to try to solve financial problems under the supervision of a federal court (contract
between debtor and creditor). The proceeding is intended for debtors, particularly businesses, whose
financial problems may be solvable if they are given some time and guidance and if they are relieved of
some pressure from creditors.
o Family Farms and Fishing Operations (Chapter 12)
- Chapter 12 of the Bankruptcy Act provides a special proceeding whereby a debtor involved in a family
farming operation or a family owned commercial fishing operation can develop a plan to work out
financial difficulties. Allowed to own and continue to operate farm until plan is implemented)
Consumer Debt Adjustments (Chapter 13)
- Chapter 13 of the Bankruptcy Act sets out a special procedure that enables individuals with regular
income who are in financial difficulty to develop a plan under court supervision to satisfy their creditors.
Allows compositions (reductions) of debtors and/or time extensions to pay out of debtors future earnings.
Bankruptcy Courts
- Bankruptcy cases and proceedings are filed in federal district courts. If a dispute falls within what is
known as a core proceeding, the bankruptcy judge (appointed by pres for 14 yr term) can hear and
determines the controversy. If dispute is a state claim, bankruptcy judge drafts findings and conclusions
for review by district judge. Certain kinds of proceeding what will have an effect on interstate commerce
have to be heard by the district court judge if any party requests that this be done.
Chapter 7: Liquidation Proceedings
Voluntary Petition (filed by debtor) in bankruptcy me be filed by an individual, a partnership, or a
corporation. However, municipal, railroad, insurance, and banking corporations and savings and
loan associations are not permitted to file for liquidation proceedings. It is not necessary for a
person who files a voluntary petition be insolvent, that, be able to pay his debts as they become
due. Must be able to allege that he has debts. The primary purpose for filing a voluntary petition
to obtain a discharge e from some or all of the debts.
-2005 Revision: established a new means test for consumer debtors to be eligible for relief under
chapter 7. It ensures that individual who will have income in the future might be used to
pay off at least a portion of their debts must pursue chapter 13 as opposed to pursuing
relief and discharge of liabilities through liquidation provisions under chap 7.
Involuntary Petitions
-A petition filed by creditors of a debtor. The creditors seek to have the debtor declared bankrupt and his
assets distributed to the them.
- Cannot be field against :
1) Farmers
2) Ranchers
3) Nonprofit Organizations
4) Municipal, railroad, and banking corporations
5) Credit Unions
6) Savings and loan associations
- If a debtor has 12 or more creditors, an involuntary petition to declare him bankrupt must be signed by
at least 3 creditors. If there are fewer than 12 creditors, an involuntary petition can be filed by a single
creditor. The creditor or creditors must have valid aggregate claims against the debtor that exceed by

$12,300 or more the value of any security they hold. To be forced into involuntary bankruptcy the debtor
must be unable to pay his debts as they become due or have had a custodian for his property appointed
within the previous 4 months.
- If an involuntary petition is filed against a debtor who is engaged in business, the debtor may be
permitted to continue to operate the business. However, an interim trustee may be appointed by the court
if this is necessary to preserve the bankruptcy estate or to prevent loss of the estate.
-2005 Revisions:
Requirement for Credit Counseling and Debtor Education
-Individuals are ineligible for relief under any chapter of the bankruptcy code unless within 180
days preceding their bankruptcy filing they received individual or group credit counseling from
an approved nonprofit budget and credit counseling agency or receive an exception from the req.
The req. briefing, can be done by telephone or internet, must outline the opportun. for
counseling/ budget analysis. Debtor must file a certificate from agency that describes services and
also file any debt repayment plan developed by agency.
Attorney Certification
-Increased liability for attorney who signs a bankruptcy petition. Signature constitutes a
certification that they, after inquiry, has no knowledge that the info contained in schedules filed
by debtor are incorrect. Signature acts on a petition, motion or other written pleading constitutes a
cert. that they, after inquiry, determined that the pleading is well grounded in fact and is either
warranted by existing law or is based on a good faith argument for extending existing law. If
motion signed by trustee to dismiss case for substantial abuse court may order debtors attorney to
reimburse costs.
Automatic Stay Provisions
- The filing of a bankruptcy petition operates as an automatic stay (holds in abeyance) of various forms
of creditor action against a debtor or his property. These actions include
1) actions to begin or continue judicial proceedings against the debtor
2) actions to obtain the possession of the debtors property
3) actions to create, perfect, or enforce a lien against the debtors property
4) actions to set off indebtedness owed to the debtor that arose before commencement of the
bankruptcy proceeding
- A court may give a creditor relief from the stay if the creditor can show that the stay does not give him
adequate protection and jeopardizes his interest in certain property.
-(1994) Debtors must either file a plan of reorganization that has a reasonable chance of being confirmed
within a reasonable time or must be making monthly payments to each such secured creditor that are in an
amount equal to interest at a current fair market rate on the value of the creditors interest in the real
- (1994) Amendments also specifically provide that the automatic stay provisions are not applicable to
actions to establish paternity; to establish or modify orders for alimony, support, or maintenance, or for
the collection of alimony, maintenance, or support from property that is not the property of the
bankruptcy estate
- 2005 Revisions:
-Additional Exceptions from the Automatic Stay provisions for the benefit of landlords seeking to evict
tenants. (1) any eviction proceeding where landlord obtained judgment of possession prior to filing of
bankruptcy petition can be continued (2) if landlords claim for eviction based on use of illegal substances
on prop. or endangerment of the property, eviction proceedings are exempt from the stay even if
intimidated after bankruptcy proceeding filed so long as endangerment occurred within 30 days before
-Revisions also include provisions dealing with serial filings for bankruptcy designed to keep debtors
from abusing auto. Stay provisions to the detriment of creditors.
Order of Relief
- If a voluntary petition was filed by the debtor or if the debtor does not contest an involuntary petition,
this step is automatic. If the debtor contests an involuntary petition, then a trial is held on the question of
whether the court should order relief. The court orders relief only if

1) the debtor is generally not paying his debts as they become due
2) within four months of the filing of the petition, a custodian was appointed or took possession
of the debtors property
Meeting of Creditors and Election of Trustee
- The bankrupt person is required to file a list of his assets, liabilities, and creditors, and a statement of his
financial affairs.
-2005 Revisions:
New production req.s on debtors. Individuals must file along with their schedules of assets and liabilities:
A certificate that they have received and/or read notice from Clerk of the Bankruptcy Court
that they must receive credit counseling to be eligible for relief under Bankrupt. Code.
Copies of all payment advices and other evidence or payment theyve received from
employer within 60 days before filing of petition
Statement of amt of monthly net income, itemized to show how calculated.
Statement showing any anticipated increase in income or expenses over 12 month period after
date of filing petition.
-Should an indiv. debtor in a voluntary chap. 7 case or chap 13 case fail to file req. info within 45 days of
filing, case is auto. dismissed. If extension is justified court can extend time to submit paperwork to max
of an additional 45 days.
-Indiv, debtors must also provide copies of recent tax returns to trustee and creditors making timely
request- failure to do so can result in dismissal of case.
Once court receives petition/cert/schedules- the meeting of creditors is called. At the meeting, the United
States Trustee is required to examine the debtor to make sure he is aware of:
1) the potential consequences of seeking a discharge in bankruptcy, including the effects on credit
2) the debtors ability to file a petition under other chapters of the Bankruptcy Act
3) the effect of receiving a discharge of debts
4) the effect of reaffirming a debt
- The creditors may elect a creditors committee. They also elect a trustee, who, if approved by the judge,
takes over administration of the bankrupts estate.
-Creditors have chance to ask debtor Qs about assets, liab., financial difficulties. The questions
commonly focus on whether the debtor has concealed or improperly disposed of assets.
Duties of the Trustee
- The trustee takes possession of the debtors property and has it appraised. The debtor must also turn over
his records to the trustee. For a time, the trustee may operate the debtors business. The trustee also sets
aside items of property that a debtor is permitted to keep under state exemption statutes or under federal
-Trustee examines claims that have been filed by various creditors and object those that are improper.
- The trustee separates the unsecured property from the secured and otherwise exempt property.
-Sells bankrupts nonexpemt prop. as soon as possible and consistent with best interest of creditors.
- The trustee is required to keep an accurate account of all property and money that he receives and to
promptly deposit moneys into the estates account.
-At end of meeting, trustee provides debtor with detailed statement of admin of the bankruptcy estate.
-2005 Revisions:
-2005 act restricts authority of the trustee to sell personally identifiable info about indiv. To person who
are not affiliated with debtor (promise of confidentiality).
o Health Care Businesses
-first, trustee must use best efforts to transfer patients in a health care business that offers similar services
and maintain reasonable qual of care.
-second, the actual, necessary costs of closing health care business are considered admin expenses entitled
to priority.
- third, the auto stay provisions do not apply to actions by secretary of health and human services to
exclude debtor from participating in medicare and other fed. health care programs.

-Finally, req. for disposal of patient records where there are insufficient funds to continue to store them as
req. by law. (proper notification to affected patients is also assumed)
Liquidation of Financial Firms
-Bankruptcy code contain special provisions for liquidation of stockbrokers, commodity brokers and
clearing banks that are designed to protect interests of customers of entities who have assets on deposit
with the bankrupt debtor. (overseen by trustee)
The Bankruptcy Estate
-Commencement of chap 7 bankrupt case by filing of involuntary or voluntary petition creates a
bankruptcy estate.
-The estate is composed of all debtors legal and equitable interests in prop. Including certain community
- The estate also includes the following:
1. Profits, royalties, rents and revenues along with proceeds from debtors estate received during
chap 7 proceeding
2. Property received by debtor in any of following ways within 180 days of chap 7 petition filing
(a) by bequest or inheritance (b) as a settlement with a divorces spouse or result of divorce decree
or (c) as proceeds of a life insurance policy.
3. Property received by bankruptcy trustee because (a) a creditor of debtor received a voidable
preferential transfer or (b) the debtor made a fraudulent transfer of her assets to another person.

- Even in liquidation proceeding, the bankrupt is generally not required to give up all of his property but
rather is permitted to exempt certain items of property. Debtor can choose between state and federal
- Debtor may choose to keep either certain items of property that are exempted by state law or certain
items that are exempt under federal (unless state forbids use of federal exemption).
-2005 Revision: The state or local law governing the debtors exemptions is the law of the place where the
debtor was domiciled for 730 days before filing. If debtor didnt maintain domicile in a single stte for that
period, then the law governing the exemptions is the law of the place of the debtors domicile for the
majority of 180 day period that is between 2 and 2 yrs before filing of petition.
-Debtor must elect to use either set of exemptions provided by the state or federal bankruptcy law- she
cannot pick and choose between them.
-The exemptions permit the bankrupt person to retain a minimum amount of assets considered necessary
to life and to his ability to continue to earn a living. (fresh start philosophy) The general effect of the
federal exemptions is to make a minimum exemption to all debtors in every state.
-States that wish, can provide liberal exemptions called debtors havens, for example- family Bible,
tools or books of the debtors trade, life insurance policies, health aids, personal and household goods/
jewelry, furniture and cars worth up to a certain amount.
- 12 Categories of property are exempt under the federal exemption which the debtor may elect in lieu of
the state exemptions.
The debtors interest not to exceed
1) $21,625 in value, in real property or personal property that the debtor or dependent of the
debtor uses as a residence
2) $3,450 in one motor vehicle
3) up to a total of $11,525 in household furnishings, household goods, wearing apparel,
appliances, books, animals, crops, or musical instruments that are held primarily for the
personal, family, or household use of the debtor or a dependent of the debtor
4) total interest of $1,400 in jewelry held primarily for the personal, family, or household use of
the debtor or a dependent of the debtor
5) $1,150 in value of any other property of the debtors choosing, plus up to HALF of unused
homestead exemption
6) total interest of $2,175 in any implements, professional books, or tools of the trade
7) life insurance contracts

8) Interest up to $11,525 in certain dividends or interest in certain life insurance policies

9) Professionally prescribed health aids
10) Social security, disability, alimony, and other benefits reasonably necessary for the support of
the debtor or his dependents
11) The debtors right to receive certain insurance and liability payments
12) Retirement funds that are in a fund or account that is exempt from taxation under the Internal
Revenue Code. For certain retirement funds, the aggregate amount exempted is limited to 1
- The term value means fair market value as of the date of the filing of the petition. In determining the
debtors interest in property, the amount of any liens against the property must be deducted

-2005 Revision:
Limits on State Homestead Exemptions
-Limits on state homestead exemptions include the following:
1. The value of the debtors homestead for purposed of a state homestead exemption is reduced to
extent it reflect an increase in value on acct of disposition of nonexempt prop. By debtor during
10 yrs. Prior to the filing with the intent to hinder, delay or defraud creditors.
2. Any value in excess of $125,000- irrespective of the debtors intent- that is added to the value
of a homestead during the 1215 days (3yr, 4 mos.) preceding bankrupt. Filing may not be
included in state homestead exemption unless it was transferred from another homestead in same
state or if is a principal residence of a family farmer.
3. An absolute $125,000 homestead cap applies of (a) bankruptcy court determines debtor been
convicted of felony or (b) debtor owes a debt arising from a violation of fed or state securities
laws, fiduciary fraud, racketeering or crimes or intentional torts that caused serious injury or
death in the preceding 5 yrs.

Avoidance of Liens
- The debtor is also permitted to void certain liens against exempt properties that impair his exemptions.
The liens that can be avoided on this basis are judicial liens or non possessory, non- purchase money
securities in
1) household furnishings, household goods, wearing apparel, appliances, books, animals, crops,
musical instruments, and jewelry that are held primarily for the personal, family, or household use
of the debtor or a dependent of the debtor
2) implements, professional books, and tools of trade of the debtor or of a dependent of the debtor
3) professionally prescribed health aids for the debtor or a dependent of the debtor.
-2005 revision:
-The household goods as to which non-possessory purchase money security interest can be avoided has
been limited. The new definition limits electronics to one radio, one TV, one VCR and one computer.
Excluded are works of art other than those created by debtors and close family, jewelry worth more than
$500 (except wedding rings) and motor vehicles (includes tractors, ORVs, boats, planes).

- Debtors are also permitted to redeem exempt property from secured creditors by paying them the value
of the collateral. Then the creditor is an unsecured creditor to any remaining debt owed by the debtor.
-2005 revision: value of personal prop. Securing a claim of an indiv. debtor in a chap 7 proceeding based
on cost to debtor of replacing prop- w/o deduct for costs of sale or mkting- and if prop was acquired for
personal, family or household purposes, the replacement cost will be the retail price for prop of similar
age and condition. Debtor is not permitted to retain collateral w/o redemption or reaffirmation of debt by
just continuing to mk. payments on secured debt.

Preferential Payments
- The trustee has the right to recover for the benefit of the bankruptcy estate preferential payments above a
certain threshold that are make by the bankrupt debtor. If an indiv. debtor whose debts are primarily
consumer debts, trustee isnt entitled to avoid preferences unless total value is >$600 . If a corporate
debtor, transfer by debtor of <$5000 in aggregate isnt subject to avoidance.

-A preferential payment is a payments made by an insolvent debtor within 90 days of the filing of the
bankruptcy petition that enables the creditor receiving the payment to obtain a greater percentage of a
preexisting debt than other similar creditors of the debtor receive.
-Ex.Fred has $1,000 in cash and no other assets. He owes $650 to his friend Bob, $1,500 to the credit
Union, and $2,000 to the finance company. If Fred pays $650 to Bob and then files for bankruptcy, he has
made a preferential payment to Bob. Bob has obtained his debt paid in full whereas only $350 is left to
satisfy the $3,500 owed to the credit union and the finance company. They stand to recover only 10 cents
on each dollar that Fred owes to them. The trustee has the right to get the $650 back from Bob.
- The 1994 amendments provided that the trustee may not recover as preferential payments any bona fide
payments of debts to a spouse, fromer spouse, or child of the debtor for alimony, maintenance, or support
pursuant to a separation agreement, divorce decree, or other court order.
Preferential Liens
- A creditor might try to obtain an advantage over other creditors by obtaining a lien on the debtors
property to secure an existing debt. Such liens are considered preferential and are invalid if they are
obtained on property of an insolvent debtor within 90 days of the filing of a bankruptcy petition and the
lien is to secure a preexisting debt. A pref. lien obtained by insider within 1 yr of bankruptcy can be
Ex. George, a grocer, is insolvent. Georges purchase of new inventory such as produce and meat for cash
would not be considered a preferential payment. Geroges assets have not been reduced; he simply has
traded money for goods to be sold in his business. Similarly, George could buy a new display counter and
give the seller a security interest in the counter until he has paid for it. This is not a preferential lien The
seller of the counter has not gained an unfair advantage over other creditors, and Georges assets have not
been reduced by the transaction. The unfair advantage comes where an existing creditor tries to take a lien
or obtain a payment of more than his share. The creditor has obtained a preference and it will be
-The act also permits payments of accounts in the ordinary course of business.
o Transactions in the ordinary course of business
-The Bankruptcy Act provides exceptions to the trustees avoiding power thatre designed to allow a debtor
and his creditors to engage in ordinary business trans. They include:
(1) Transfers that are intended by the debtor and creditor to be contemporaneous exchanges for new
(2) Creation of a security interest in new prop where new value was given by the secured party to enable
the debtor to obtain the property and where the new value was in fact used by the debtor to obtain the
prop. And the security interest was perfected w/i 20 days after debtor took possession of collateral.
-The B. Act also provides an exemption for transfers made in payment incurred in the ordinary course of
business, like paying your utilities bill in a timely fashion without the creditor being vulnerable to having
the transfer of funds avoided by the trustee.
Fraudulent Transfers
- If a debtor transfers property or incurs an obligation with intent to hinder, delay, or defraud creditors,
the transfer is voidable by the trustee. Similarly, transfers of property for less than reasonable value are
voidable by the trustee.
Ex. Kathys in financial trouble so she sells her $500 car to her mom for $5000.
- This could be declared void by a trustee if it was made within a year before the filing of a bankruptcy
- The provisions of law concerning fraudulent transfers are designed to prevent a debtor from concealing
or disposing of his or her personal property in fraud of creditors.
- If creditors wish to participate in the estate of a bankrupt debtor, they must file a proof of claim in the
estate within a certain time (usually six months) after the first meeting of creditors. Only unsecured
creditors are required to file proofs of claims; secured creditors do not have to do so. However, a secured
creditor whose secured claim exceeds the value of the collateral is an unsecured creditor to the extent of
the deficiency. A proof of claim must be filed to support the recovery pf the deficiency.
Allowable Claims

- If a claim is provable- it does not ensure that a creditor can participate in the distributions of the assets
of the bankruptcy estate= the claim must be allowed. If the trustee has a valid defense to the claim, she
can use the defense to disallow the claim or to reduce it.
Secured Claims
- The trustee must also determine whether a creditor has a lien or secured interest to secure an allowable
claim. If the debtors property is subject to a secured claim of creditor, that creditor has the first claim to
it. The property is available to satisfy claims of other creditors only to the extent that its value exceeds the
amount of the debt secured.
Priority Claims
- The Bankruptcy Act declares certain claims to have priority over other claims (10 classes of PC)
1)Domestic support obligations of the debtor, including claims for debts to a spouse, former
spouse or child for alimony, maintenance for, or support of such spouse or child in connection
with a separation agreement, divorce decree, or other court order
2) expenses and fees incurred in administering the bankruptcy estate
3) unsecured claims in involuntary cases that arise in the ordinary course of the debtors business
after the filing of the petition but before the appointment of a trustee or the order of relief
4) unsecured claims of up to $10000 per individual for employees wages earned within 180 days
before petition was filed or the debtors business ceased.
5) contributions to employee benefit plans up to $10,000 per person
6) unsecured claims
a) for grain or the proceeds of grain against a debtor who owns or operates a grain
storage facility
b) up to $4,925 by a U.S. fisherman against a debtor who operates a fish produce storage
or processing facility and who has acquired fish or fish produce from the fisherman
7) claims up to $2,225 each by individuals for deposits made in connection with the purchase,
lease, or rental of property or the purchase of goods or services for personal use that were not
delivered or provided
8) certain taxes owed to governmental units
9) allowed unsecured claims based on a commitment by the debtor to a federal depository
institution regulatory agency
10) Allowed claims for liability for death or personal injury resulting from operation of a motor
vehicle where the operator was unlawfully intox. From alcohol, drugs or other substances.
Distribution of Debtors Estate
- The priority claims are paid after secured creditors realize on their collateral or security but before other
unsecured claims are paid. Payments must be made to the 10 priority classes in order- to the extent there
are funds available. Each class must be paid before the next. To the extent there are insufficient funds to
satisfy all the creditors within a class, each class member receives a pro rata share of his claim
-Unsecured Creditors include
1) those creditors who had not taken any collateral to secure the debt owed to them
2) secured creditors to the extent their debt was not satisfied by the collateral they held
3) priority claimholders to the extent any funds are available for them, share in proportion to their
claims; they frequently receive little or nothing on their claims.
- Secured claims, trustees fees, and other priority claims often consume a large part or all of the
bankruptcy estate.
Discharge in Bankruptcy
o Discharge
- A bankrupt person who has not been guilty of certain dishonest acts and who has fulfilled his duties as a
bankrupt is entitled to a discharge in bankruptcy. A discharge relieves the bankrupt person of further
responsibility for those debts that are dischargeable and gives the person a fresh start. A corporation is not
eligible for a discharge in liquidation bankruptcy proceedings. An individual may not be granted a
discharge if she has obtained one within the previous six years.

Objections to Discharge

- After the bankrupt has paid all the required fees, the court gives creditors and others a chance to file
objections to the discharge of the bankrupt. Objections may be filed by the trustee, a creditor, or a U.S.

Acts that Bar Discharges

-Discharges in bankruptcy are intended got honest debtors. There are a number of acts that bar debtors
from being discharged: (1) unjustified falsifying, concealing or destroying records (2) making false
statements, presenting false claims or withholding recorded information relating to the debtors property or
financial affairs (3) transferring, removing, or concealing property in order to hinder, delay, or defraud
creditors (4) failing to account satisfactorily for any loss or deficiency of assets (5) failing to obey court
orders or to answer questions by the court.

Non-dischargeable Debts
-The Bankruptcy Act provides that a discharge in bankruptcy releases a debtor from all provable debts
except for those that:
1. Are due as a tax or fine to the US or any state or local unit of gov.
2. Result from liabilities for obtaining money by false pretenses or false representations
3. Arise out of a debtors purchase of more than $600 in luxury goods or services on credit from a single
creditor within 90 days of filing a petition
4. Are cash advances in excess of $875 obtained by use of a credit card or a revolving line of credit at a
credit union and obtained within 70 days of filing a bankruptcy petition
5. Were not scheduled in time for proof and allowance because the creditor holding the debt did not have
notification of the proceeding even though the debtor was aware that he owed money to that creditor.
6. Were created by the debtors larceny or embezzlement or by the debtors fraud while acting in a fiduciary
7. Are for domestic support obligation, unless excepting them from discharge would impose an undue
hardship on the debtors dependents
8. Are due for willful or malicious injury to a person or his property
9. Are education loans
10. Are judgments arising out of debtors operations of a motor vehicle while legally intoxicated
11. Are debts incurred to pay a tax to the UD that would not be dischargeable
12. Are property settlements arising from divorce or separation proceedings that are not covered by the
support provisions that are priority claims
-All of these nondisch. Debts are provable debts. Creditor who owns them can participate in the
distribution of estate & has an additional advantage: his right to receive the unpaid balance is not cut off
by the bankrupts discharge.

Reaffirmation Agreements
-The agreement must be made before the discharge is granted and must contain a clear and conspicuous
statement that advices the debtor (1) that the agreement may be rescinded at any time prior to discharge or
within 60 days after filing with the court and (2) that the reaffirmation is not req. by the bankrupt law and
any other law or agreement
-The agreement must be filed with the court accompanied by a statement from the debtors attorney that
(1) represents a voluntary agreement by the debtor (2) it doesnt impose an undue hardship on debtor (3)
the attorney fully appraised the debtor of the legal effect and consequences of the agreement and of any
default under such an agreement.
-Court approval not req. for the reaffirmation of loans secured by real property.

Dismissal for Substantial Abuse

-In 1984 too many individuals with an ability to pay debts over time pursuant to chap. 13 were filing
petitions to obtain chap. 7 discharges of liability. Bankruptcy courts dismiss cases that they determined
were substantial abuse of the bankruptcy process.

Means Testing (2005 Revision): Abuse can be establish in two ways: (1) through an unrebutted finding of
abuse based on a new means test that is included in the code or (2) on general grounds of abuse, including bad
faith, determined under the totality of the circumstances.
-The means test is designed to determine the debtors ability to repay general unsecured claims. It has
three elements (1) a definition of currently monthly income which is the total income a debtor is
presumed to available (2) a list of allowed deductions from the currently monthly income for the purpose
of supporting the debtor and his family and the repayment of higher priority debts (3) defined trigger
points at which the income remaining after allowed deductions would trigger the presumption of abuse.
-Debtors have to file a statement of their calculations under the means test as part of their schedule of
income and expenses.

Chapter 11: Reorganizations

o Relief for Businesses
-Chap 11 allows debtors to reorganize financial affairs rather than liquidated under supervision of
bankruptcy court. Available to all business enterprises, including individual proprietorships, partnerships
and corporations. (except banks, savings/loans, insurance, brokers)
-Chap11 debt is usually larger and predominately non-consumer debt. 2005 revision created sib class of
small business debtors with less than 2 mill in debts and an expedited decision making rule.
-Once petition for reorg. Is filed and relief is orders court appoints (1) committee of creditors holding
unsecured claims (2) a committee of equity security holders (3) trustee.
-The reorg. Plan is contract b/w debtor and creditors. It must (1) divide the creditors into classes (2) set
forth how each creditor will be satisfied (3) state which claims or classes of claims are impaired or
adversely affected by the plan (4) provide the same treatment to each creditor in a particular class, unless
creditors in class consent to diff. treatment.
-Bankrupt. Code provides an initial 180 day period after filing when only debtor can file a reorg. Plan and
180 day period within only debtor can solicit acceptance of the plan from creditors.
-2005 revision limits exclusive plan proposal period to 18 months and exclusive solicitation period to 20
months. Following initial periods, trustee and credits are free to propose plans.
- reorg. Plan must be confirmed by court either through voluntary agreement of creditors or through a
cram down before becomes effective. Cram Down is where the court forces dissenting creditors
whose claims would be impaired by a proposed plan to accept the plan when court can find that its fair
and equitable to the class of creditors whose claims are impaired.
-Until plan is confirmed, b. court has no auth to distribute any portion of bankruptcy assets to unsecured

Use of Chap. 11
-critics point out that many of chap 11 cases are permitted to drag on for years, thus depleting the assets
of the debtor through payments to trustees and lawyers involved in admin. And diminishing the assets
avail. to creditors.
-2005 revision: congress responded by estab. tighter time frames and limits on avail. of extension of time.
EX- limit on time that debtors have to develop reorg. plan and rules forcing debtors to make decision as to
whether assume or reject unexpired leases on nonresidential prop. like shopping centers.

Collective Bargaining Agreements

-CBAs pose special problems. In 1984, Congress acted to try to prevent the misuse of bankruptcy
proceedings for collective bargain purposes. Among other reqs, The debtor must submit proposal to
employees representative that details the necessary modifications to the collective bargaining
agreement and assures all creditors, the debtor and all affected parties are fairly treated. Before
bankruptcy court can authorize rejection of original CBA, it reviews proposal to find that (1) the
employees representative refused to accept it without good cause and (2) the balance of equities clearly
favors the rejections of the original CBA.

Chapter 12: Family Farmers and Fishermen

o Relief for Family Farmers and Fisherman

-In 1978: farmers were exempted from involuntary proceedings. EX- a small farmer who filed a voluntary
chap 11 or 13 petition could not have the proceeding converted into a chap. 7 liquidation over his
objections as long as he complied with act requirements in a timely fashion. Awarded additional
protection through the provision allowing states to opt out of the fed exemptions scheme and provide own
-1986: added chap. 12 targeted to the financial problems of the family farm due to appreciated farmland
prices. In 2005: Chap 12 made available to family fishermen.
-To qualify, a farmer or spouse must have less than 80 percent of total noncontingent liquidate debts
arising out of their farming operations. Aggregate debt must be less than 3237000 and at least 50 percent
of an individ. Or couples income during year preceding the filing of petition must have come from the
farming operation.
- A corporation can also qualify, provided that more than 50 percent of the stock or equity is held by one
family or its relatives, they conduct the farming operations and at least 80 percent of assets are related to
the farming operation.
-To qualify, a fisherman or spouse must have aggregate debts less than $1,500,000 and no less than 80
percent of aggregate nonconting. Liq. Debts arise out of commercial fishing operation.
- Debtors must file plan within 90 days of filing for chap. 12.
Chapter 13: Consumer Debt Adjustments
o Relief for Individuals
-Chap. 13 provides way for indiv. Who dont want to be declared bankrupt to be given an opp. to pay their
debts in installments from future income under protection of fed. Court. Debtors have this opp. free from
garnishments and attachment of prop by creditors.
-To be eligible, indiv. Must have regular income who owe individually liquidated, unsecured debts of less
than $307,675 and secured debts of less than $922,975.

-Initiated by voluntary NOT involuntary petitions for a chap. 13 filing stating he is insolvent or unable to
pay his debts as they mature and that he desires to effect a composition or an extension or both out of
future earnings.
-A composition of debts is an arrangement whereby the amount the person owes is reduced, whereas an
extension provides person with longer period of time to pay them.
***court calls meeting of creditors following filingproofs of claims received and allowed or
disallowed. debtor is examined and submits a plan of payment plan is submitted for acceptance to
secured creditors. If accepted and courts satisfied proposed in good faith, meets legal req, and in interest
of creditors= court approves plan! (Appoints trustee to carry out plan.)
-If debtors income above states median income for a family of the size of family, then plan must provide
for payments over 5 yrs unless all claims will be fully paid in shorter period. If income less than median
income of applicant state, plan may not provide for payments over 3 or more yrs unless court approves
otherwise (cant exceed 5 yrs).
-Plan details: must provide that all of debtors disposable income during applicable period will be applied
to make payments to unsecured creditors, provide for less than full payment of any priority claims ONLY
is plans provides that all of debtors projected disposable income for 5 yr period beginning when first
payment is due will be applied to plan.
-A critical question that trustee and other creditors focus on is whether plan appears to have been
proposed in good faith. Plan is not approved if trustee or creditor objects unless plan provides objecting
creditors with present value of what is owed.
-Payment deadlines: debtor must begin making payment within 30 days after plan filed. Interim
payments must continue to be made until plan is confirmed or denied. If denied, money less admin
expenses is returned to debtor by trustee. Once approved, plan may be substantially modified on petition
of debtor or creditors when there is a material change, for Example:
*Curtis owes three creditors when loose job unexpectedly- files chap 13 bankruptcy and spreads
payments over 5 yrs.


-court is req. to grant debtor discharge of all debts provided for by plan or specifically disallowed except for
Debts covered by a waiver of discharge executed by debtor and approved by court
Debts that are for taxes required to be collected or paid and for which the debtors is liable.
Certain debts that are not dischargeable under chap. 7, such as those that result from liabilities
for obtaining money by false pretenses or false representations.
Debts for restitution or a criminal fine included in a sentence on the debtors conviction of a
Restitution or damages awarded in a civil action against the debtor as a result of willful or
malicious injury by the debtor that caused personal injury or death of an individual.
Repeat Bankruptcies
-2005 Revision prohibits a court from granting a discharge of the debts provided for in the plan or
disallowed if the debtor received a discharge in a case filed under chap. 7, 11 or 12 of Bankruptcy Act in 4 yr
period preceding date of order of relief under chap. 13- or in case filed under chap 13 during 2 yr period
preceding date order of relief in current case.

Advantages of Chap. 13
-A debtor files under chap 13 to avoid stigma of bankruptcy or try to retain more of own property. So long
as payments are made as called for by the plan, debtor can get some protection from financial creditors.
Debtors creditors stand to benefit by possibly being able to recover a higher percentage of debt owed to
them than they would in straight proceedings.