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To determine the structure of a relationship look to:

i. duration/termination
ii. control
iii. risk of loss
iv. sharing of gain

- Agency: Agency is a consensual relationship where one person acts on behalf of another. Agent agrees to be
subject to principal’s control, usually in exchange for compensation. Principal maintains the right to control the
physical conduct of the servant (Rest. 2d Agency §§ 1-2). Agency is a fiduciary relationship.
o Example: go to the bar and buy me a drink. The principal will be responsible for the cost of the
- Principal: the person/entity for whom the agent acts.
- Agent: the person/entity who is acting for another.
- Third Party (usually in context of suing the principal for agent’s act).
- Respondeat Superior/Vicarious Liability: a “master” (employer) is liable for the torts of its servants
(employees) as long as the torts were within the servants’ scope of employment.
- These relationships are not limited to people, all types of business entities can be agents and principals.

Relevant sections of the Restatement (Second) of Agency:

§ 1—Agency; Principal; Agent
Agency is the fiduciary relation which results from the manifestation of consent by one person to another that
the other shall act on his behalf and subject to his control, and consent by the other so to act.
§ 2—Master; Servant; Independent Contractor
(1) A master is a principal
who employs an agent to perform service in his affairs and who controls or has the right to control the
physical conduct of the other in the performance of the service.
(2) A servant is an agent
employed by a master to perform service in his affairs whose physical conduct in the performance of the
service is controlled or is subject to the right to control by the master.
(3) An independent
contractor is a person who contracts with another to do something for him, but who is not controlled by the
other nor subject to the other’s right to control with respect to his physical conduct in the performance of
the undertaking. He may or may not be an agent.
§§ 219 and 220—When Master is Liable for Torts of His Servants; Definition of Servant.
§§ 228 and 229—General Statement and Kind of Conduct within Scope of Employment
§§ 230-31: An act, although forbidden, or done in a forbidden manner, may be within the scope of employment.
An act may be within the scope of employment although consciously criminal or tortuous.

CH. 1, SECTION 1: Who Is An Agent?

Gay Jenson Farms Co. v. Cargill, Inc.: Party A, by its control and influence over Party B, may become a principal
with liability for the transactions entered into by Party B.
- Principal will be bound by the Ks of agents if Ks are within the scope of the agency because agent is making K
for the benefit of the agent and the principal.

CH. 1, SECTION 2: Liability of Principal to Third Parties in Contract


Authority: the Agent’s power to effect the Principal’s liability, rights, and duties; concerned with the contract and
property rights

3 Types of Agency Relationships: Actual, apparent, and inherent

Actual Authority

Actual: authority that flows directly from principal to the agent. Principal manifests to an Agent that Agent had
power to deal with others as representative of Principal. Agent’s actions bind Principal. When an Agent acts within
the scope of his actual authority, his is not personally liable to 3d parties. (This can be contractually modified.)
a. Express. “You go and do X.” Telling an Agent what to do OR knowingly acquiescing to an
Agent’s actions.
b. Implied. “You can do what you need to do to accomplish X.” This flows from express authority.
It is the power to act in ways reasonably necessary to accomplish the purpose for which the express
authority was granted. Custom and relations between the parties is relevant.

Mill Street Church of Christ v. Hogan:

- Bill Hogan reasonably believed because of present or past conduct of the principal (Mill St. Church) that the
principal wished him to act in a certain way (hire an assistant) or to have certain authority.

Apparent Authority

Apparent: power to affect the legal relations of another person by transactions with third persons, professedly as
agent for the other, arising from and in accordance with the other’s manifestations to such third persons.
Principal manifests to a third party, directly or indirectly, that another person is authorized to act as his agent.
Rest. 2d (Agency) § 8: Depends on communications with the 3d party. There can be apparent authority by
something agent does or says. Example: Joe has the authority to buy my textbooks. X tells this to a 3d party.
Usually there is underlying actual authority.
- The Principal’s actions must cause 3d party to reasonably believe that the purported agent has the authority to
act for the principal; and 3d party must reasonably and in good faith rely on the authority held out by the
- The Agent may have apparent authority even though no such authority was ever actually granted to him.
- The Agent’s acts do not create apparent authority, only the principal can.
- Unlike actual authority, which flows from direct instructions to the agent, Apparent Authority flows from the
impression created or permitted by the Principal.
- 3 ways to establish apparent authority:
1. Prior talks: The Principal tells a 3d party that a person has the authority to act for them.
2. Prior acts: By allowing an Agent to carry on similar transactions in the past, a Principal impliedly
creates the impression in 3d parties that the Agent is authorized to do so in the future.
3. Position: Principal allows an Agent to occupy a position, which according to locality, trade, or
profession, carries a particular type of authority.
- A third party has a duty of reasonable diligence to verify that the person they are dealing with is an agent.
- Marital status does not automatically confer agency on one spouse from another. (Botticello v. Stefanovicz)
- Ratification: a grant of authority after the fact. This occurs when a Principal gains knowledge of an
unauthorized transaction, but then retains the benefit or otherwise takes a position of affirmation. This can be
expressed or implied (long-term acquiescence or acceptance of the benefits).
HYPO: Board of Jenny Craig tells president of company to negotiate with Monica Lewinski to make commercials.
Remember: Corporations are principals. Officers are agents of a corporation.
a. Authority: Actual Expressed & Implied
Express authority: to negotiate. Implied authority: go to Monica’s location to see her and company
will reimburse.
b. Agent: President
c. Principal: Board
d. Reasonable test: what is necessary to accomplish the express

Lind v. Schenley Industries, Inc.

Three-Seventy Leasing Corp. v. Ampex Corp.:

Inherent Agency Power

Inherent: last ditch effort to hold the Principal liable.

1. Rest. § 8A: When one holds out another as
an agent, that agent can bind the principal on matters normally incident to such agency, even if he was not
authorized for a particular type of transaction.
2. Rest. § 194: Acts of General Agents: a
general agent for an undisclosed principal authorized to conduct transactions subjects his principal to liability
for acts done on his account, if usual or necessary in such transactions, although forbidden by the principal to do
3. Rest. § 195: Acts of Manager Appearing to
be Owner: An undisclosed principal who entrusts an agent with the management of his business is subject to
liability to third persons with whom the agent enters into transactions usual in such businesses and on the
principal’s account, although contrary to the direction of the principal.
4. In the Rest. 3d, the ALI has abandoned
apparent authority; instead, they state that inherent authority is just a form of estoppel. § 2.06—Estoppel.
Under some circumstances, a principal should not be allowed to get out of liability. Usually, used when you
have an undisclosed principal. Inherent authority exists when an agent’s position gives him the power or
control to do certain things even though he does not have the actual authority or apparent authority to do so.
5. Policy: to protect individuals who have been
harmed by an agent.

Use Inherent Agency when:

1. General or managerial agents (authorized to conduct a series of transactions, President or General Manager)
2. Undisclosed principals (3d parties don’t know there’s a principal)
3. Weak apparent authority…agent is doing something that general agents in the same situation usually or
normally do, but is doing so without actual authority

- Undisclosed principal: if agent is doing acts within the normal scope (any deviate from those acts is minor).
The undisclosed principal will be held liable.
- Disclosed principal: a principal is disclosed if the third party knows, or can figure out, the identity of the
Principal at that time the transaction is entered into.

Rules on Un/Disclosed Principals

1. We don’t want “secret principals”
to be shielded from liability, the agent would be liable and principal not.
2. If you have an undisclosed
principal and agent acting within the scope of agency, both the agent and the principal will be liable.
Otherwise, we would never be able to get at undisclosed principals.
3. With a disclosed principal, only the
principal will be liable unless there is an express agreement holding the agent liable as well.
4. With a partially disclosed principal
(you know there is a principal, but you don’t know who they are—this is being changed to “unidentified
principal”) both the agent and the principal are liable. The policy is that you don’t know how solvent the
principal is and agents should make indemnification agreements.
5. The only time we will be tested
on inherent authority is when there is an undisclosed principal and we are dealing with general agents
(Rest. 2d § 3—general agent).

Agency by Estoppel:
Party may become principal by estoppel if:
(1) Party harmed must have changed position (given money, adversely affected)
(2) Reasonable… there must be a reasonable belief in authority.

CH. 1, SECTION 3: Liability of Principal to Third Parties in Tort

Servant vs. Independent Contractor

Master-servant relationship: where the servant has agreed to (1) work on behalf of the master and (2) to be subject
to the master’s control or right to control the “physical conduct” of the servant. Restatement (2d) of Agency §§ 1
and 2. All servants are agents. Almost all employee/employer relationships are master/servant relationships.

Independent contractor: see above definition, Rest. § 2.

- Agent-type independent contractor: one who has agreed to act on behalf of another, the principal, but not
subject to the principal’s control over how the result is accomplished (over the “physical conduct” of the task).
- Non-agent independent contractor: one who operates independently and simply enters into arm’s length
transactions with others.
- If you give an independent contractor the authority, then they can be your agent to go and do the specific act
you gave them the authority to do.

Humble Oil & Refining Co. v. Martin: Whether the relationship is independent contractor or agency is one of fact;
where evidence indicates a master-servant relationship, contrary items will not be conclusive.

Hoover v. Sun Oil Co.: Whether a party is an agent (instead of an independent contractor) is determined by
measuring the right to control the day-to-day operations of the business, not just considering the actual control
- There is no bright line rule—truly fact sensitive. Rest. 2d Agency § 220, the factors laid out as a test.


Franchise: an entity who provides something to an individual to enable them to provide something; brand identity
of loyalty. There is value in a brand name.
- A franchise sells its name and the right to use its system to the franchisee, or the local operator. It is hard to be
successful as a local operator. If the local operator is unsuccessful, the franchisor can terminate the relationship.

General Notes on Franchises

- The franchiser provides quality assurance, national advertising, intellectual property, know-how, process
knowledge, etc. The franchisee pays the franchiser a fee for the rights to use those. The franchisees have
history of being abused by the franchiser so there is substantial state legislation on franchises. There are certain
things the franchiser must tell the franchisees, including realistic odds of having a successful franchise if there’s
another one a mile away.
- Characteristic of franchises: uniformity of products—the hamburgers of McDonalds, pizzas at Pizza Hut, etc.
- The idea is “quality control”. In Cargill, what was the issue they looked at when they decided whether there
was agency? CONTROL.

Murphy v. Holiday Inn: A franchisee is not automatically an agent of franchisor; control over the day-to-day
operations is still the critical test for agency.
- If an agency relationship exists, parties cannot escape it by calling it something else, or by “disclaiming” it.
- “The critical test is the nature and extent of the control agreed upon.”
- Architectural style and guidelines as to furnishings and equipment are not sufficient to establish agency where
there is no power to control the details of how the work gets done.

Tort Liability and Apparent Agency

Billops v. Magness Construction Co.: Where a franchise agreement gives control (or right to control) daily
operations of franchise, agency exists. (“If, in practical effect, the franchise agreement goes beyond the stage of
setting standards, and allocates to the franchiser the right to exercise control over the daily operations of the

- Where no reasonable basis exists in the operation or environment of the franchise to indicate that someone other
than the franchisee owns it, apparent agency exists.

Manning v. Grimsley: Where an employee commits assault in response to π’s conduct which was interfering with
employee’s ability to perform his duties, the employer may be held liable for that assault.
- Servant’s acts may be within the scope of employment even if they are criminal or tortious, but serious crimes
are not within the scope. Rest. 2d Agency § 231.
- A servant’s use of force against another is within the scope of employment if that use of force could be expected
by the master. Rest. § 228(2).

Statutory Claims

Arguello v. Conoco, Inc.:

- To hold employer liable for racial discrimination of an employee, must show agency relationship. In Arguello,
the Agreement signed by the stores specifically stated that there was no agency and no control. Guidelines and
specifications for architecture and equipment are not sufficient to establish “control” for agency.
- Scope of employment.
(1) time, place & purpose of act
(2) similarity of the act to those which servant is authorized to perform
(3) whether the act is commonly performed by servants
(4) extent of departure from normal methods
(5) whether the master would reasonably expect such act would be performed
- Even where company could not have expected employee to act a certain way (e.g., shouting racial slurs), if it
occurred while the employee was performing her normal duties while on the clock at her job, then the company
may still be held liable. Similarly, even where the master would not expect the behavior, if the other factors are
present, the company may still be liable.
- The duty not to discriminate is not “non-delegable,” so π alleging it must establish a close relationship between
employer and third-party engaging in the discrimination.
- In order for an employer to have ratified the actions of an employee, the employer must (1) know of the act and
(2) adopt, confirm, or fail to repudiate the acts of the employee. Lack of firing or suspending the employee
does not constitute ratification where the company verbally corrected the employee.
- Conoco-branded: tort issue. There is no per se rule either way. Tests:
i. was the employee serving the employer? Then the employer could be liable;
ii. policy (not as popular);
iii. characteristic risk with intent to serve;
iv. enterprise liability.

See Restatement (Second) of Agency § 219: When Master is Liable for Torts of His Servants.

Liability for Torts of Independent Contractors

Majestic Realty Associates, Inc. v. Toti: Contractees may be liable if they hire an incompetent contractor because
they had the control over selecting the party to hire. Court in Majestic suggests that hiring a financially
irresponsible contractor may be enough to expose a contractee to liability.
- Contractee may also be liable where contractor hired negligently fails to take precautions when engaging in an
inherently dangerous activity.

CH. 1, SECTION 4: Fiduciary Obligations of Agents

Agent’s Duties to Principal:

(1) Duty of Loyalty: Every action taken as an agent should be made to further or advance the interests of
the principal.
a. Duty to account to principal
i. E.g., if you’re making money on behalf of principal, P can request an accounting of
expenditures and incomes
b. Cannot take money for himself, i.e., no kickbacks, no bribes
c. Cannot make a “secret profit” by transacting things that could benefit the principal
(2) Duty of Reasonable Care
a. In theory, if you cause your employer liability because you weren’t exercising reasonable care,
your employer can sue you. But that doesn’t happen very often in reality.
(3) Duty of Obedience/Good Conduct
a. You’re expected to follow the orders/instructions of the principal
(4) Indemnify the Principal

Principal’s Duties to Agent:
(1) Compensation
a. …if compensation is reasonably expected. Usually in express terms (e.g., a contract)
(2) Reimburse/Indemnify
a. Equitable remedy of “exoneration”
b. If I do something as an agent in good faith on behalf of the Principal, I deserve to be reimbursed.
(3) Good Faith/Due Care
a. Cooperate with the agent. You can’t ask an agent to do something and then put obstacles in his
path to accomplishing it.
b. E.g., providing a safe working environment. If P has employees that may be unsafe for his other
employees, then P has to address the problem as part of this duty.

Duties During Agency

General Automotive Mfg. Co. v. Singer: An agent’s fiduciary duty of loyalty binds him from acting adversely to the
interests of the Principal by serving his own private interests; serving his own interests would be acting contrary to
the good faith and loyalty owed to Principal. Agent should also act for the furtherance and advancement of the
- In Singer, the general manager of the employer’s store unilaterally determined when certain work orders were
too much for the store to handle (because of manpower or lack of equipment) and would then privately farm the
work out to different locations, keeping any profit for himself (acting as a broker).
- “The title of an activity does not determine the question whether it was competitive but an examination of the
nature of the business must be made.” (p. 87)
- Every action taken as an agent should be made to further or advance the interests of the principal.

Duties During and After Termination of Agency:

Herein of “Grabbing and Leaving”

Town & Country House & Home Svc., Inc. v. Newbery: An employee may not solicit for his private interests his
employer’s (or former employer’s) customers “whose trade and patronage have been secured by years of business
effort and advertising, and the expenditure of time and money, constituting a part of the good will of business which
enterprise and foresight have built up.”
- In Newbery, the only trade secret Δs took was the customer list (household chores are not trade secrets).
- Even though Δs did not solicit the customers until they were no longer employees, they solicited only their
former employer’s customers. “[T]hese customers had been screened by respondent at considerable effort and
expense, without which their receptivity and willingness to do business with this kind of service organization
could not be known.” (p. 91)

Determining Protectable Trade Secrets:

1) Information (e.g., showing how to wash windows is not; showing a secret formula for doing so is)
2) Independent economic value
3) Not generally known or readily ascertainable by proper means by the other people who can obtain
economic value from it
4) Reasonable efforts have been made to maintain the secrecy or confidentiality of the information


CH. 2, SECTION 1: What is a Partnership? and Who are the Partners?

Characteristics of Partnerships:
1) Must have one person in a partnership
2) “Persons” is broadly defined: encompasses entities, not just humans (could have two corporations
forming a partnership)
3) Must be a business for profit
4) Usually written agreement, not the “written” not required

Partners Compared with Employees

Fenwick v. Unemployment Compensation Commission: Partnership involves a notion of co-ownership. It is more

than merely sharing profits, especially when the profits are given as compensation/wages.
- The language of an agreement or contract is considered, but is not conclusive.
- Elements of partnership:
(1) Intention of partners
(2) Right to share in profits
(3) Obligation to share in losses
(4) Ownership and control of property and business
(5) Community of power in administration
(6) Language of the agreement
(7) Conduct of parties toward 3d parties
(8) Rights of parties on dissolution
- Burden of proving the elements is on the party who alleges the partnership existed.
- Essentially, the element of co-ownership is lacking in this case. Sharing of profits, as here, is prima facie
evidence of partnership, but not so if the profits were received in payment of wages.

Partners Compared with Lenders

Important difference between lenders and partners: Lenders are not responsible for the debts of the partnership;
partners are potentially liable for the partnership’s debts.

Martin v. Peyton: The absence of a formal partnership agreement is not conclusive evidence that no partnership
existed; when taken together, separate stipulations and agreements may “cover so wide a field” as to establish a
partnership. However, where the many stipulations and agreements do not go beyond protecting an investment or a
loan, then no partnership is found to exist.
- There must be some element that goes beyond caution with respect to a loan, so that there is a sense of co-
ownership of the business. Protecting a loan is not necessarily management or ownership of the business.
o There was no intent to act as partners.
o The investors did not have active day-to-day control
o Requiring that employees make reports to the investors is insufficient
o Investors could not bind the partnership by any action of their own or initiate any transaction

Southex Exhibitions, Inc. v. Rhode Island Builders Assoc., Inc.: The UPA identifies profit sharing as particularly
decisive in determining whether partnership exists, and some courts have declared that the absence of profit sharing
defeats a claim that a partnership existed. However… the presence of profit-sharing alone does itself evidence the
presence of a partnership.
- Even where profit-sharing exists, “the record evidence indicating a nonpartner relationship cannot be dismissed
as insubstantial.” (p. 104, bottom of page)
- “Since a partnership can be created absent any written formalities whatsoever, its existence vel non normally
must be assessed under a “totality-of-the-circumstances” test.” (p. 105)

Partnership by Estoppel

Partnership by Estoppel: A person who represents himself or permits another to represent him, to anyone as a
partner in an existing partnership or with others not actual partners, is liable to any such person to whom such a
representation is made who has, on the faith of the representation, given credit to the actual or apparent partnership.
UPA § 16(1)

Elements of Partnership by Estoppel:

(1) Representation
(2) Third-party reliance (in good faith) on the representation
(3) Third-party extends credit based on the representation
Note the imbedded notion of detrimental reliance: If a party represents himself as a partner in a partnership, and a
third-party in good faith relies on that representation to his detriment, then the party will be estopped from arguing
that no partnership exists.

Young v. Jones: Liability to third-persons arising from the “Partnership by Estoppel” theory arises only when credit
is given by the third party in reliance on that represented partnership. In Young, π invested in a bank based on a
letter he received from Price Waterhouse Bahamas, where the letter did not specify that it was from “Price
Waterhouse Bahamas” and instead said “Price Waterhouse.”

CH. 2, SECTION 2: The Fiduciary Obligations of Partners

Basic Fiduciary Duties of Partner:

(1) Must account for any profit acquired in a manner injurious to the interests of the partnership
(2) Must not, without the consent of the other parents, acquire for himself a partnership asset; nor may he
divert to her own use a partnership opportunity
(3) Must not compete with partnership within the scope of the business

Fiduciary Obligations of Partner:

(1) Duty of loyalty
(2) Duty to inform
(3) Duty to account for certain benefits received on behalf of the partnership (UPA § 21)

Meinhard v. Salmon: Where a partnership existed, each partner owed a duty of loyalty to the other. In Meinhard,
Salmon signed a new lease—by himself—for a big project that involved the property he leased as a partner with
Meinhard. He did not tell Meinhard of the project or his involvement with it.
- Meinhard provided the money and Salmon provided the labor.
- There was no formal partnership agreement, but the court found the existence of a partnership in the 20-year
lease M & S signed together.
- “Joint adventurers, like copartners, owe to one another, while the enterprise continues, the duty of the finest
loyalty…Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior.”
(p. 112)
- Dissent: The nature of the relationship contemplated by M & S was finite and S had no reason to think his
duties to M extended beyond those boundaries.

Default Rule as to Duration:

- Partnership is at will if no duration is specified. (This means that, as a partner, you are able to terminate the
partnership at any time.)
- If you have a fixed term partnership and then after that term the partnership continues without further specified
term, the partnership converts automatically to an at-will partnership.

After Dissolution

Bane v. Ferguson: A partner owes a fiduciary duty to his partners, but does not owe the same duty to former
partners. In Bane, retired partners received pension based on their income until the firm dissolved. The partners
merged with another firm and then the firm dissolved.
- Theory I: Violations of UPA § 9(3)(c), which prohibits acts by partners that would make it impossible for the
partnership to continue. Court held this inapplicable, because UPA protects current partners, not former
- Theory II: Violations of fiduciary duties. Again, because Bane was no longer a partner, no fiduciary duties
were owed. Even if the Δs were fiduciaries for π for the pension plan, they are then liable only for
mismanaging the plan, not for mismanaging the firm.
- Bane had a contractual relationship with the firm post-retirement, not a partnership relationship.

Grabbing and Leaving

Meehan v. Shaughnessy: Fiduciaries may plan to compete with the entity to which they owe allegiance, provided
that in the course of such planning they do not otherwise act in violation of their fiduciary duties. In Meehan,
former partners (and an associate) planned to leave a law firm and took their own clients, but delayed in alerting the
firm as to which clients they were taking.
- As with agency, you can prepare to compete, but you may not actually take steps to compete while you’re still
affiliated with the partnership or agency.
- A partner has an obligation to render on demand true and full information of all things affective the partnership
to any partner. UPA § 20.
- The court held that Meehan & Boyle breached their fiduciary duties by:
(1) lying to the partners about their intent to leave
(2) late submission of their list of clients to take with them
(3) letter sent to clients was “one-sided” (that is, it did not make it clear to the client that they had the
choice of remaining with the current firm)

Lawlis v. Kightlinger & Gray: The fiduciary duty of loyalty applies only while the partnership exists. In Lawlis, a
partner was expelled from a law firm due to his repeated bouts with alcoholism. The court held that no duty of
loyalty was owed to Lawlis once the partnership relationship was dissolved.

If expulsion is permitted by the partnership agreement, then expulsion is proper so long as there is no bad faith.

To Terminate a Partner:
(1) Look to the partnership agreement (would expulsion of the party terminate the partnership?)
(2) Look to the reason
a. Business reason is okay
b. Whistle-blower exception: recognized by some states
c. Good faith

Six ways to breach your fiduciary duty to a partnership:

(1) Use the partnership assets for your own benefit
(2) Carry on the business for your own advantage
(3) Carry on another business in competition with the partnership
(4) Secure for yourself what you have a duty to obtain for the partnership
(5) Avail yourself of information or knowledge that is the firm’s property
(6) Disclose the pay and billing rate information of associates to a new employer seeking to hire them

CH. 2, SECTION 3: Partnership Property

Property Rights
(1) Specific partnership property
a. Can be used on behalf of the partnership; cannot be used for personal purposes
b. The only time partners get partnership property is in dissolution, and even then
they only receive their own percentage value according to their interest in the partnership.
c. Partners may have the right to possess certain property for the partnership if
such is specified in the partnership agreement.
(2) Interest in partnership
a. economic interest; right to receive profits
b. profits follow interest; default rule is that they are split equally
c. can transfer economic interest without the consent of the partnership (see (3)(a)).
(3) Right to participate in management
a. Cannot transfer management interest without consent of the partnership

Putnam v. Shoaf: Partnership property is property of the partnership. What property is put into the partnership
becomes property of the partnership and no individual interest exists as to that property. In Putnam, Mrs. Putnam
sold her economic interest in Frog Jump Gin to Shoafs. It was later discovered that the old bookkeeper had
embezzled money from FJG, and FJG received $68,000 in settlement. Mrs. Putnam claimed she was entitled to a
portion of that settlement, and the bank held that she was not.
- The Shoafs took on the risk of loss and the possibility of gain when they acquired Putnam’s economic interest,
so the good fortune attached to her interest was theirs as well.
- Two interests exist in a partnership: management and economic. You cannot transfer your management interest
without consent of the partnership, but you may transfer your economic interest.

CH. 2, SECTION 5: The Rights of Partners in Management

Individual Partnership Interests (UPA § 26):

- Partners share of profits and surplus
- A part of partners’ personal property

- UPA § 18(e): In the absence of an agreement to the contrary, “all partners have equal rights in the management
and conduct of the partnership business.”
- UPA § 18(h): “Any difference arising as to ordinary matters connected with the partnership business may be
decided by a clear majority of the partners.”
- The default rule is “one partner, one vote” but that can be modified by agreement.

HYPO: Partners X, Y and Z. Partner X has a 60% interest, Y has 20%, and Z has 20%.
- Per the UPA default rule, each has a 1/3 interest to manage, unless there is an agreement to the contrary.

Nabisco v. Stroud: Every partner is an agent of the partnership. (UPA § 9; RUPA § 301) The acts of a partner, if
performed on behalf of the partnership and within the scope of its business, are binding upon all co-partners. In
Nabisco, Stroud told Nabisco he wouldn’t be liable for any more bread purchased for the partnership, but such a
decision required a majority vote and there were only two partners—thus, when they disagree, the “status quo” wins.
- This can be modified, but it is only effective as to third parties who are notified of the modification.
- To limit the partners from making binding decision:
(4) Limit the authority internally
(5) Notify third parties of the restriction (who does and doesn’t have authority to deal with the third
- Partnership charged with the knowledge of or notice to a partner. UPA § 12/RUPA § 102(f)
- Partnership is bound by an admission of a partner. UPA § 11.
- Joint and several liability for partners. UPA § 15/RUPA § 306.

Summers v. Dooley: All business differences must be decided by a majority of the partners unless an agreement
between the partners addresses those differences. Where no majority decision is reached (such as when there are
only two partners) the status quo holds.
- When S hired another employee over D’s objections, D voiced objection and refused to allow S to pay the
employee out of the partnership funds. Thus, S could not recoup half of the cost of the employee’s salary from
D because hiring him was not a partnership decision made by a majority of the partners.

Moren ex rel. Moren v. JAX Restaurant: An act of a partner binds the partnership (and thus does not require
indemnity by the partner to the partnership) if the act is (1) carrying on the ordinary course of business of the
partnership or (2) was authorized by the other partners. In Moren, one sister partner called the other sister partner
into work when an employee called in sick, and the second sister brought her son to work with her, where he was
- Nicole Moren’s conduct was in the ordinary course of business of the partnership, so indemnity by the partner
to the partnership is not appropriate.
- Even though she was simultaneously acting in her role as mother, her conduct was still in the ordinary course of
partnership business.

Day v. Sidley & Austin: The courts are not going to protect partners who sign agreements giving up their power.
The partners can sign away their management authority and are free to make any agreement that suits them, without
concern about the “niceties” of partnership theory. Day also illustrates the principle of contract law applicable to
partnership agreements: “You made your bed, now lie in it.”
- The merger of Day’s law firm with another firm diminished Day’s absolute managerial power. The court
looked to the partnership agreement and did not see any contracted right for Day’s absolute managerial power.
Day had agreed to giving the executive committee control of the management decisions.

CH. 2, SECTION 6: Partnership Dissolution

Partnership Dissolution Review

a. Partnership can be for a term or at-will.
1. Default rule is at-will;
2. Term can be implied;
3. Always have the “power,” but having the “right”
is a different thing because they can sue for breach of contract.
b. Partners have a right to control and manage the company.
1. At minimum: the right to vote.
2. Always can be altered by agreement.
3. Negative ramification of freezing out.
c. Winding Up Period (period between the actual dissolution and when the actual business
activities end).
1. Circumstances could have partners “wind up” (e.g., a partner dies).
2. If the first one is not feasible, then courts can wind-up through a sale and a receiver (auction, broker).
Courts have a lot of discretion.
3. Remaining interested partners can bid and buy partnership assets, absent bad faith. Partners generally owe
each other a fiduciary duty (Prentiss).
4. If a partner doesn’t pay a fair price, then the court may find he breached his fiduciary duty (i.e., he must
show he paid more than a third party was going to pay).
d. What Should a Departing Partner Do?
1. Give notice to creditors and clients that you are no longer a partner of the partnership.
A. Good to get a document from the
creditor saying they will no longer hold you liable.
B. Also, get an indemnification agreement
from the other partners (always include attorneys’ fees).
2. If it’s a limited partnership, file the proper paperwork.

e. RUPA: allows dissolution by buying out the departing partner’s interest OR dissolving /
winding up.
UPA: only allows dissolution / winding up.

Process of Dissolving:
a. Dissolution (UPA § 31): partners cease to carry on
business as partnership.
Dissolve Without Violating the Agreement:
(1) Termination of term;
(2) Express will of one;
(3) Express will of all;
(4) Expulsion of any partner
Dissolve by Violating the Agreement:
(1) Violate the agreement;
(2) It becomes unlawful for the partnership to
(3) Death of a partner;
(4) Bankruptcy of partner or partnership;
(5) Decree of court.
b. Winding-up: process of settling partnerships affairs.
c. Termination: winding up done, dissolution complete.

The Right to Dissolve

Owen v. Cohen: A court may order the dissolution of a partnership where there are disagreements of such a nature
and extent that all confidence and cooperation between the parties has been destroyed or where one of the parties by
his misbehavior materially hinders a proper conduct of the partnership business. UPA § 32.
- Courts have a lot of discretion in deciding whether to dissolve a partnership under UPA § 32(1)(f): “other
circumstances that render a dissolution equitable.”
- Dissolution is the worst economic option that you have. It is much better to buy out one of the partners and
keep the business running.
- “Estoppel”: A partner cannot behave so as to render necessary the dissolution of a partnership, and then insist
upon its continuance.

Collin v. Lewis: A partner who has not fully performed the obligations required by the partnership agreement may
not obtain an order dissolving the partnership.
- Collins provided the money and Lewis managed it. They had no written partnership agreement (but an implied
term of 30 years, the term of their lease). The court did not order dissolution.
- If the court dissolves the partnership, there is no liability for a K breach. If one of the parties exercises their
right to dissolve, the partner who dissolves is liable for breach of K.
- As the attorney for Collins: Put a cap on the funds, secure the loan, and put a right to dissolve if the business
was not profitable in the agreement.
- As the attorney for Lewis: Management rights, “sweat equity”—protect his time, make sure the cap cannot
include things that aren’t Lewis’ fault.

Page v. Page: There is a right of a partner in an at-will partnership to dissolve the partnership (no implied term of
the partnership). However, the dissolving partner must act in good faith.
- Partners have a fiduciary duty not to dissolve in bad faith just to get the business for himself.
- A partnership existing because of the expectation to meet current expenses and recoup investment does not
create a term partnership.

The Consequences of Dissolution

Prentiss v. Sheffel:
- Partners can purchase assets of the partnership at a judicial sale if they are acting fairly.

o Benefits:
 Keeps the business running
 More effective partnership because everyone is happy
 Δ gets more money (increases the bidding, even if the other partners aren’t the highest
o Watch for a bad faith of a “squeeze out” or a “freeze out.”
o If a majority deprives a partner of management rights, that may dissolve the partnership.
- Partners have a right to manage and participate in the process. Two of the three partners can make all of the
decisions (because they represent a majority of the partnership), but the must involve the other partner in the
meetings where he is outvoted. They can outvote him every time, but they must include him in the vote.

Monin v. Monin: There is a high degree of good faith of trust and confidence in a partnership. Partners’ fiduciary
duties extend beyond the partnership to persons who have dissolved the partnership but have not completely wound
up and settled the partnership affairs.
- In Monin, two brothers had a milk hauling business and dissolved it. They held a private auction between
themselves and had a covenant not to compete with the auction winner. Charles was the high bidder, but DI
(the milk company) refused to work with him, and instead contracted with Sonny.
- The court found a breach of S’s duty to C which continued beyond the partnership, when he did not withdraw
his application to contract with DI even after C won the private auction.
- Huss agrees with the dissent that the sale of the partnership was contingent upon the DI contract.

Sharing of Losses

Kovacik v. Reed: The general rule is that all partners share equally in the losses and the profits unless an agreement
states otherwise. RUPA § 401(b). The exception to this rule: When one partner offers labor/skill and one partner
gives money, upon loss of the money, the partner who contributed it is not entitled to recover any part of it from the
party who contributed only services.
- To get around this exception, make all partners contribute money (even if it’s not much); that gives them an
incentive to work hard (to earn profits on their contribution) and it escapes the exception.
- Partnership losses are allocated the same way as profits (unless an agreement speaks to the contrary). The
default rule is that they are equal.
- Partnership is bound by partners’ wrong acts. UPA § 13.
- Partnership is bound by a partner’s breach of trust. UPA § 14.
- Partners have unlimited personal liability. They are jointly and severally liable for all partnership losses.

Buyout Agreements

A buyout agreement (or buy-sell agreement) is an agreement that allows a partner to end his relationship with the
other partners and receive a cash payment, or series of payments, or some assets of the firm, in return for his interest
in the firm.

Issues to Consider in a Buyout Agreement: (see p. 180-181)

(A) Trigger events
i. death
ii. disability
iii. will of any partner
(B) Obligation to buy versus option
i. firm
ii. other investors
iii. consequences of refusal to buy: is there an obligation?
(C) Price
i. book value
ii. appraisal
iii. formula (e.g., five times earnings)

iv. set price each year
v. relation to duration (e.g., lower price in first five years)
(D) Method of Payment
i. Cash
ii. Installments (with interest?)
(E) Protection Against Debts of Partnership
(F) Procedure for Offering Either to Buy or Sell
i. First mover sets price to buy/sell
ii. First mover forces others to set price

Why do we have buyout and breakout agreements?

- Protect the entity, when a partner leaves, without interruption
- Protect the individual if they need to get out of the company with fair value assigned to their interest
- Control over the partner leaving for the remaining partners
- S-Corp: restrictions on who can be shareholders, so the buyout will make sure that your status as an S-Corp
isn’t destroyed.

Events that can trigger a buyout:

You can always set different trigger events in the agreement/contract.
- Interest holder (partner, member of a company, or shareholder employee of a company) is terminated: you don’t
want to give them the benefit of the company if they are no longer working for the company.
- Resignation: going away to compete, or going away but not competing (each of these will have different
- Disability: insurances, social security (could get very complicated)
- If someone holding an interest pledges their interest: giving your economic interest away.

- Option: that company may take
- Obligation: that company must take
- Who has the right to buy out? Company or other members/partners

Three Restrictions on the Ability to Transfer Your Interest:

(1) Right of First Refusal. An interest holder is unhappy and finds a willing buyer. The potential seller
must tell the remaining interest holders; they have the right to buy at the same price offered by the
potential buyer, and the departing interest holder must sell to them instead. This makes it more
difficult to sell your shares because the outside party has to invest the time and money to value the
company and may not end up getting to buy your interest anyway. This protects the people in the
(2) Right of First Offer. Before you go out to the world and try to sell your interest, you must first go to
the remaining interest holders and get a price. Then you can go out and try to find a better price (90
days). So the remaining interest holders have to give a better price than the market will pay. There is
no counter-offer for the remaining interest holders.
(3) Russian Roulette / Shotgun Provision: Usually works where there is equality between partners
(including economic equality). E.g., A & B own 50% each; A says to B, “I want out for $100.” B has
the option to purchase at that price or sell his own interest to A for $100. Setting the price is very

Valuation Options:
- Market Value. Difficult for a small company, but good for business with stock trading.
- Yearly Valuation. “Every March 15 an accounting firm will do a valuation.” Advantage is that you always
have an accurate valuation. Disadvantage is that it is not practical in reality.
- Appraiser: This is the best choice. Vague: what application—formula?
- Formula: Cash flow, market multiplier
- Book Value: The value of the company on the books. Generally a low value. We only see it when someone
argues that it isn’t fair. The non-tangible assets make a company more valuable.

G & S Investments v. Belman: Nordale was using cocaine and making bad business decisions. The issue came up
because the money going to his estate would be much higher if it was a dissolution rather than if it was a buyout.
The company used a formula in its buyout provision. The court found the provision clear and applied it.

Law Partnership Dissolutions

Jewel v. Boxer: Absent a contrary agreement, any income generated through the winding up of unfinished business
is allocated to the former partners according to their respective interests in the partnership.
- The benefit is that you know you will be compensated for post-dissolution time so you will work hard.
- The disadvantage is that it is complicated, and there will be competition within the partnership for the lucrative

Meehan v. Shaughnessy: The partnership agreement may provide different rights than the default UPA provisions.

CH. 2, SECTION 7: Limited Partnerships

- Limited partnerships are a creature of statute.

- You must file a certificate of limited partnership, and the partnership starts the moment that is filed.
- If you start working before the certificate is filed, you are just a general partnership.
- LPs must have at least one (but may have more than one) general partner plus one or more limited partners.
o The GPs are personally (fully and severally) liable for the debts of the firm, have the power to act
on behalf of the firm, and the power to control the firm.
o The LPs are “passive investors”; they do not participate in control, do not have the power to act
for the firm, and are not personally liable for the firm’s debts (they are liable only for the amount they put
into the partnership).
- LLPs consist of general partners, and all members are shielded from liability.
- Profits are distributed by agreement (or proportion of shares under the ULPA which is the default). LPs are not
limited to being people; they can be organizations too.

Holzman v. De Escamilla: Limited partners may become liable as general partners if, in addition to exercising their
rights and powers as LPs, they also take part in the control of the business.
- In Holzman, the LPs dictated what crops to plant, wrote checks, and forced the resignation and replacement of
the GP. Thus, they exercised control and lost their limited liability of protection and became GPs.
- The RULPA states things that LPs can do without losing their “limited” status. Always have the right to vote
out the GP. Before the safe harbor rules, there was always a question of what could be done without losing the
LP status. RULPA § 303(b) = safe harbor rules.


When you want to have a company or limited liability organization:

(1) Pick and name the company and make sure the name is available
(2) File Articles of Incorporation/Organization
(3) Draft By-Laws and Shareholder Agreements
(4) File to keep limited liability partnership status every year
(5) LLLP (very new); similar to LLP; generally partner protection

CH. 3, SECTION 1: Promoters and the Corporate Entity

Promoter is a term of art referring to a person who identifies a business opportunity and puts together a deal,
forming a corporation as the vehicle for investment for other people. Brings the people together and gets capital.
- Acting as an agent for a not-yet-formed corporation

- It is common for the corporations to enter into Ks before they are incorporated and this is done through the
- The promoter owes a fiduciary duty to others in the venture to be honest, not keep secret profits, and use the
money only for the corporation
- Absent an agreement to the contrary with the third party, the promoter will be personally liable for K signed for
the not-yet-formed corporation. The analogy is to an undisclosed principal: the principal (the corporation)
doesn’t really exist yet so it can’t really be a disclosed principal. The corporation will not be liable for the K
unless it ratifies it, and even then the promoter remains liable unless some agreement states otherwise. The
promoter can be sued by subsequent investors, co-promoters, and the corporation itself.

- Incorporator: the person who actually signs and files forms for incorporation
- Race to the Bottom: states are trying to have the lowest or most favorable regulations for businesses. States vie
for the best laws.
- Where to Incorporate:
(a) Money involved. Cost for being a foreign corporation (not being in the state of
(b) Look at the substantive advantages and disadvantages of the laws. Usually you
incorporate in the state you do business, or in Delaware.
- Every corporation has perpetual incorporation unless specified otherwise in the Articles of Incorporation. The
powers of the corporation: equal rights of a person (can be a partner in a partnership and can be an agent).
MBCA § 3.01.
o Frigidaire v. Union Properties: General partner of a limited partnership is a corporation. As a
result, the individual shareholders are not liable.
o Limited partners do not incur general liability for the limited partnership simply because they are
officers, directors, or shareholders of the corporate general partner. The shareholders will not lose their
status as limited partners if they exercise control in the parent corporation.

Southern Gulf Marine Co. v. Camcraft, Inc.: Δ tried to argue that K entered into by a non-incorporated company
was void.
- De facto corporation: A court might treat a firm that is not properly incorporated like a corporation if:
(1) People must try on good faith
basis to incorporate
(2) People had a legal right to
(3) People are acting like they are
a corporation; a good faith exercise of corporate power
- De jure corporation: A corporation under the law; actually is a corporation
- Corporation by Estoppel: Courts will treat a firm that is not properly incorporated as a corporation IF the
person dealing with the firm thought:
(1) It was a corporation AND
(2) If the court decides it is not a corporation, the entity will get a windfall.
(3) Corporation by Estoppel is only available for K, not torts, because there is a knowledge requirement. It is
also used against third-party by the corporation.
- The above doctrines protect those in the process of incorporation, who thought they were incorporated, or who
are incorporated somewhere else (unlike partnership by estoppel which protects the outsider third party).

CH. 3, SECTION 2: The Corporate Entity and Limited Liability

- Main Idea of Limited Liability: The corporation is liable for its debts, but the shareholders are not personally
liable for those debts. Their only risk is losing their investment in the corporation.

Piercing the Corporate Veil: Creditors cannot go after individual shareholders unless they are able to pierce the
corporate veil. The courts may disregard the corporate form when necessary to prevent fraud or to achieve equity,
and to hold the owners of the entity liable.
(1) Must be some claim or judgment against the corporation.
(2) Once that is established, there are two paths:
a. Fraud/Injustice. Must be some fraud or situation where the failure to pierce would promote
injustice. Courts use general equitable powers to create this remedy.
b. Unity of Interest
i. Lack of Corporate Formalities. Bank accounts, books, phone, annual meetings, separate
directors and managers. Corporations should act as their “own person” under the concept of
1. This factor is easy to get around, because all you have to do is file the proper
paperwork (this is where small businesses can run into trouble).
ii. Undercapitalization. Minimum amount of assets/money in each company to protect any party
injured. The court doesn’t do an economic analysis.
iii. Instrumentality/Alter Ego: Using funds for your personal use. It’s okay for a director to get a
salary, but you can’t utilize the corporation for your own personal gain, i.e., co-mingling. In
other words, you shouldn’t co-mingle the funds: use the corporate bank account as your
personal bank account or allow the corporation to own the CEO’s house or pay the CEO’s
personal bills.
c. Trends in Piercing the Corporate Veil:
i. In closely held corporations (few shareholders), piercing occurs more frequently. No public
company has ever been pierced to the shareholder level.
ii. Parent subsidiaries: one corporation can own shares in another corporation (Bristol-Myers).
Might start looking like alter ego; could use apparent agency.
iii. Tort vs. Contract Claims: should be easier to pierce with a tort claim. A contract claimant had
the opportunity to choose, research the debtor, etc., whereas the tort claimant did not have that
option to choose. However, in practice, there is really no difference.

Walkovszky v. Carlton: A corporation will be liable for its own debt, but shareholders’ liability is limited to the
amount of their contribution/investment. In Walkovszky, Carlton owned 10 cab companies, each with only two
cabs, allowing him to insure each cab minimally. (If he had one big company, he would have had to insure the cabs
- Enterprise liability (cross-piercing); veil between corporations would be pierced. This is not common because
the sister corporation probably won’t have any money either. But this provides another way to pierce: Since all
of the sister corporations aren’t connected, then you have to go up to the parent corporation and pierce up, down
and over.
- We allow incorporation to avoid personal liability and encourage business. To protect π, the legislature could
increase the insurance minimums, have mandatory medical insurance, or require capitalization.
- Agency theory: The smaller cab companies were acting on behalf of the principal (Carlton) and Carlton could
be liable to the third parties for the cab companies’ actions.

Sea-Land Services, Inc. v. Pepper Source: In Sea-Land, Marchise was the only shareholder for many corporations
(except for one, in which he was half shareholder). He ran all companies from the same office, co-mingled their
accounts, and used their funds for his own personal use. The court found that Sea-Land could not pierce because
they failed to establish that some wrong beyond a creditor’s inability to collect would result.
- Two part test established by Van Dorn:
(1) Unity of interest and ownership such that the separate personalities of the corporation and the individual (or
the other corporation) essentially no longer exists; AND
(2) Circumstances must be such that adherence to the fiction of separate corporate existence would sanction a
fraud or promote injustice.
- Reverse piercing: Target the sister corporation or subsidiaries. Reverse pierce and have the subsidiaries cover
the parent corporation’s debt.

In re Silicone Gel Breast Implants: When a corporation owns all the shares of common stock of another
corporation, the first corporation is referred to as the “parent” corporation and the second as the “subsidiary.”
Generally, the parent, like any other shareholder, is not liable for the debts of the subsidiary. Usually, big
corporations are smart enough to have some separation sufficient to avoid being pierced.
- Bristol Myers (BM) is the parent of MEC. BM may be liable because:
(1) BM had substantial control of MEC
(2) Money transferred into an account established by BM
(3) 2/3 of MEC’s shareholders were from BM
(4) MEC did not give any money to BM as it should have if BM was a shareholder
(5) BM’s name was on MEC’s products and promotional materials
- A parent corporation is expected to exert some control over its subsidiaries. However, when a corporation is so
controlled so as to be the “alter ego” or “mere instrumentality” of its shareholders, the corporate form may be
disregarded in the interests of justice.

It is difficult to pierce the parent of a subsidiary. These factors will not work to engage the doctrine:
(1) Participation in a cash management program
(2) Parent’s requirement that subsidiary get approval for the sale or lease of property, capital expenditures, and
(3) Parental domination of the subsidiary
(4) Common use of logos

Substantial Domination. Look at the totality of circumstances (the alter ego prong), including:
(1) Common directors and officers
(2) Common business departments
(3) Filing consolidated financial statements and tax returns
(4) Parent finances the subsidiary
(5) Parent caused the incorporation of the subsidiary
(6) Subsidiary operates with grossly inadequate capital
(7) Parent pays the salaries and expenses of the subsidiary
(8) Parent uses subsidiary property as its own
(9) Daily operations of the two corporations are not kept separate
(10) Subsidiary does not observe the basic corporate formalities

There are three claims in this type of case:

- Agency: respondeat superior
- PCTV (including enterprise liability)
- An alternative is to sue on “uniform act on fraudulent conveyance”

Frigidaire v. Union Properties: Limited partners do not incur general liability for the limited partnership simply
because they are officers, directors or shareholders of the corporate general partner. The shareholders will not lose
their status as limited partners if they exercise control in the parent corporation.
- Difference between LLP and LP: LLP consists of general partners sharing a shield, and LP consists of one GP
and multiple LPs.

CH. 3, SECTION 3: Shareholder Derivative Actions

Demand Futility / Demand Special Litigation Committee

Excused Review
(1) Majority of Board was Process
Delaware interested +
(2) Dominated/Controlled Court’s own judgment
(3) Not product of the BJR
New York (1) Interest (including control Process ONLY
or domination)

(2) Board’s decision not fully
(3) Not the product of BJR

- Business Judgment Rule: Presumption that in making a business decision, the directors of a corporation acted
on an informed basis and on good faith and in the honest belief that the action taken was in the best interest of
the company. We are concerned with the process, not with the outcome. [Doesn’t matter how stupid the
decision is, so long as they made it in good faith.]
o E.g., Arson v. Lewis: Courts aren’t going to get involved in the directors’ stupid decisions. The
court won’t substitute its decision for that of the board. We want businesses to take certain kinds of risks.
The BJR applies to Boards of Directors, individual directors, and officers.
- General Rules for BJR Burden Shifting:
o If there is no conflict, π will have the Burden of Proof. Unless there is a significant breach of the
duty of care, π will lose because the BJR will apply.
o If there is an unratified conflict, then the Δ directors will probably have the BOP to show that the
transaction was fair and reasonable.
o If there is a ratified contract by disinterested directors, then π has teh BOP and has to overcome
the BJR. What gets argued here is that the “disinterested” directors were not adequately informed.
- Two different types of litigation can be brought:
(1) Shareholder Derivative Suit. Suit in equity to compel corporation to sue a third party – indirect loss for the
shareholder. The shareholder is telling the board what they want to be done for the benefit of the
corporation. Generally any recovery goes to the corporation.
a. E.g., compel a corporation to sue a manager for fraud. The shareholder has an indirect loss of
share value declining; however, the focus is the manager’s fraud because the whole business has lost
b. It is difficult to bring a shareholder derivative suit. With the BJR, the company might not want to
sue the manager and it is hard to show that this doesn’t have a rational business purpose (in light of
Enron and bad P.R.).
c. Two options for a derivative suit:
i. allege the board rejected your pre-suit demand, or
ii. allege that you were justified in not having to make a demand (demand excused)
(2) Direct Suit: There is a direct loss to the shareholder personally due to company choices.
a. The Securities Litigation Reform Act of 1995 has made it more difficult to have securities law
class actions.

- The first question you should ask when reading a case or doing the exam is: “Is it a direct or derivative suit?”
- Internal Affairs Doctrine: The relationship within a corporation should be governed by the state of
incorporation. (This is often disregarded by NY courts who apply their own law.)

Demand Rule: Most states require you to go to the board and make a demand to the board before you file a
derivative suit.
- If you don’t make a demand first, you will be procedurally estopped from bringing your claim.
When Demand is Required: The BJR applies and the π almost always loses.
- We require demand so the board can bring a cause of action or contest the claim.
When Demand is Excused: The board makes a special litigation committee (SLC) who makes a decision on
whether the case should go to trial.
- If No SLC is formed: π procceds with his claim, and settlement is likely
o When we’re talking about settlement, we’re usually talking about attorney fees. The attorneys
always get paid; the corporation might not end up getting any benefit.
- If SLC is formed: Various types of review and π usually loses
Demand may be excused if you can show:
- That a majority of the board has a material, financial or familial interest

- That a majority of the board is incapable of acting independently (subject to domination or control)
- The underlying transaction is not a valid action of the BJR
Policies: We don’t want shareholders to bring frivolous derivative suits, and the board should be able to run the
company and have the opportunity to bring the suit.
- Court Costs and Legal Fees. If a derivative action is settled before judgment, the corporation can pay the legal
fees of the π and of the Δs. If money damages are imposed on the Δs, they will be required to pay those
damages and may be required to bear the cost of their defense as well.

Three Reasons for Requiring Demand:

(1) If litigation is beneficial, corporation can control the proceedings.
(2) If demand is excused or is wrongfully refused, π will usually control the proceedings.
(3) By requiring exhaustion of intracorporate remedies, we invoke a species of ADR which might avoid
litigation altogether.

Direct vs. Derivative Claims: Distinction Based on Recovery to the Company: Generally, a direct suit is harm to the
shareholder, and a derivative suit is harm to the company.
o Exception to the General Rule: In Delaware in certain circumstances, if the recovery is not
monetary, you may be able to bring a direct suit.
o Universal Demand: A minority of states have a universal demand requirement such that every
time a derivative suit is brought, you have to make a demand.
 The universal demand is a “bright line” rule.

Cohen v. Beneficial Industrial Loan Corp.: A statute holding an unsuccessful π liabile for the reasonable expenses
of a corporation in defending a derivative action and entitling the corporation to require security for such payment is
- Cohen involves a derivative suit. Cohen is challenging the constitutionality of a statute requiring him to post a
bond to bring the suit since Cohen is not a 5% shareholder.
- The policy behind this is to discourage frivolous suits by nominal shareholders, but the effect is that it prevents
the “little person” from suing.

Eisenberg v. FTL: A cause of action that is determined to be personal (direct), rather than derivative, cannot be
dismissed because the π fails to post security for the corporation’s costs.
- Eisenberg brought a direct suit to enjoin the company from merging because he claims that his vote will be
- Shareholders’ only rights are to get dividends and to approve the board at the annual meeting.
Grimes v. Donald: If π makes a demand on the corporation (to bring a suit), then π is conceding that a demand is
required, and π cannot later argue that demand is excused.
- If π demands a suit to the Board, an SLC will be set up and the suit will most likely not go forward.
MBCA § 7.42 Demand: No shareholder may commence a derivative proceeding until (1) a written demand has been
made upon the corporation to take suitable action; and (2) 90 days have expired from the date demand was made
unless shareholder was notified that demand was rejected or unless irreparable injury to corporation would result by
waiting 90 days.

Marx v. Akers: π must show by pleading with particularity that the Board’s behavior was so egregious that they
could not have exercised business judgment.
- New York’s demand requirements are not under the “universal demand rule”:
o Majority of directors are interested –or–
o Majority of directors failed to inform themselves –or–
o Majority of the directors failed to exercise business judgment
- Delaware’s Law Basis for Claiming Excusal of Demand:
o Majority of board has material or financial interest

o Majority of Board is incapable of acting independently for some other reason such as domination
or control
o Underlying transaction is not a product of valid exercise of BJR.

Auerbach v. Bennett: The court will give deference to the SLC unless the committee is not independent, doesn’t use
a good faith basis, or doesn’t investigate sufficiently. These are very minimum standards. Usually the π will lose
when an SLC is created because the board will know that a court will review their decision, so the board will take
caution to make sure that the SLC is disinterested.
- π brought a derivative suit and the Board created an SLC which decided that there should not be a lawsuit. The
court applied the BJR.

Zapata Corp. v. Maldonado: In a derivative action, an SLC was created and decided not to pursue litigation.
- Delaware Rule (Zapata Test):
o Adequacy of investigation, and
o Court’s own judgment
o Only in “demand excused” situations
- This is a higher standard of review: the Court is trying to balance the right of board members to control
corporate affairs with the right of shareholders to protect their interests (Delaware often sides with the

Other Rules
- Some states do a “middle ground” where the Board doesn’t help select the SLC, and the court will defer to the
- Alfred: Court can review recommendations but doesn’t have to rely on the SLC’s opinion (can make an
independent determination)
- Indiana: Essentially Auerbach: Look at the committee, not its decision. The board may create SLC to
determine what to do. If the committee determines the case is not in the best interest of the company, this
decision is conclusive on shareholders, unless not disinterested or not in good faith.

Summary of Tests for Special Litigation Committees:

- New York Rule: (Auerbach) Procedural Adequacy
- Delaware Rule: (Zapata) Procedural Adequacy + Court’s independent judgment
CH.3, SECTION 4: The Role and Purpose of Corporations

The purpose of a corporation is to make money, to increase shareholder value. Therefore, what are the limits
beyond which a corporation cannot stray?
- Corporate charitable donations must have a corporate purpose. If they do not, then we are concerned with a
breach of the duty of loyalty. There can almost never be anonymous giving, because what would be the
corporate purpose of that?

Smith v. Barlow: Usually courts declare the decision to donate money to a charity a “business judgment.” It is
favorable because it benefits the community, creates goodwill and potential employees, and there is a free flow of
information. In Smith, Stockholders sued because the corporation donated money to Princeton University.
- Restriction on Donations:
o Courts say that it must be reasonable
o Cannot have a “pet charity,” it must be broader than that
o Watch conflicts: who is on the boards for the charities?
o Political implications
o Anonymous gifts: lower benefit to the corporation
- Note that the court decided that state legislation adopted in the public interest may be constitutionally applied to
preexisting corporations under the reserved power.

Dodge v. Ford Motor Co.: Normally, shareholders do not have the right to dividends, and the courts will defer to
the judgment of the Board of Directors with whether or not to give out dividends. (This case, therefore, is an
aberration, having the court rule that the company has to give out dividends). However, directors cannot make an
arbitrary refusal to distribute dividends when it is evident that such dividends should be distributed. In Dodge, the
Dodge brothers were minority shareholders and did not want Ford to spend money on reinvestment in the company
for the “public good”; rather, they wanted payment of dividends to go to the shareholders.
- The court held that despite Mr. Ford’s goals of returning the profit to the public, the purpose of a corporation is
to make money and the board can only use its power to act in furtherance of increasing the shareholders’ profits.
- Usually the problem occurs that there isn’t enough money to give out dividends, and if the directors disperse too
much money to the shareholders, they may be personally liable for the corporate debts. (There are sometimes
protective devices in place to protect creditors in the event that directors give all the corporation’s money to its
- Shareholders may compete with the company in which they hold share.
Shlensky v. Wrigley: A shareholder’s derivative suit can only be based on conduct by the directors which borders
on fraud, illegality, or conflict of interest. In Shlensky, π was a minority shareholder who wanted lights for evening
games installed at Wrigley Field, and the owners did not install them (π claimed) because of other reasons than
business (the owner’s feelings that baseball is a daytime sport). Wrigley won the case because they could show
there was an alternative, rational reason for not installing the lights, such as concern for the community.
- The BJR applied: The presumption was that the board acted in good faith (which is a pretty low standard—you
can’t use business for your own gain, but that’s not hard to overcome).

The Inevitable and Relatively Useless Policy Discussion

- Corporations are profit-maximizing entities, so that even though charity is a good thing, corporations must
adhere to the fact that their existence’s purpose is to make money.
- By 1840, most states were allowing for limited liability. There are a few states, New York is one of them,
where you don’t have limited liability for very specific instances (e.g., wages).
- Two broad ways to think about the “positives” of limited liability:
(1) Democratic.
a. People with “modest means” have an increased opportunity for participation in entrepreneurial
b. Entry in business; competition. Everyone gets a stake in the business, and therefore everyone has
a personal reason to work hard.
(2) Economic.
a. Encourages investment. If shareholders know they won’t be held personally liable for the debts,
they’re more likely to invest.
b. Risk-Taking.
c. Consumer choice.
d. Taxation? The government gets additional tax benefits from the company, because the company
is taxed, and later, the partner is taxed.
e. Creates jobs.
f. Generates money.
g. Efficiency.
h. Stock market benefits because people know liability is limited.
i. Diversification. Corporations can diversify because of limits on liability.
- The “negatives” of limited liability:
(1) Risk-Taking. With true limited liability, the corporation may be unduly risky in the products they put into
the marketplace.
(2) Moral hazard. Limiting a person’s liability may prevent them from fully engaging in moral decisions.
(3) Quality issue.
(4) Personal responsibility.

Introduction: Policies (Economic and Democratic) of Limited Liabilities

(2) Liability Protection

a. Shareholders are not protected from losing their investment, but can protect their personal assets.
b. Unlimited liability was the old rule. By 1849, most states had the ability to make limited
corporate liability. Initially, the state granted you a charter so you had to follow the state rules. Now it’s a
contractual relationship and the assets of the corporation are on the line; not personal assets. It’s no longer
a privilege to have a corporation.
(3) Allows people of modest means to act in an entrepreneurial spirit (democratic idea).
a. E.g., Microsoft starting in the garage (“Pirates of Silicon Valley”)
b. Can share a corporation if one has capital and the other has labor.
(4) Specialization (economic)
(5) Efficiency (economic)
a. Can fire someone who doesn’t do their job
(6) Investment Benefits (for shareholders and managers)
a. If you had to check out liability of the company before you invest, there would be no transfer of
b. Could save companies that couldn’t have been saved before
c. Managers are allowed to take risks, which is essential in capitalism
(7) Diversification (economic)
a. You can buy one share of a company and not put all your savings into one company.
b. Diversify your portfolio
(8) Market Benefits
a. Selling and buying shares on the open market
b. Efficient Capital Market Hypothesis
(9) Separation of Capital and their Agents
a. Monitoring costs (less with limited liability) because you risk less. If you knew that you could be
personally liable for any company you invest in, you would want to constantly monitor the company.
(10) Limiting the assets in a situation where you need to pay all creditors or injured parties (option is to
change insurance) – NEGATIVE
(11) Creating a moral hazard: might act riskier because they will not be personally liable – NEGATIVE
(12) Inefficiency: encourages being too risky and wasting money – NEGATIVE


The limited liability company is an alternative form of business organization that combines features of corporate
form with others more like a General Partnership.
- Investors are called members. The LLC provides a liability shield for its members.
- May be managed by all its members or by a manager who may or may not be a member.
- LLC Tax Benefit: A corporation pays tax on its profits earned and the shareholders pay a second tax when
profits are distributed to them. But LLC investors are taxed only once when the profits are earned.
- Requires paperwork and filing with a state agency.

CH. 4, SECTION 2: The Operating Agreement

Elf Atochem North America, Inc. v. Jaffari: The ULLCA provides maximum effect to freedom of contract and the
enforceability of LLC Agreements, so parties are able to contract to avoid the applicability of certain provisions of
the ULLCA. Elf involved a joint venture between Elf (30%) and Malek, Inc. (70%) in creating Malek LLC.
- The court found that it did not have jurisdiction because the agreement specified an arbitration clause, and
California law applied.
- Courts defer to the parties’ agreement, and parties may make agreements to arbitrate instead of litigate.
- There is flexibility as a member of an LLC (like management). You can have manager-managed, or member-
managed, or a hybrid of the two. Under most state statutes, you can do anything you want.

CH. 4, SECTION 3: Piercing the LLC Veil

LLC Piercing. (There has no yet been a case of LLP piercing.)

- Fraud or failure to pierce would lead to injustice.
- Instrumentality/alter-ego
- Corporate formalities
o Difficult to apply to LLCs because there are no required “formalities”
o Probably doesn’t apply very often for that reason
- Undercapitalization
o Same problem as with corporate formalities: who makes this determination?
- Not a lot of agreement. Some courts ignore that the LLC entity is different, some recognize the difference but
apply the rules anyway. Some states have put in their statute that piercing will apply the same way. Some
states aren’t going straight forward and some say nothing about piercing in their LLC statutes—so “revel in the
ambiguity” or absence.

Kaycee Land & Livestock v. Flahive: In the absence of fraud, a claim to pierce the veil of an LLC is treated in the
same manner as a court would pierce a corporate veil. In Kaycee, Kaycee entered into K with Flahive allowing
Flahive to use the surface of its property. Kaycee brought suit against the managing member of Flahive for
environmental contamination of the land.
- There is no reason, in law or policy, to treat LLCs differently than corporations in considering whether to pierce
the veil.
- If members and officers of an LLC fail to treat it as a separate entity, they do not get limited liability for acts
causing damage to third parties.
- Court notes that every state that has enacted LLC piercing legislation has followed the corporate law standards
rather than developing separate LLC standards.

CH. 4, SECTION 4: Fiduciary Obligation

McConnell v. Hunt Sports Enterprises: A member of an LLC does not breach his fiduciary duty to the company by
directly competing against it where the operating agreement expressly permits competition. In McConnell,
members of an LLC formed to explore the possibility of applying for a new NHL franchise sought a declaration for
breach of K against each other based on the exclusion of certain members’ ownership interests in the franchise.
- Facts: McConnell (community leader) and Hunt Sports formed CHL (Columbus Hockey Ltd.). The planned tax
to finance construction of the hockey arena failed to pass approval. McConnell signed paperwork to lease the
arena in HSE’s place, but in signing the paperwork in an individual capacity, McConnell identified himself as
the majority owner. McConnell requested a declaration permitting him to compete with CHL itself for the
position of majority owner of the franchise.
- There was no ambiguity in the agreement, which “members may compete” in “any other venture of any nature.”
- The business was speculative, and they didn’t want to limit themselves from going into other related areas
(indirect competition) but probably didn’t think they would end up directly competing and trying to get the
franchise agreement—but intent doesn’t matter.
- You can always contract away any rights or protections you have.

Uniform Limited Liability Company Act: Still has a lot of gaps in it.
- Nine states: not yet corporate codes where there are similarities across the board. Delaware is particularly bare-
boned: do what you want.
- Not a lot of legislative history yet.

CH. 4, SECTION 5: Dissolution

New Horizons Supply v. Haack: A member or manager of an LLC is not personally liable for any debt, obligation,
or liability of the company only if the member or manager follows statutorily prescribed formalities of LLC
incorporation, dissolution, and creditor notice.
- Koch (brother) and Haack (sister) owned Kickapoo Valley Freight LLC. Haack had a credit card from New
Horizons, and signed her personal name without a corporate designation when she made purchases, even though
the first paragraph of the credit card agreement form listed the “Patron” as the LLC. Koch had a breakdown,
and Haack took over and sold all the assets. She did not file articles of dissolution, however, and she did not
give proper notice to the LLC’s creditors of the dissolution.
- The appellate court found that the Trial Court’s decision to “pierce” the LLC veil and hold Haack responsible
for the debt to New Horizon was correct, but for a different reason than given.
o The trial court found dispositive the fact that it was taxed as a partnership.
o Appellate court said there was little evidence to show that Haack controlled company affairs such
that the LLC was her mere instrumentality.
o Instead, appellate court said she failed to establish that she took appropriate steps to shield herself
from liability when the LLC was dissolved and its assets disposed of.

Articles of Dissolution
- Each state statute tells you what to do when your business starts to fall apart:
o Tell them about claims, take care of debts with assets
o In some states you have to publish a notice of dissolution
- Statute formalities must be followed to avoid liability.


Ch. 5, Section 1: The Obligations of Control: Duty of Care

Duty of Care: To conduct business of corporation with the same degree of fidelity and care that a reasonably
prudent person would exercise in position. In DE, even if directors breach their duty of care, they can sustain the
burden of proving the “entire fairness” of the transaction. It is very difficult to prove a breach of duty of care.

Duty of care is “shirking”; duty of loyalty is “stealing.”

These fiduciary duties are a prerequisite to the application of the BJR. If they’ve met the duty of care (by gathering
information, for instance) and they’ve avoided any conflict of interest (so there’s not duty of loyalty problem) then
the BJR will apply and the courts won’t second-guess their judgment.

Kamin v. American Express Co.: Whether or not a dividend is to be declared or a distribution made is exclusively a
matter of business judgment for the board of directors, and the courts will not, therefore, interfere as long as the
decision is made in good faith.
- Facts: Kamin brought a derivative suit claiming AmEx engaged in waste of corporate assets by declaring a
certain dividend in kind.
- Negligence (a mistake in judgment, an imprudent decision or the fact a better choice was available) is not
enough to violate the duty of care. Gross negligence or egregious conduct is required to breach the duty of
- The board used an outside account consultant to view the tax issues; this fulfilled their duty of care to gather
information and get outside opinions. So the action was dismissed.
- There was no violation of duty of loyalty because there was no self-dealing, no conflict, and there were 16
outside directors. Not getting the result you want doesn’t equal a violation of the duty of loyalty. To breach
the duty of loyalty, you need a conflict of interest.

Smith v. Van Gorkom: The business judgment rule shields directors or officers of a corporation from liability only
if, in reaching a business decision, the directors or officers acted on an informed basis, availing themselves of all
material information reasonably available.
- Facts: Van Gorkom (CEO for TransUnion) had a secret meeting with Pritzker (a corporate takeover specialist)
for marketing the sale of the company (valuation of the company). The board was unaware of the meeting. The
proposed agreement had a “no-shop clause”—can’t find anyone else to buy the company ($55/share). Not a
breach of duty per se—must be taken in light of the agreement.
- The duty of care casevery high profile—potential duty of loyalty issues
- The Board of Directors were held liable because they weren’t adequately informed on the sale to Pritzker (only
received a 20 minute presentation by Van Gorken before they voted). Board violated its duty of care because
they were inattentive to the possibility of better offers from third parties.
- Pritker cannot be sued because he owed no fiduciary duty to the shareholders.
- The possible negative of this case is that it slows things down. We could be so concerned with the process that
we cannot move quickly and sometimes “time is of the essence.”
- Leveraged Buy-Out: Corporation uses assets of company you are buying as collateral for the loan you’re taking
out to buy the company. The purchase of the company by one of the investors (a friendly takeover).
- Inside Director: Involved in the day-to-day business
- Outside Director: Not employed by the company, no day-to-day dealings. Decisions made by outside directors
are favored (like the SLC) because they aren’t affiliated with the company—no self-interest
- The Efficient Capital Market Hypothesis: The price on the open market should be truly representative of the
stock’s value and take into consideration all available information
Legislative Response to Van Gorkom:
- Statute says we aren’t going to hold directors liable for the breach of the duty of care. A large part of DE’s
income is incorporation fees. The holding of Van Gorkum makes it less favorable for corporations (directors—
not officers).
- Directors will be held liable in DE if:
(1) Breach of loyalty
(2) Acts or omissions not in good faith or involving intentional misconduct or a knowing violation of law
(3) Any transaction when a director derived an improper personal benefit.
- Directors will not be held liable in IN unless:
(1) Willful or reckless misconduct (“pure heart, empty head” standard). This requires nearly intentional
(2) IN specifically says they will not follow DE law: When you do a bad act, you will have breached your
duty of loyalty in DE before you will have breached it IN.

Stock Options
- Two basic types of options:
(1) Put: A right to sell; betting the stock price will go down
(2) Call: A right to buy; betting the stock price will go up
- Option is a contract that gives someone the right to sell or the right to buy a fixed number of shares of the
specific stock at a particular price.
- Price:
(1) Strike Price:
(2) Exercise Price:
- Options aren’t infinite. There’s usually a period of time where you cannot exercise the option, and there’s
usually an expiration or maturity date for the option. In other words, eventually, the contract will expire.
- You have a put option: We know there’s a set price of $25, and the date is June 1. You can have a “naked put”
where you don’t actually own the stock yet.
o If the stock price goes down to $20 and it’s June 1, would you want to sell your stock at the option
price? YES. You can sell at $25, and if you still want stock in that company, you can buy more stock at
$20 each.
o If the stock price goes up to $30 a share…you would not exercise your put option.

- “In the money” means you’ll make money when you exercise the option. With a put option, you’re in the
money if the market price is below the option price. You’re “out of the money” and you would not exercise
your put option if the market price goes above the option price.
- The put option is really a bet that you’re making that the stock price will go down.
- The efficient capital market hypothesis.
- Someone who has a call option thinks the market price is too low and the value of the company will increase.
So for a call option you have the right to buy stock at $25. If the price goes up, you would exercise your call
option. If the stock price goes down, you would not exercise the call option.

Note on Cinerama, Inc. v. Technicolor: Factors to consider for the “entire fairness” of a transaction:
(1) Timing
(2) Initiation
(3) Negotiation
(4) Structure of the transaction
(5) Disclosure and approval by the directors; and
(6) The disclosure to and approval by the shareholders

In the legal model, the CEO and other officers of a corporation are supposed to be subservient to the will of the
board of directors. The Board is supposed to have the legal power and responsibility to manage (or to supervise the
management). The CEO and other members of the management team have the authority to make routine operating
decisions, develop corporate plans and strategies, and major decisions requiring Board approval.

Brehm v. Eisner: An extraordinarily lucrative compensation agreement and termination payout awarded to a
company president who underperformed does not necessarily constitute a breach of fiduciary duty on the part of
corporate directors.
- Facts: Board of Disney hired Michael Ovitz as its President, but he soon displayed negligence and a lack of
commitment to Disney. CEO Eisner and Ovitz agreed for Ovitz to leave Disney on a non-fault basis, leaving
Ovitz with a very nice severance package ($10 million termination payment and $7.5 million for part of the year
remaining on his contract). Total value of Ovitz’s severance package was over $140 million. Various
stockholders brought suit alleging corporate waste & breach of fiduciary duties to Disney corp.
- Mere disagreement cannot serve as grounds for imposing liability on Directors based on alleged breaches of
fiduciary duty and waste.
- This was a derivative action. The court found that the Board didn’t breach their duty of care because the hiring
was sloppy and Ovitz’s severance package was very lucrative for him. Shows the strength of the BJR: Ovitz
had a lot of money on the line. “Irrationality is the outer limit of BJR.”

Francis v. United Jersey Bank: Generally, the duty of directors is to the shareholders, not to the creditors. Usually,
the creditors cannot step into the shoes of the shareholders and sue for a breach.
- There are three exceptions to this rule.
(1) Type of business. Special obligation of directors of financial institutions, including resinurers.
(2) Insolvency. If a corporation is insolvent, the creditors can step into shareholders’ shoes.
(3) Reification. The duty is not really owed to the shareholders but is owed to the corporation as an entity.
- Facts: Mrs. Pritchard inherited 48% interest in reinsurance broker from her husband. She and 2 sons served as
directors. Sons withdrew over $12 mil. as loans from client trust accounts. Mrs. Pritchard was ignorant as to
the fundamentals of the reinsurance business, and paid no attention to the affairs of the corporation.
- Mrs. Pritchard violated her duty of care because she had access to information that her sons were “borrowing”
$12 million and bankrupting the company, but she failed to exercise supervision of the company (reviewing
financial statements). She should not have accepted the director position if she couldn’t handle it.
- A lack of awareness or capacity is NOT an excuse for breaching the duty of care. There is a minimal level of
care that you must exhibit as a director.
- Liability of a corporation’s directors to its clients requires a demonstration that (1) a duty existed, (2) the
directors breached that duty, and (3) the breach was a proximate cause of the client’s losses.
- A director should:
(1) Have at least a rudimentary understanding of the business of the corporation

(2) Keep continually informed of business activity
(3) Not shut eyes to misconduct
(4) Perform general monitoring of corporate affairs and policies
(5) Do regular review of financial statements
(6) Object to illegal conduct and resign if necessary
(7) Seek advice of counsel if needed
(8) Maintain fiduciary duty with corporation and its stockholders
(9) Duty to creditors when insolvent

In re Caremark Internatl. Inc. Derivative Litigation: A Board of Directors has an affirmative duty to attempt in good
faith to assure that a corporate information and reporting system exists and is adequate.
- Facts: Caremark, which provided patient healthcare & managed healthcare services, entered into service Ks
with physicians who at times prescribed Caremark products or services to Medicare recipients. The Anti-
Referral Payments Law (ARPL) didn’t specifically prohibit that, but it did raise the issue of unlawful kickbacks.
Caremark’s Board sought legal advise on this matter and devised guidelines for employees. In spite of these
efforts, government investigated Caremark and 2 officers were indicted. Shareholders filed derivative suits
charging the Board with failure to monitor the company as part of the duty of care.
- Directors generally do not have the obligation to monitor the day-to-day operations, but where there is a basis
for suspicion they must make a good faith effort to ensure that the information and reporting system is adequate.
Basically, the choice of what structure to use in informational gathering is subject to the safe harbor of the BJR;
therefore, a claim that the duty to monitor has been breached is very hard to prove.

Beam v. Martha Stewart Living Omnimedia, Inc.: A Board of Directors is not required to monitor a party in the
company so closely that she loses her right to privacy. Also, the mere fact that the Board of Directors maintains a
friendship with each other or others in the company is not alone sufficient to render a demand excused.
- This is a derivative suit alleging Stewart violated her duty by taking this action, and wanted more monitoring by
the Board.
- Court asks the plaintiffs what more they wanted the Board to do. It doesn’t make sense for somebody to follow
Martha Stewart around all day, listening in to every telephone conversation she has, etc. The Board has the
duty to hire good people, but they are not required to monitor to the extent that someone (in this case, Martha)
would lose their sense of privacy.
- What does the Court say about demand? Plaintiffs claim the Board would’ve rejected their demand because
Martha Stewart created the Board out of her friends, people she liked. The Court said that’s not enough
evidence: friendship alone doesn’t mean that the demand would’ve been rejected. After all, the nature of the
Board is that people are chosen based on personal social relationships, who someone knew from a previous
employment, going to the same country club, etc. Plus, it’s the “same people” who tend to sit on boards—if
you’re on one board, you tend to be asked to be other boards too.
- Main Ideas:
(1) How much monitoring is needed. As it relates to Stewart: It’s not reasonable to go farther into the personal
life so that she loses her privacy.
(2) The issue of demand and independence.
Ch. 5, Section 2: Duty of Loyalty

- Business Judgment Rule: Presumption that in making a business decision, the directors of a corporation acted
on an informed basis and on good faith and in the honest belief that the action taken was in the best interest of
the company. We are concerned with the process, not with the outcome. [Doesn’t matter how stupid the
decision is, so long as they made it in good faith.]
- If there is no duty of care problem, and no duty of loyalty problem, then the BJR applies and the court will not
second-guess what the Board of Directors has done.

Duty of Loyalty: Something outside of the director’s normal scope that makes it difficult to make a decision. IN the
late 19th century, only shareholders could void a K between director and company (to protect the shareholders), but

corporation could be out a good K. So the states have provided specific rules for these Ks. Could breach duty of
loyalty by setting director compensation too high.

Subsection (A): Directors and Managers

- When a court invokes the BJR, the directors will almost always win.
- The court will apply the BJR only (1) if directors have been conscientious enough to have exercised real
“judgment (the duty of care) and (2) if they have not had conflicting personal interests at stake (duty of loyalty).

Bayer v. Beran: Policies of business management are left solely to the discretion of the board of directors and may
not be questioned absent a showing of fraud, improper motive, or self interest (even though the decision may be
judged unwise or unprofitable).
- The court analyzed the company’s process of deciding whether or not to engage in radio advertisements, and
who should be the singers, and how much they were paid, etc., and found that the BJR rule covered all of those
decisions…the only “glitch” was that one of the singers was the President’s wife, which calls for stricter
examination of the Board’s decision.
- The burden shifts to the “interested” director to demonstrate good faith in the transaction and its inherent
fairness to the corporation.
- Board hired an outside party to audition the singers, evidencing no breach of duty of loyalty.
- Also, there was no evidence that the advertising program was inefficient, disproportionate in price, or conducted
for the personal gain of the President’s wife.

Subsection (B): Corporate Opportunities

We do not apply § 144—This is a subsection of the duty of loyalty.

Broz v. Cellular Info Systems, Inc.: The doctrine of corporate opportunities is a subset of the duty of loyalty, where
the fiduciary agrees to place the interest of the corporation before his or her own in appropriate circumstances. This
doctrine is implicated only in cases where the fiduciary’s seizure of an opportunity results in a conflict between the
fiduciary’s duties to the corporation and the self-interest of the director as actualized by the exploitation of the
- President & Shareholder (Broz) of RFB, also a member of Board of CIS. Broz is offered the chance to purchase
a district for cell phone use. RFB was not interested in the district, but another company, PriCellular, that later
took over RFB, did try to buy that district and was outbid by Broz.
- The corporate opportunity doctrine did not apply:
(1) Broz disclosed the opportunity to three of CIS’ directors, all of whom testified that CIS wasn’t interested
(2) CIS could not afford the license, and was in the process of getting rid of several of their current licenses
(3) Broz was approached for the license in his individual capacity, not as Boardmember of CIS
(4) Broz owed no duty to PriCellular, who had no interest in CIS at the time Broz outbid them.
- “The right of a director or officer to engage in business affairs outside of his or her fiduciary capacity would be
illusory if these individuals were required to consider every potential, future occurrence in determining whether
a particular business strategy would implicate future duty concerns…” (p. 382)

A corporate opportunity is one that the corporation could take.

(1) Identify the potential interest the corporation might have. Ordinarily expect would come to the
(2) Officer/Director has to offer the opportunity to the corporation, though there is no requirement of an
actual board meeting.
(3) If disinterested directors/shareholders reject the opportunity, then the individual can take it.
- Refusal to Deal Defense. If an office or director of a corporation invokes refusal to deal as a defense to a charge
that he seized a corporate opportunity, he must first disclose the refusal to the corporation, along with a
statement of reasons for the refusal.
- Financial Capacity Defense: Director or officer who used the opportunity argues that the corporation lacked the
money to exploit the opportunity effectively. Courts reject this argument unless the executive has explicitly
offered the opportunity to the corporation.

- Under Delaware Code § 144, a director or officer may engage in self-dealing IF:
(1) The Board of Directors knows of the interested transaction AND in good faith authorizes it by a majority
vote of the disinterested directors, or
(2) The shareholders know of the interested transaction and approve it in good faith, or
(3) The contract is fair as to the corporation as of the time it was authorized, approved, or ratified by the board
of directors or shareholders.
- See pages 383-384 for the ALI’s description and definitions of corporate opportunity.

Subsection (C): Dominant Shareholders

Directors and shareholders do not have the same fiduciary duties. Directors have fiduciary duties inherent in their
job. Shareholders mainly buy stock to make money, not to look out for anyone else. However, under certain
circumstances, courts impose some duties on the shareholders. They are “Controlling” because they have control
over the Board. The Board is supposed to be an objective overseeing body.

Sinclair Oil Corp. v. Levien: Transactions between controlling shareholder and company with the potential for self-
dealing will be subject to the “entire fairness standard” or “intrinsic fairness.” The “intrinsic fairness” test should
not be applied to business transactions where a fiduciary exists but is unaccompanied by self-dealing.
- This is a derivative action.
- Because Sinven’s (the subsidiary’s) shareholders benefited from the payment of dividends (the vast majority of
which went to Sinclair, the parent, at a time when Sinclair was in need of cash), and because no evidence
indicated that Sinclair took business opportunities away from Sinven, no self-dealing was demonstrated.
Therefore, the BJR applies, not the “intrinsic fairness” test.
- However, it was self-dealing when Sinclair forced Sinven to K with another (wholly-owned) subsidiary
International, and then failed to abide by the terms of that K—this invokes the intrinsic fairness test. BOP shifts
to Δ to prove the fairness, and when Sinclair could not prove that its actions under the K were fair to Sinven’s
minority shareholders, it was required to account for damages.

Subsection (D): Ratification

- If the BJR presumption is rebutted, then the Board’s decisions are looked at through the “entire fairness rule.”
There are three scenarios and duty of loyalty claims:
(1) Self-dealing transactions: Statutory provisions tell you how to cleanse the deal. You need fully informed
shareholders to vote in favor of the transaction, then the BJR is invoked and it is difficult for π to overcome
that BJR.
(2) Parent subsidiary (“controlling shareholder”) transaction: The standard of review is entire fairness. The Δ
has the BOP of proving that the transaction was fair to the corporation. But an informed ratification by the
majority of the minority shifts the BOP to π to show that it is not entirely fair.
(3) No controlling group: If there is no controlling group and you have a transaction where you need
shareholder approval, absent fraud, if you have an informed and uncoerced shareholder vote, then the BJR
will apply to the Board. So if you are making decisions, put them to a vote.

In re Wheelabrator Technologies, Inc. Shareholders Litigation: A fully-informed shareholder ratification does not
extinguish a duty of loyalty claim, but it serves to make the business judgment rule the applicable review standard
with the burden of proof resting on the π stockholder.
- The Disclosure Claim. Del. law imposed on the Board a duty to disclose fully and fairly all material facts
within its control that would have a significant effect on a stockholder vote. No evidence that the proxy
statement given by WTI did not fulfill that duty.
- The Fiduciary Duty Claims. Merger was approved by fully-informed stockholder vote. Ratified.
o The Duty of Care Claim. The effect of the informed vote is to extinguish the due care claim in
negotiating and approving the merger.
o The Duty of Loyalty Claim. Approval by fully informed and disinterested shareholders invokes
BJR and places BOP back on the party attacking the transaction.
- The Appropriate Review Standard. Because there was no contention or evidence that Waste, a 22% shareholder
of WTI, exercised de jure or de factor control over WTI, the review standard is BJR.

Ch. 5, Section 3: Disclosure & Fairness

Subsection (A): Definition of a Security

- There are two basic types of markets:

(1) Primary Market, in which the issuer of the securities sells them to investors (e.g., an initial public
offering by a corporation).
(2) Secondary Market, in which investors trade securities amongst themselves without any significant
participation by the original issuer (e.g., the NY Stock Exchange).

- Securities Act of 1933: The Act that registers the securities.

o E.g., File S-1 and distribute prospectus. Disclose certain information prior to selling stock.
o You cannot sell before you register—timing is important.
o The federal regulations don’t care if it’s a bad investment; the purpose is disclosure of material
information and to avoid fraud.
- Securities Exchange Act of 1934: The Act that registers companies.
o E.g., if you are a 1934 reporting company, you have certain obligations to continue reporting on
the status of the company so people buying and selling have the up-to-date information.
- Blue-Sky Laws: State laws regulating securities.
o Some try to regulate the quality of the stock (if the state thinks the stock is too risky, they can
refuse the sale)
o The federal rules don’t care about the individual stock or the stockholder; the federal rules are
more concerned with the market as a whole.
o This means that it allows you to make really bad and/or really stupid deals.

Great Lakes Chemical Corp. v. Monsanto Co.: The interests of an LLC do not constitute a “security” for the
purposes of the Securities Exchange Act.
- The Court asked if there was an investment K, used the Howey test (see below). There was an investment of
money, but there was no common enterprise because Great Lakes alone was buying the LLC’s interests.
Furthermore, the profits were not solely from the efforts of others, because Great Lakes had the right to remove
managers, which thus gave them control to impact the profits.
- π wanted it to be a security because that would render the interests subject to federal protection.
- When you have a lot of people investing in an enterprise, you’re going to have a security.
o “Stock” is always going to be treated like a security.
o Generally, if it looks like a security, it probably will be.
- The LLC’s interests were treated like a GP (not stock, not investment K, not securities). Because of the
flexibility of LLCs, we cannot set a brightline rule for when an LLC’s interests will be securities and when they
won’t be: each case must be looked at and analyzed under the Howey test. When LLCs get big enough, we
treat them like securities.
- LP interests can be considered securities. But if the LP is active in management, then under the Howey test,
they may not be securities.

Limited Partnership Interests are generally securities, whereas General Partnership interests are not. LLC interests
may or may not be securities. The interest need only meet one of the following tests to be a security.

(1) If you issue stock, then it is almost a per se rule that it is a security.
(2) Howey Test for Investment Contracts
a. An investment of money…
b. …With other people…
c. …In a common enterprise…
d. …With profits to come solely from the efforts of others.
(3) Check the Reeves Enhanced Family Resemblance Test for Notes (Debt Instruments)
a. Motivation of Seller & Buyer
i. Why is the Buyer loaning the company money? To expand the company generally—
looks like a security. To help the company buy a particular asset—looks like it’s just a
b. Plain of Distribution

i. Is there a broad distribution of the Notes? Distributing them to the general public?
Looks like a security.
ii. Getting a loan from a bank? Less like a security.
c. Expectations of the Investing Public
i. Why is someone loaning the money? Because you expect to get the principle back with
ii. A bank would loan money to get interest and a continuing line of business.
d. Does any of the Regulatory Scheme Protect the Risk Involved?
i. If the notes are covered by another government regulation, then it looks less like a

The Forman Test (Five Most Common Features of Stock):

(1) Right to receive dividends contingent upon an apportionment of profits
(2) Negotiability
(3) Ability to pledged or hypothecated
(4) Voting rights in proportion to the number of shares owned
(5) The ability to appreciate in value

Landreth Rule:
Traditional stock shall always be treated as stock; once it has been shown to be stock and bear the five features of
the Forman test, then it shall not be put through the Howey test.

Subsection (B): The Registration Process

If it’s a security:
- File a registration statement with the SEC (this is very expensive and a big time commitment)
- Try to determine if your securities are exempted (not likely) or if your transaction is exempted (usually smaller
o If you have an exempt transaction, then the person who has the security has to find an exemption
to transfer it again. When you go to sell it to that person, make sure they know the rules.
- You cannot offer securities until the registration statement is filed.
- You cannot sell securities until the registration statement is effective.
- You must give each potential buyer (offeree) the prospectus.

Two Parts of Registration:

- Prospectus (all about the corporation), financing statement, and disclosure of all risk factors, and
- Other information not in the prospectus but disclosed to the SEC.

Doran v. Petroleum Management Corp.: Even where an offering of securities is relatively small and is made
informally to just a few sophisticated investors, it will not be deemed a “private offering” exempt from the
registration requirements of the 1933 Act unless the issuer shows proof that each offeree was furnished, or had
access to, such information about the issuer that a registration statement would have disclosed.
- Doran was investing in an LP.
- There are four factors in considering an exemption under §4(2) for a private offering:
(1) Number of offerees and their relationships to the issuer.
a. This is not the number of ultimate purchasers, but the number to whom the deal was offered.
b. When looking at the relationship, look to the sophistication of the purchaser and availability of
information. This also helps to determine whether the offer was made to “friends and family” or to the
(2) Number of units offered (how many shares). The fewer the shares, the more likely it will be private.
(3) Size of offering: Limited amount / small amount of money makes it more likely to be private
(4) Manner of offering: If it is an ad in the paper, it is more likely public. If it is phone calls, it is more likely

- If you’re selling under a private placement, then there are restrictions on how long those securities must be held
(you cannot sell them for a certain period of time, to enforce that it is to be held for investment purposes and not
for resale).
- In addition to getting the federal exemption, must also get a state exemption for the transaction.
- The danger of a §4(2) exemption is a lack of certainty. It is a vague balancing test.
o The §4(2) exemption should not be the first choice.
o It is an affirmative defense to not registering a security.
o The goal is to allow no registration when the offering is not public, but the same information is
still given to the buyers.
- Regulation D (“Reg D”) Exemption: Generally only exempts the initial sale.
o Safe harbor rules (number of offerors, amount of money, and number of stock)
o Provides that issuers can protect the exemption by using “reasonable care” to make sure the buyers
are planning to hold the stock themselves.
 The should exercise “reasonable inquiry” into the buyer’s plans
 Disclose to the buyers that the stock is unregistered and subject to various resale
restrictions, and
 Print those restrictions directly on the stock.

Note on Securities Act Civil Liabilities:

- Before the 1933 Act, securities fraud was a matter of state law and private party plaintiffs would not have
played an important enforcement role.
- Securities Act § 11: Principal express cause of action directed at fraud committed in connection with the sale of
securities through the use of a registration statement.
- Securities Act § 12(a)(1): Imposes strict liability on sellers of securities for offers or sales in violation of § 5.
The main remedy is rescission.
- § 10(b) requires scienter, but § 11 does not.

Escott v. BarChris Construction Corp.: Due diligence is a defense under § 11 of the Securities Act of 1933 when the
defendant believes after a reasonable investigation, and there are reasonable grounds to believe, that alleged
misstatements are correct and that there are no material omissions.
- If registration has misstatements or is materially misleading, if you signed or expert or underwriter signed, then
you can be liable.
- The company itself has no defense.
- What defense is available to you is based on the portion of the statement and whether you are an expert.
o Expertised section is that prepared by a certified expert.
o Nonexpertised sections are the parts prepared by anyone else who composes the company reports.
Portion of Reg Statement Liability of Parties Result
Non-Expertised Expert § 11(a)(4) Not liable for misstatements
Nonexpert § 11(b)(3)(A) Must show that after reasonable investigation
had reasonable grounds to believe true and
did believe it was true
Expertised (account, valuation) Expert § 11(b)(3)(B) Must show that after reasonable investigation
had reasonable grounds to believe true and
did believe it was true
Nonexpert § 11(b)(3)(C) No reason to believe and did not believe the
statements were misleading.
- Debenture: Debt with a high risk (a bond)
- Underwriter: Investment banking firm. Helps take security to the market by setting the prices. “Shepherding
the securities to market.”
- Court went through each director and investigated whether they were experts or nonexperts and what kind of
experience they had. The house counsel (and director) Birnbaum will be held liable since he didn’t do any
investigation on his own.
- Don’t accept a director position if you cannot handle it: You will be held to the higher standard.

- If you’re an insider, the court is going to think that you knew what was going on.

Integrated Disclosure: Starts with reports that must be filed under the Exchange Act by all publicly-traded
corporations, as well as some large close corporations. Other forms are required:
(1) Form 10: only filed once with respect to a particular class of securities
(2) Form 10-K: audited financing statements of previous year, filed annually
(3) Form 10-Q: for each of the first 3 quarters containing unaudited financial statements
(4) Form 8-K: within 15 days of certain important events affecting operations or financial conditions

Subsection (C): Rule 10b-5:

“It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate
commerce, or of the mails or of any facility of any national securities exchange, (a) to employ any device, scheme,
or artifice to defraud, (b) to make any untrue statement of a material fact or to omit to state a material fact necessary
in order to make the statements made, in light of the circumstances under which they were made, not misleading, or
(c) to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon
any person, in connection with the purchase or sale of any security.”
- Broader than just insider trading. It is applied anytime there is a material misstatement, relied on by anyone
trading in the market.
- If you are an insider, you must “disclose or abstain” from trading on insider information. You cannot state
wrong facts or omit facts.
- Different aspects / test of Rule 10b-5:
(1) Materiality: Factually-based test assessing the magnitude of the event and probability that it will occur.
Materiality will depend on a balancing of both the indicated probability that the event will occur and the
anticipated magnitude of the event in light of the totality of the company activity.
(2) Reliance: Must rely on misstatement, but there is a rebuttable presumption that there has been a fraud on
the market.
(3) Standing: Only if the π has bought or sold securities can the π have a claim under 10b-5.
(4) Scienter: The intent to deceive or manipulate, or “recklessness” to a high degree. How much bad faith you
must have as a company to fall under 10b-5 is the intent to deceive or defraud, or gross negligence.

Basic, inc. v. Levinson: Levinson (Basic stockholder) was upset because if the merger was a good deal, then the
price of the stock he sold earlier would have gone up and he would have made more money.
- Whether a company statement is material, in the context of merger discussions, requires a case-by-case analysis
of the probability that the transaction will occur and the significance of the transaction to the stockholders.
- An investor’s reliance on material, public misrepresentations may be presumed under a fraud-on-the-market
theory for a 10b-5 action.
- Fraud-on-the-Market Theory: People rely on the integrity of the market. The rebuttable presumption of
reliance occurs because of the notion that the market itself relied on the misstatements.
- To rebut the Fraud-on-the-Market Presumption: Petitioners can show:
(1) The “market markers” were privy to the truth
(2) That despite the allegedly fraudulent attempt to manipulate the market, credible news entered the market
and dissipated the effects of the misstatements
(3) π believed the statements were false and sold their shares anyway due to unrelated concerns
- Efficient Capital Market Hypothesis: The market reflects all statements (all available material information).
o Securities prices reflect all available information. New information is absorbed into the market
price so immediately that it is impossible for any trader to earn profits by trading on such information.
o A market is “efficient” with respect to specific information “if prices act as if everyone knows the
information.” The implication is that no amount of diligent research or hard work will enable analysts to
identify undervalued stock.
o Any change in price is a result of new and unforeseen information and the market price is the best
estimate of the securities’ true or fundamental value.
o Three versions of “efficient”:

(1) Weak: Past price information about a security does not enable one to predict the security’s future price
(2) Semi-Strong: (The consensus of the theory): The market price quickly reflects all publicly available
(3) Strong: Even non-public information is reflected in securities prices.
- Materiality Standard: There must be a substantial likelihood that the disclosure of the omitted fact would have
been viewed by the reasonable investor as having significantly altered the total mix of information made
o This is essentially a balancing test: there is a lot of wiggle-room and no bright line.
o The impact of a merger can be big or small, depending on the company (reasonable investor

West v. Prudential Securities, Inc.: A class action may not be brought on behalf of everyone who purchased stock
during a period when a broker was violating securities laws by providing material non-public information. In
Pommer, Hofman (Prudential stockbroker) gave false, material, non-public information to his clients about a non-
existent impending acquisition. A class action was certified on behalf of everyone who bought the stock during the
period the misinformation was given.
- The fraud-on-the-market theory is based on the rationale that public information affects the market; but
Hofman’s information was not public, and there is no equivalent theory that deals with non-public information.
- It is hard to see how Hofman’s non-public statements could have caused changes in the stock.

Pommer v. Medtest: A statement is material when there is a substantial likelihood that the disclosure of the omitted
fact would have been viewed by the reasonable investor as having significantly altered the total mix of information
made available. In Pommer, π claimed he was induced to purchase stock in Medtest as a result of materially false
statments made to him by Medtest’s agents.
- Two Main Issues: (1) K with Abbott Labs and (2) status of patent—there is a big difference between something
being “patentable” and actually getting a patent.
- A materially false statement does not redeem itself just because it happens to come true.

Judicial Limitations on Rule 10b-5 Actions:

(1) Standing: Only purchasers and sellers of a corporation’s securities can bring a 10b-5 suit
(2) Scienter: Proof of a false statement with the intent to deceive, manipulate, or defraud (or a high degree of
(3) Secondary Liability: No implied private right of action against those who aid and abet violations of 10b-5.
This makes it so lawyers and accountants cannot be sued for aiding and abetting; however, now they can be
sued for doing the bad act (primary liability) (Enron). However, it is harder to prove actually doing the bad
act than just aiding or abetting it.

Santa Fe Industries, Inc. v. Green: Before a claim of fraud or breach of fiduciary duty may be maintained under
10(b) or Rule 10b-5, there must first be a showing of manipulation or deception.
- Short-form Merger: Authorizes a corporation that owns some specified percentage of the stock of another
corporation to merge this subsidiary into the parent without a shareholder vote. Can get 100% when Santa Fe
owned 95% of Kirby Lumber by paying cash to the minority shareholders at least 10 days after the merger.
- Santa Fe gave more to the minority shareholders than it believed the stock was worth, in order to avoid a
- Dissenter / appraisal rights: Vote “no” on the merger and then assert the right to get the fair value of the stock.
The minority interest is worth less because the majority is in control.

Option Review & Vocabulary:

- Put: Right to sell a fixed number of shares after a set date for a certain price.
- Call: Right to buy a fixed number of shares after a set date for an agreed price.
- Strike / Exercise Price: The price agreed upon to buy or sell.
- Maturity / Expiration Date: The last date the option may be exercised.

- Naked Put: If you don’t own the stock you’re selling
- Cashless Exercise: You don’t have to buy and sell; you just get the profit.

Deutschman v. Beneficial Corp.: A purchaser of options to buy stock in a corporation may state a § 10(b) claim
against the corporation and its officers for affirmative misrepresentations affecting the market price of the options
whether or not there is any fiduciary relationship between the purchaser and the corporation or its officers. In
Deutschman, π claimed that Beneficial Corp. (Δ) and its officers Caspersen and Halvorsen violated §10(b) when
they made knowingly false statements causing artificial inflation in the market price of options to buy Beneficial
- Court held that π had standing under 10b-5 because he had an option contract.
- Companies do not have fiduciary duties to option holders because the option holders do not have any money
invested in the company.
- Two Ways that Option Contract Holders can be Damaged:
(1) Insiders trading on undisclosed material information can injure option holders by market activity causing
the stock price to move.
(2) Misstating material facts to the public, thereby causing a distortion in the market price.

Ch. 5, Section 4: Inside Information

Goodwin v. Agassiz: When a director personally seeks a shareholder for the purpose of buying her shares without
making disclosure of material facts within the director’s peculiar knowledge and not within the reach of the
shareholder, the transaction will be strictly scrutinized. However, the fiduciary obligations of directors are not so
onerous as to preclude all dealing in the corporation’s stock where there is no evidence of fraud.
- This case was prior to the 1933 and 1934 Acts: before securities laws and during the Great Depression
- The director and general manager of the corporation wanted an option but did not disclose that there was ore on
the land, and the officers bought shares from the shareholders.
- At common law, no fiduciary relationship existed between management and shareholders, so trading was
governed by “caveat emptor” and was legal unless provably fraudulent. Even when a duty was found to exist,
at common-law, it existed only in “face-to-face” dealings, not on the open market.

SEC v. Texas Gulf Sulphur Co.: General rule of insider trading: Disclose information or abstain from trading
(buying or selling!).
- Two main points from SEC v. TGS:
(1) It is unlawful to trade on material inside information until such information has been disclosed to the public
and has had time to become equally available to all investors.
(2) A company press release is considered to have been issued in connection with the purchase or sale of a
security for purposes of imposing liability under the federal securities law, and liability will flow if a
reasonable investor, in the exercise of due care, would have been misled by it.
- The inside information must be material. Insiders can trade if information is not material, or if it is material but
has been disclosed to the public.
o Materiality: Whether a reasonable person would attach importance in determining whether or not
to participate in the transaction.
- The employees bought and sold stocks and options while TGS downplayed a mineral find through a press
release. The company wanted to wait to release the information because it was not a “sure thing” and they
wanted to purchase the land around it without that land’s price going up. If there was information of a strike,
then the surrounding land’s price would increase.
o NOTE: It is Business Judgment whether or not to release information to the public if there are
business reasons to keep it secret, but then the insiders with that information have to refrain from trading
until it has been disclosed!

Argument Against SEC Regulation Arguments For SEC Regulation

(1) corporation could prohibit (government should stay (1) equity, everyone trading on the same playing field.
out) (2) Harm to the corporation itself. Incentives that are
(2) good for the market. If an insider is trading, it different than goals of the corporation. Release

points the market in the true situation of the information prematurely.
corporation. It is a good indicator (no materiality (3) Delay disclosure. Insiders could make money off a
standard). loss (short-selling)—borrow stock, wait for price to fall,
(3) Compensation stake in company—incentive to and then sell it back.
make a successful company. (4) Fraud-on-the-market—harm the markets allocation of
(4) investors would sell to anyone—Is anyone efficiency.
harmed? (5) Harm to individual investors (but general securities
laws are there to protect the marketplace).
(6) Not good compensation—not always an incentive to
work hard. Not necessarily compensating the right person
(if going to give bonuses, give for good reasons).

Chiarella v. U.S. (Note Case): Supreme Court held that the duty to abstain from trading arises from the fiduciary
relationship between the company’s shareholders and its employees. If there the person trading on inside
information is not one of the company’s employees, then no fiduciary duty exists to abstain from trading.

Dirks v. SEC: If a party has a fiduciary duty (e.g., they are an employee of the company), he will be held liable
under insider trading laws for “tipping.” If you are “tipped” information from an insider and you use it to trade, then
you, the “tippee”, can be held liable too if you know or should have known that the insider was breaching his
fiduciary duty by disclosing the information or would somehow benefit from disclosing it.
- Note that if the person giving the insider information does not have a fiduciary duty, then the tippee has no duty
either, and no liability would be imposed.
- Constructive Insider: The theory that a party who would otherwise have no fiduciary duty to abstain from
trading my constructively become an insider with such a duty if the party receives information from someone
who does have a fiduciary duty and is breaching that duty by disclosing the information.
- Rule 10b-5 is not included when you overhear someone say something that makes you want to buy stock:
you’re not a constructive insider if you come across the information by accident.

U.S. v. O’Hagan:
- Misappropriation Theory: A person commits fraud in connection with a securities transaction and thereby
violates § 10(b) and Rule 10b-5 when he misappropriates confidential information for securities trading
purposes in breach of a duty owed to the source of the information.
o Look at the employer and determine if that is from whom the duty is breached. (E.g., O’Hagan
was an attorney of a law firm representing Pilsbury, who bought stock and options on information obtained
through the law firm’s representation.)
- TenderOffer: A purchaser makes an offer (“I will buy…”) to buy outstanding stock under a certain price and
factors. This is a way to get around the company’s Board of Directors, and overtake a company by buying up
shareholders’ stock.
- Rule 14e-3: No one—even people without any fiduciary duty—may trade when they have information on a
pending tender offer because there is a presumption that tender offers are secret. This includes people who
receive information accidentally, by overhearing a conversation (although in that case, it may be tough to prove
how they got the information). This is limited because it is not triggered until the offeror has taken substantial
steps toward making the offer.
- Rule 10(b): Makes it unlawful for any person to use manipulation or deception in the buying or selling of

Rule 10b-5-2:
A person has a duty of trust or confidence for the purposes of the misappropriation theory when:
(1) Someone agrees to maintain information in confidence
(2) The two parties have a pattern or practice of sharing confidences so that the recipient of the information knows
or should know that the speaker expects the recipient to keep the information confidential.
(3) Someone receives or obtains material nonpublic information from a spouse, parent, child or sibling.

Ch. 5, Section 5: Short Swing Profits

§ 16(b) only applies to companies who register the stock under 1934 rules (NYSE or NASDAQ) or to companies of
a certain size (500 shareholders or more and over $10 million in assets). Applies to both stock and convertible debt.

If you are a director, officer, or 10% shareholder, you cannot make a profit within six months of acquiring that

- Directors, officers and 10% shareholders must file SEC report of all the security they own, both immediate and
- They have 10 days at the beginning of each month, or they will be in violation of § 16(b). Companies often
help officers, directors, and friendly 10% shareholders.
- Someone can sue in a derivative action to force the company to force the director, officer or 10% shareholder to
disgorge their profit.

Reliance Electric Co. v. Emerson Electric Co.: When a holder of more than 10% of the stock in a corporation sells
enough shares to reduce its holdings to less than 10%, and then sells the balance of its shares to another buyer within
six months of its original purchase, that holder is not liable to the corporation for the profits made on the second
- This means you can get around § 16(b) if you get your interest lower than 10% and then dispose of the rest of
your shares. This is what you should do.
- Emerson owned 13.2% of Reliance’s stock. It sold enough shares to bring its interest to 9.96%, and then sold
the rest of its shares within a six month period.
- Holding: Only the first sale needs to be disgorged. § 16(b) is about form, not about substance. The number
10% is arbitrary: it doesn’t actually mean you have access to inside information.

Foremost-McKesson, Inc. v. Provident Securities Company: In a purchase-sale sequence, a beneficial owner must
account for profits only if he was a beneficial owner before the purchase.
- The transaction by which a shareholder gets 10% is not a matchable transaction.
- The timing of insider status is the second before you purchase or sell the stock.
o A sale is not within § 16(b) if you don’t hold 10% immediately before the transaction.
o A sale is not within § 16(b) if purchaser becomes a 10% shareholder by virtue of that transaction.

Kern County Land Co. v. Occidental Petroleum Corp.: Neither accrual of the right to exchange recently acquired
shares for shares in the survivor of a merger, nor the granting of an option to buy the shares received in such
exchange, constitutes a “sale” within the meaning of § 16(b), absent any abuse, or potential for abuse, of inside
- This case is in 1973, before the SEC in 1991 set forth the rule below. Tenneco had an option to purchase
Occidental stock.
- Unorthodox transaction: Look to statutory intent. § 16(b) is intended to prevent insider trading. Occidental
wasn’t able to get any insider information because the company they were trying to overtake viewed them as
“the bad guys.”
o § 16(b) is a bright-line test. To argue legislative intent is risky.

Notes on § 16(b):
- Section § 16(b) only applies to companies that register stock under the 1934 Act.
- Officer: an issuer’s president, principal financial officer, principal accounting officer, any VP of the issuer in
charge of a principal business unit, division or function, and any other officer who performs a policy-making
- Deputization: If a firm’s employee serves as director of another firm, § 16(b) may apply to the first firm’s
trades in stock of the second firm.

o Example: Corporation A’s president is Abel. Abel also sits on Corporation B’s Board. Corp. A
owns stock in Corp. B. Since Able is a director acting on behalf of Corp. A, short-swing profit rules will
apply to Corp. A’s trading of Corp. B’s stock.
- Courts consider classes of stock separately under § 16(b). § 16(b) only applies to “equity securities”—
convertible debt, but not other bonds or debentures.
- Shareholders may enforce § 16(b) deriviatively.
- A court must match a defendant’s purchase with its sales: whichever way maximizes what the company can


(1) Bill is CEO of SCLI, a chain of proprietary law schools in southern CA. SCLI stock is registered under the
1934 Act, and 1,000,000 shares are outstanding. On January 1, Bill purchased 200,000 shares of SCLI
common stock for $10/share. Determine his liability, if any, under § 16(b):
a. If he sells all 200,000 shares on May 1 for $50/share.
He is an officer of SCLI, he made a profit within six months of acquiring the stock, so he must disgorge his
profits regardless of whether he’s a 10% shareholder.
Sale proceeds minus purchase price
= (200,000 x $50) – (200,000 x 10)
= 10,000,000 – 2,000,000
= $8 million disgorgement

b. If he sells 110,000 shares on May 1 for $50/share, and the remainder on May 2 at the same price.
Because Bill’s an officer, he’s liable for proceeds of sales that occur even if he isn’t a 10% shareholder at
the time.
Sale proceeds minus purchase price
= [(110,000 x $50) + (90,000 x $50)] – (200,000 x $10)
= (5,500,000 + 4,500,000) – 2,000,000 = 10,000,000 – 2,000,000
= $8 million disgorgement

c. If he sells 110,000 shares on May 1 for $50/share, resigns from SCLI, and sells the remainder on
May 2 at the same price.
Officers are subject to § 16(b) liability if they are an officer when they purchase or when they sell. They
don’t have to hold office for both transactions to be liable. So it’s the same liability as in Problem 1(b).

(2) Renee is a shrewd investor with 200,000 shares of SCLI stock that she has held for several years. She is not an
officer or director of the company. Determine her liability, if any, under § 16(b).
a. If she sells her entire holding of SCLI shares (200,000) on January 1 at $50/share, and buys
110,000 more shares on May 2 at the same price.
Renee was not a beneficial owner at the time she bought 110,000 shares, so there is no 16(b) liability.

b. If she sells her entire portfolio of SCLI shares on January 1 at $50/share, buys 110,000 shares on
May 1 for $10 per share, and 50,000 more shares on May 2 at the same price.
To be liable under § 16(b), must be a beneficial owner at the time of both purchase and sale. Renee was a
10% owner at the time she sold 200,000 shares for $50/share (Transaction 1), and she was a beneficial
owner (as a result of Transaction 2) when she bought 50,000 shares for $10/share (Transaction 3). We
have match a purchase to a sale within a six month period. So she must disgorge the profits of Transaction
3. She sold those 50,000 shares in Transaction 1 for $50 ($2,500,000) and she bought them in Transaction
3 for $10 (costing $500,000), so she must disgorge $2,000,000 in profit (2,500,000 – 500,000).

c. If she sells 110,000 shares on January 1 at $50/share, sells the remainder of her shares (90,000
shares) on January 2 at the same price, and buys 300,000 shares on May 1 for $10/share.
Renee was a 10% shareholder when she sold her stock (Transaction 1). But she was not a 10% shareholder
when she bought either set of stock, so there is no purchase/sale match to be made. No disgorgement.

(3) Bill, still the SCLI CEO, buys 100,000 shares on March 1 at $10/share, 700,000 shares on April 1 at $90/share,
and sells all his shares on May 1 at $30/share. Did he make any money? For what amount, if any, is he liable
under § 16(b)?
Bill doesn’t make money—he’s actually in the hole by $40 million
Sale proceeds minus purchase costs
= (800,000 x 30) – [(100,000 x $10) + (700,000 x $90)]
= $24,000,000 – (1,000,000 + 63,000,000) = $24,000,000 – 64,000,000
= ($40,000,000)

He is liable under § 16(b) anyway, despite not making money.

Match a purchase to a sale: Bought 100,000 for $10/share, Sold them at $30/share
= (100,000 x 30) – (100,000 x 10)
= 3,000,000 – 1,000,000
= $2 million disgorgement

(4) Suppose Renee owns none of the 1,000,000 shares of SCLI stock but has owned, for several years, 5,000
convertible debentures, with a face amount of $1,000 each, for which she paid $1,000 each or $5,000,000 total.
Each of the debentures is convertible into 100 shares of common stock. Suppose that Renee buys 100
additional debentures on March 1 at $800 each. Without converting any debentures, she then sells 100
debentures on April 1 at $900 each. Is she liable under § 16(b)? If so, for how much?
Renee owns debentures that she could convert into 500,000 shares of stock (5,000 debentures convertible to 100
shares each). So she is a beneficial owner and is liable under § 16(b).
Sales proceeds minus purchase cost
= (100 x $900) – (100 x $800)
= $90,000 - $80,000
= $10,000 disgorgement

(5) Suppose there are 1,000,000 shares of class A SCLI stock and 1,000,000 shares of class B SCLI stock. On
March 1, Mary (not an officer or director) buys 110,000 shares of Class A stock at $10/share. On March 2, she
buys 50,000 shares of Class B at $10/share. On April 1, she sells all her stock for $50/share. What is the
amount, if any, of her liability?
Mary becomes a beneficial owner when she buys 110,000 shares of Class A stock. Match purchase and sale
made after she was a beneficial owner:
Sale proceeds minus purchase cost
= (50,000 x $50) – (50,000 x $10)
= 2,500,000 - $500,000 = $2 million disgorgement

Ch. 5, Section 6: Indemnification and Insurance

If a company doesn’t insure you on the job, then you will negotiate for a higher salary to insure yourself. Directors
and officers will require indemnification.

- Most states have detailed statutory provisions covering the authority or obligation of a corporation to indemnify
officers and directors for any damages they might incur in connection with their corporate activities, and for the
expense of defending themselves. In considering these statutes, several points should be noted:
(1) There are several different situations that might give rise to liability:
a. Claims by third persons
b. Injury to the company or its shareholders
(2) The risk of liability may be remote, but the amount of damages can be large in relation to the individual
wealth of the officers and directors and there may be forms of relief other than money damages.
(3) Corporations may be able to buy insurance to cover damages and expenses of defense.
(4) Officers and directors need to be concerned about the possibility that the corporation will be taken over by
people hostile to them.

Waltuch v. Conticommodity Services, Inc.: A corporate director or officer who has been unsuccessful on the merits
or otherwise vindicated from the claims asserted against him is entitled to indemnification from the corporation
against reasonably incurred legal expenses.
- Under 145(c), Delaware courts will not look to why the employee was successful in litigation. It is a bright-line
rule: As long as the employee was in fact successful, for whatever reason, the corporation must indemnify him.
- There were two suits, one personal and one against the company. There must be a good-faith basis to
indemnify in Delaware, and Waltuch didn’t prove a good faith basis at trial level, so he wasn’t reimbursed for
the $2.2 million in legal fees. However, because of the bright-line rule, the court held that as long as Waltuch
was successful in the litigation, regardless of whether there was “good faith,” he had to be indemnified.

Citadel Holding Corp. v. Roven: A corporation may advance reasonable costs in defending a suit to a director even
when the suit is brought by the corporation itself.
- Check the protection offered by the statute of the state for indemnification (costs up front, or reimbursement).
If the statutes don’t provide enough, then indemnification may be negotiated in contract or bylaws.
- § 145(e) said “may” indemnify, but the agreement between Roven and Citadel in this case said that the
company “shall” pay costs in advance. Thus, the costs must be paid up front, but indemnification will be
determined after suit. The agreement was controlling as long as it was not conflicted by state law. (State law
said “may” so it gave permission for a company to do that—if the company chose to make that “may” a “shall”,
that’s the company’s business.)
- § 145(a) – only indemnified if the corporate officer acted on a good faith basis.
- § 145(f) – “catch-all”; however, this does not include bad faith.


Ch. 6, Section 1: Proxy Fights


- Usually there is a notice period to call meetings where shareholders can vote (this is one of their only rights, so
we want to make sure they have the opportunity to exercise it) to elect directors and vote on other matters.
However, usually few shareholders attend.
o For small closely-held companies, state codes allow “unanimous written consent” and thereby
avoid the annual meeting.
- Record Date: The date on which a shareholder must own shares to be entitled to a right to vote. If you sell your
stock after the record date, you still have a right to vote. But if you buy your stock after the record date, you
don’t have the right to vote.
- Proxy Relationship: The stockholder is the principal giving the right to vote on their behalf to the proxy (their
agent). NOTE: Directors cannot give someone else their right to vote. Generally the proxy is revocable at the
discretion of the shareholder.
- Transfer Agent: Company hired to monitor and manage the proxy and voting process so that the company itself
doesn’t have to keep track of all the paperwork. In the event that proxies have not come back to indicate there’s
a quorum and it doesn’t seem likely that there will be a quorum, then these Transfer Companies can resolicit the
- Proxy Fights: Result when an insurgent group tries to oust incumbent managers by soliciting proxy cards and
electing its own representatives to the board
o Two reasons for proxy fights: (1) Shareholder proposals, and (2) Contest for corporate control
(directors are seen as not doing a good job)
- Institutional Investors: Will vote management or sell their shares…special rules set by the SEC for
communications (SEC does not have to preview your statement)
- Cumulative Voting: Allow for the possibility of minority shareholders to elect someone to the board. The
default is straight voting.

Subsection A: Strategic Use of Proxies

Levin v. Metro-Goldwyn-Mayer, Inc.: Incumbent directors may use corporate funds and resources in a proxy
solicitation contest if the sums are not excessive and the shareholders are fully informed.
- Incumbents should not have to shoulder the financial burden if someone decides to challenge them.
- The costs of proxies go to the firm as well. No one would be a director if they had to pay themselves.
- These costs go back to the shareholders in the form of higher stock prices.
- The prices must be reasonable, but anything that isn’t completely unrealistic will be reasonable.
- Insurgents pay their own costs unless they win or the shareholders ratify payment.

Subsection B: Reimbursement of Costs

Rosenfeld v. Fairchild Engine & Airplane Corp.: In a contest over policy, directors have the right to make
reasonable and proper expenditures from the corporate treasury for the purpose of persuading the shareholders of the
correctness of their positions and soliciting their support for policies that the directors believe, in good faith, are in
the best interests of the corporation.
- This was a shareholder derivative suit to return the costs used in a proxy fight.
- For the insurgent to get reimbursed, they must win.
(1) Dispute Must Relate to Policy: to get costs back for the insurgents or the incumbents. Never going to be
about personality issues; always going to be about policy issues.
(2) Reasonable & Proper Expenses: Only reasonable and proper expenses will be reimbursed. You cannot
commit waste.
(3) Incumbents: The firm can reimburse incumbents whether they win or lose. Incumbents shouldn’t have to
pay more because their positions are contested. If an insurgent wins, the new party still pays the former-
incumbent, (1) for good public relations and (2) because the insurgent would want to be paid if it they get
challenged by another insurgent.
(4) Insurgents are only going to get reimbursed if they win AND the shareholders ratify the reimbursement.
There is no incentive to pay insurgents or your company will always have struggles if insurgents know their
fight will be reimbursed by the company.

Notes on the Regulation of Proxy Fights:

- Section 14(a) of the 1934 Act prohibits people from soliciting proxies in violation of SEC rules.
o Courts construe the concept of “solicitation” broadly.
o Rules 14a-3, 14a-4, 14a-5, and 14a-11 require people who solicit proxies to furnish each
shareholder with a “proxy statement.”
o When an insurgent group wants to contest management and solicit proxies, the management has
the choice: (1) mail the insurgent group’s material and charge the insurgent group for the cost, or (2) give a
copy of the shareholder list to the group and allow them to mail their own.
- Proxy fights are not economically smart.

Subsection C: Private Actions for Proxy Rule Violations

J.I. Case Co. v. Borak: Where a federal securities act has been violated, but no private right of action is specifically
authorized or prohibited, a private civil action will lie and the court is free to fashion an appropriate remedy.
- Court held that the SEA authorizes a federal cause for rescission or damages to a stockholder when a merger
was authorized pursuant to a proxy statement alleged to contain false and misleading statements violative of the
- The purpose of 14(a) is to prevent management or others from obtaining authorization for corporate action
through false or misleading proxy solicitations.
- Because SEC cannot probe the accuracy of every proxy statement submitted for registration, a private right of
action for wronged shareholders must be provided.
- If we allow only declaratory relief in federal court, and force shareholders to seek all other remedies in state
court, then a shareholder might get declaratory relief and find out his state doesn’t view the defendant’s acts as
unlawful, and then the shareholder would be out of luck.

Mills v. Electric Auto-Lite Co.: Where a trial court makes a finding that a proxy solicitation contains a materially
false or misleading statement under SEC 14(a), a stockholder seeking to establish a cause of action under such
finding does not have to further prove that his reliance on the contents of the defects in the proxy solicitation caused
him to vote for proposed transactions that later proved unfair to his interests in the corporation.
- Once it has been established that the false or misleading information was material (that it had a significant
propensity to affect the voting process), then the shareholder does not need to show that the particular defect in
the proxy solicitation had a decisive effect on voting, but only that it was false or misleading in violation of
- Note that the vote at issue must have been needed (if you’re just sending out a proxy statement because you’re
trying to keep people informed, but there was no vote needed, then there is not a cause of action)
- Whether the merger was fair has no bearing on establishing a cause of action under 14(a), because the purpose
of 14(a) was to promote free exercise of shareholder voting through truthful proxy solicitations.
- Remedies: Prospective relief, but may also include retrospective relief (setting aside the merger or granting
equitable relief with fairness of the merger as a contributing factor)

Seinfeld v. Bartz: Valuations of option grants to outside directors are not material information which must be
included in a corporation’s shareholder statement to solicit proxy votes.
- An option depends, among other things, on the value of the underlying asset at the time the option is exercised,
and there are different ways for the formula to be set forth. Nothing requires that Cisco calculate the value of
the options at the time of grant.
- Seinfeld showed no substantial likelihood that the disclosure of the option grants’ valuation would have been
viewed by the reasonable investor as having significantly altered the “total mix” of information.

Subsection D: Shareholder Proposals

If I have complied with the procedural requirements, on what other bases may a company rely to exclude my
(1) Improper under state law
(2) Violation of law
(3) Violation of proxy rules
(4) Personal grievance / special interest
(5) Relevance
(6) Absence of power / authority
(7) Management functions
(8) Relates to election
(9) Conflict with company’s proposal
(10) Substantially implemented: if already done, you don’t do it again
(11) Duplication
(12) Resubmission: so you can’t keep brining it up each year
(13) Specific amount of dividends

Why do we have shareholder proposals?
(1) Remove poison pill plans (shareholder rights plans). These plans allow management to entrench
themselves and make it tough to take over the company.
(2) Require annual election of directors, as opposed to staggered (or classified) board, which is elected in
three groups, one group elected each year. If you have a staggered board, it makes it tougher to take
over the company.
(3) Secret balloting in director meetings. Relieves peer pressure, and increase the appearance of individual
thought with less influence from other directors.
(4) Require directors to hold a certain percentage of the company’s shares. Gives directors the same type
of interest as shareholders. Sometimes, depending on circumstance, the directors’ shareholding might
encourage them to do something that may not have a shared interest with other shareholders.
(5) Adopt cumulative voting. This allows for minority shareholders to have a possibility of representation
on the Board.
(6) Break up power structure. Prevent having the CEO be the chair of the Board.
(7) Prohibit green-mail: The corporation buys someone off who was trying to take over the company.
Corporate funds shouldn’t be spent preventing takeover; maybe the company would benefit from a
takeover if current management is not doing as well as the insurgent.
(8) Independence: Require a majority of the board or key committee members be outside (independent)
members. Trying to insure there’s not an inherent conflict among insiders who also sit on the Board.
Eg., a compensation committee should be made up of independent directors, otherwise there will be a
conflict of interest.
(9) Effective Choice: Allow a ballot with more candidates than spots, rather than having nominated
directors get in.
(10) Perform for Pay: Link director pay to corporate performance. Incentivize directors to do what’s best
for the corporation.
(11) Role of advising for shareholders (create a committee). Shareholders should always have the
opportunity to bring proposals, even if they won’t pass.

Shareholder proposals usually ask for:

(1) Forming a committee
(2) Making recommendations
(3) Doing investigations
(4) By law amendments are typically allowable areas for shareholder proposals

Lovenheim v. Iroquois Brands, Ltd.: Shareholders can only form committees and advice, they can’t tell the
company to change things. Ordinary business decisions are the types of things that shareholders cannot put
proposals on.
- Rule 14a-8(i)(5) Exception: Can omit a proposal and any statement from its proxy statement if (1) the proposal
relates to operations which account for less than 5% of the issuer’s total assets at the end of its most recent
fiscal year and less than 5% of its net earnings and gross sales for its most recent fiscal year; AND (2) is not
otherwise significantly related to the issuer’s business.
- In Lovenheim, π wanted a proxy statement included to request a study on the inhuman treatment of geese to get
pate. The company doesn’t want to publish that because it could cause bad publicity.
- SEC “no action” letters: You can send a letter to the SEC telling them why you are excluding the proxy
statement and they will send a letter back saying, “We agree…the SEC will not sue you for excluding the
proposal,” or “We disagree and you must include it.” If you don’t like what the staff says, then you can appeal
to the commission, and then to the D.C. Court of Appeals. The shareholder will seek a federal injunction to
enjoin the company from not including their proposal.

The NY City Employees’ Retirement Sys. v. Dole Food Co., Inc.: Corporations may omit shareholder proposals
from proxy materials only if the proposal falls within an exception from Rule 14(a) – 8(c).
- Three exceptions to including the proposal:

(1) Ordinary business operations [14a-8(i)(7)]: Must make the proposal deal with social issues. The proposal
must be included, even if it relates to ordinary business matters, if it involves a decision that will
significantly affect the corporation’s manner of conducting its business.
(2) Insignificant relationship [14a-8(i)(5)]: The “5% Rule”
(3) Power to effectuate: The company can argue that they do not have the power to make the change requested
by the shareholder. Stockholders should only ask for research or committee.
- In NYCERS, π was asking for a committee to look at the health care plan. After trying all three of the above
exceptions, the company was required to include the proposal.

Austin v. Consolidated Edison Company of NY, Inc.: In attempting to exclude a shareholder proposal from its
proxy materials, the BOP is on the corporation to demonstrate whether the proposal relates to the ordinary business
operations of the company.
- In Austin, π wanted to include a proposal of pension amendment and Δ argued that the proposal was dealing
with the conduct of ordinary business and won under 14a-8(i)(7).
- This proposal would likely fail also because it was a personal claim or grievance and the SEC issued a no-action
letter. While the SEC is not the final arbiter, they have a good idea of the rules and their interpretations.
Companies usually present multiple reasons why they can exclude a proposal.

Note on Social Issue Proposals and the Ordinary Business Exception:

- Cracker Barrel held that all employment related proposals can be excluded on the ordinary business exception.
The SEC in 1998 overruled Cracker Barrel and said that employment related matters under social policy will be
dealt with on a case-by-case basis.
- Stockholders have the right to bring proposals because they are the owners of the company with a vested
interest in the company and they have the rights and desires to manage parts of the company. We let
stockholders be a part of the process by bringing proposals—the right to be heard
- If there is a personal benefit (not a universal issue), then the court will exclude the proposal.

Subsection E: Shareholder Inspection Rights

During a proxy fight the incumbents can either send out the information on behalf of the insurgents or give the
insurgents a copy of the shareholder lists.
- The incumbents will want to keep the list confidential so they will mail out the information for the insurgents.
- Look at state law. § 14 only affects 1934 companies. Demand for a shareholder list must be reasonable and for
a legitimate business purpose.

Crane Co. v. Anaconda Co.: A shareholder wishing to inform others regarding a pending tender offer should be
permitted access to the company’s shareholder list unless it is sought for an objective adverse to the company or its
- Tender offer: Saying that you will buy shares at a certain price under certain circumstances—one way to gain
control of a company.
- The pendency of a tender offer necessarily relates to the business of the corporation and to the safeguarding of
the shareholders’ investment, so the shareholders should be allowed to be informed about that.
- When you don’t own stock, you have no right to inspect documents
- Internal affairs doctrine: Normally, you apply the law of the state where the company was incorporated, but
New York has said that shareholder lists are an exception to this doctrine. NY is very pro-shareholder in some
ways: by bringing the suit in NY you get some rights under NY Corporate Law.

State ex rel Pillsbury v. Honeywell: In order for a stockholder to inspect shareholder lists and corporate records, the
stockholder must demonstrate a proper purpose relating to an economic interest. In Pillsbury, Pillsbury bought 100
shares of Honeywell for the sole purpose of trying to stop Honeywell’s involvement in Vietnam, and Pillsbury asked
for the shareholder list.
- There must be a bona fide interest to inspect the shareholder list. Morality is not a proper purpose, but a tender
offer is.

- “To inspect is to destroy.” The proper purpose in Pillsbury might have been to stop making the munitions
because it was an unpopular war and the stock might go down or the company could have boycotts.
- New York: If you’re a “qualified shareholder,” you get access to the list and lots of records. The company has
the BOP to show that there is an improper purpose.
- Delaware Proper Purpose Test: If requesting a shareholder list, requestor must have a proper purpose. Don’t
have to be a “qualified shareholder,” but do have to show proper purpose, and probably won’t get access to
much more than the list. The company has the BOP to show that the shareholder doesn’t have a proper purpose
and the shareholder has the BOP to get other documents by showing a proper purpose.
- In the exam, discuss both Delaware and New York views if the state has not yet made a decision.
- Shareholder lists are treated differently because they are already produced.

Sadler v. NCR Corp.: A state may require a foreign corporation with substantial ties to its forum to provide resident
shareholders access to its shareholder list and to compile a NOBO list, in a situation where the shareholder could not
obtain such documents in the company’s own state of incorporation.
- CEDE: Identifies brokerage firms and other record owners who bought shares in a street names for their
customers and who have placed those shares in the custody of depository firms such as Depository Trust Co.
- NOBO (non-objecting beneficial owners): Shareholders are generally on the NOBO list unless they request to
be taken off.
- AT&T wanted to take over NCR but didn’t have 5%, so they asked the Sadlers who had 6,000 shares and were
owners for over six months (need to be either >5% shares or 6 month owners) to request the lists. This court
said this was okay. The NY rule is that qualified shareholders (5% or 6 months) can get the list unless there is
an improper purpose.

Problems, Pages 590-591

(1) Tender offer is a proper purpose to request a shareholder list. Instead of using it for their own
commercial purposes, they instead use it for a tender offer, and that is fine.
(2) Stock splits are a proper purpose because it relates to the investment. A shareholder may want a stock
split because it increases the available pool of stockholders. $100 is a good rule of thumb as a price
point for individual shares of stock; more than that usually seems “too expensive.”
(3) If they want to have the list in order to carry out their tender offer, that is okay again.
(4) Goes back to the Honeywell idea…the rumors that they’re discriminating…this goes back to how you
articulate your request. If your only concern is that it’s immoral, then it is not a proper purpose. If
they instead show that it’s not a financially good thing because of possible boycott, then that is a
proper purpose. It’s all in how you draft the document.

- We’ve talked primarily about shareholder lists, but they also have rights to other company books and records.
- Look first to state statute. Shareholder lists, articles of incorporation, bylaws, etc. are accessible, as are meeting
minutes and materials relating to governance of the company.
- You may have access to other information, and if the company is concerned about your use thereof, the
company can go to court and request limits on your access to the material.
- In addition, you can be required to sign a confidentiality agreement.

Ch. 6, Section 2: Shareholder Voting Control

Shareholders have the right to vote for the election of directors and on certain “fundamental matters” according to

Common Matters for Stockholder Voting

(1) Merger
(2) Amendment to the Articles of Incorporation
(3) Sale of substantially all of the corporate assets
(4) Liquidation

Stroh v. Blackhawk Holding Corp.: A corporation may prescribe whatever restrictions or limitations it deems
necessary in regard to the issuance of stock, provided that it not limit or negate the voting power of any share.
- Class B stock was created, but they were not entitled to dividends, so π argued that they weren’t really “shares”
because they didn’t have economic value.
- You do not have to give dividends for it to be a stock. Now we give non-voting stock, but this time this was
prohibited. You might get “preferred stock,” which could allow you to turn your dividends into a voting right.
- You can also have stock with more than one type of voting right—super size voting. This allows original
shareholder to maintain control and the shareholder would agree because it’s a good deal. Most investors are
rational, believe in management.
- SEC tried to stop “super-size voting,” but it was not passed. Still, most companies do one share = one vote.

- Straight Voting: The majority wins (default rule)

- Cumulative Voting: Used to protect minority shareholders (this used to be the default, but now is not). Instead
of the majority vote winning, you are able to allocate your vote, so the minority shareholders can elect a
candidate of their own. Under cumulative voting, all positions are voted upon at once, and each shareholder
may concentrate his or her voting rights by casting all her votes for one or more candidates. But most corporate
managements tend to be hostile to cumulative voting, so where it is mandatory, they decrease the number of
directors, it is harder for the minority shareholder to get control. Mathematically it increases the percentage that
a dissident shareholder must own to be assured board representation.
- # of shares required to elect a director > or = the # of shares able to vote divided by the # of directors +1
o This is the minimum number of shares you have to have to elect someone to the board.
o The # of shares multiply with the number of board seats to get votes you have. VOTES

Why would you want to restrict concentrated voting power?

 The company managers may not want the ability of a minority group of individuals to take over the company.

The major exchanges have a rule now (the SEC tried to make the rule and failed) that one-share-one-vote is how it
works. There are also rules saying you can’t change the rights of your stockholders midstream. That doesn’t mean
that you don’t have different classes of stock that allow certain shareholders to control the company, though.

State of Wisconsin Investment Board v. Peerless Systems Corp.:

- A shareholder need not attend a shareholders’ meeting and record an objection in order to challenge the
propriety of the vote.
- Where the primary purpose of an adjustment of a shareholders’ meeting is to ensure passage of a proposal by
interfering with the shareholder vote, corporate directors breach their fiduciary duty of loyalty.
- Peerless had 4 outside directors and 1 inside. Proposal 2 was objected by SWIB so Peerless adjourned the
meeting for 30 days (“to get more voters”) but then Proposal 2 passed on the 2d vote because Peerless solicited
votes in the interim.
- The court held that SWIB had standing to challenge even though they weren’t at the meeting, because the whole
point of proxy is that you don’t have to go to the meeting, and SWIB was owed a duty.
Blasius Standard of Review:
- π must establish that the Board acted with the primary purpose of thwarting the shareholder right to vote
- Then the Board must show a compelling justification for their actions.
- If the π cannot establish that the Board’s primary purpose was to thwart shareholder rights, then the BJR
- Delaware is concerned about protecting shareholder right to vote—takes a diminished view of anything that
infringes on that right. This is the highest standard for the Board to meet. If the action taken by the Board
impacts the shareholders’ franchise, they “better be careful”—the Blasius Standard applies
- Main points: voting process, adjournment process (adequate notice of adjournment), and Blasius standard

- Cumulative voting is used only for the election of directors.

- All directors are elected in one “swoop” and you accumulate your vote.
- In Indiana the default rule is straight voting and you must put cumulative voting in your articles of incorporation
if you want to use that.
- Companies can take steps to prevent minority representation or decrease minority shareholders’ ability to get
representation. They do that by reducing the number of directors to be elected each year, either by reducing the
size of the board or by having staggered elections.

# of shares able to vote = 100 shares to vote
# of directors = 6 directors
Shareholder A = 60 shares
Shareholder B = 40 shares
Under straight voting, A could always control. Under cumulative voting, B can elect someone to the board
- Formula: # of shares required to elect director = (# of shares outstanding / # of directors elected plus 1)
# shares to elect = 100 / (6+1) = 100 / 7 = 14.28 = (round up) 15
- Formula for number of votes: number of shares needed to elect x number of directors
15 x 6 = 90
- A has 360 votes (60 shares time 6 seats to elect). B has 240 votes (40 shares times 6 seats to elect).
- Now if B used 90 of his votes to elect himself to the board, he’s left with 150 votes. So he can control one more
seat. (You can see this too by looking at the number of votes necessary to elect a director, which is 15, and the
number of votes B has, which is 40, and you can see that 40 divided by 15 is 2 with some extra.)
- A has 360 votes, so he could use 90 votes four times to control four seats.
- A could be an idiot, though, and use all of his shares to control just one seat. Let’s say he does that, and B uses
90 votes to control two seats, and then uses 20 seats to control the other three seats. But that wouldn’t happen
in real life because A’s attorneys would be committing malpractice.

Ch. 6, Section 3: Control in Closely Held Corporations

Ringling Bros. v. Ringling: A group of shareholders may lawfully contract to vote in any manner they determine.
Vote pooling agreements, then, are valid—but you must be careful about your language.
- Generally, a shareholder may exercise wide liberality of judgment in the matter of voting, and it is not
objectionable that his motives may be for personal profit, as long as she violates no duty owed to fellow
- Edith has 2205 votes (315 x 7), Aubrey has 2205, and North has 2590 (370 x 7). If Edith and Aubrey work
together, they can elect five of the officers and North would elect two. So Edith and Aubrey make an
agreement on how to vote, but Aubrey doesn’t vote per the agreement.
- The agreement was held as valid, but the enforcement mechanism was a problem.

Note on Shareholder Agreements, Voting Trusts, Statutory Close Corporations and Involuntary Dissolution: Other
Ways to Control the Voting Process:
(1) Vote Pooling: Provide referee, but give the referee irrevocable proxy (more than in Ringling). This
gives us an enforcement mechanism. You keep your right in the stock, but you agree to vote a certain
way. Since you can shut out other voters, courts don’t like them as much and will only enforce them
on their terms.
(2) Create Classes of Stock: Must amend articles of incorporation. Understand that if the Board creates
new classes of stock, your vote will be diluted. Only works as long as a class member is there to vote.
Preferred stock has no voting rights, but might have preferred liquidation rights over common stock.
a. E.g., Father = Class A with voting rights. Kids = Class B with no voting rights. Father controls.
If he is the only one and he becomes disabled or dies there is a problem. We would need a
b. S-Corps cannot have different classes of stock; therefore, some go to LLC because there are no
limits on classes of stock.

(3) Have Specific Board Members Elected by Certain Classes of Stock: Remember, directors are
independent, so you cannot control them once they are on the Board; you can only vote them off.
Sometimes this is referred to as “classified board.”
a. E.g., You have six directors on a board and two classes of stock, one with four seats on the board
and one with two. That way, if you’ve got a group that wants to maintain control over the
company, they can control four seats, and the other class can control two seats.
(4) Voting Trust: A voting trust is an agreement establishing a trust, whereby shareholders transfer their
legal title to their shares to a trustee who is then authorized to exercise their voting powers. Trustee
has fiduciary duty to do what is best on behalf of the beneficial owners, who retain the equity in the
stock and continue to receive the dividends from the stock. 10-year limit, usually. Must file
something to alert incoming shareholders that there is a voting block in place. Unenforceable if you
don’t comply with statutory requirements. If you put your stock in a voting trust, then who is the one
with the right to inspect the books? Is it the beneficial owner or the trustee? This can be a problem.
(5) Irrevocable Proxy: Proxy must be coupled with an interest; someone must retain an interest in the
stock. Courts are very reluctant to enforce against a stockholder because any vote could change at the
last minute. Therefore a proxy vote by default should be revocable. Only transfer your right to vote in
a given vote.

Close Corp. vs. Closely-Held Corp.

- A closely-held corp. means simply that there are not very many shareholders (35 or less, or only a couple of
families. A close corp. is one in which the stock is held in a few hands, or in a few families, and wherein it is
not at all, or only rarely, dealt in by buying or selling.
- A statutory close corp. means that you have agreed that you want to be treated as a close corp. under state
- The statute allows you to bypass corporate structure and shareholders can run the corporation.
- States allow them because all that structure is a paperwork formality and this allows the corporation to run as it
actually happens.
- If you don’t elect this status, you will have to do corporate formalities (which can be a problem with piercing)
- Unless Huss specifies statutorily close corporation, assume they are closely-held. If statutory close corporation
and regular corporation did the same bad thing, the regulated corp. will be in bigger trouble.

Galler v. Galler: Shareholders in a closely-held corporation are free to contract regarding the management of the
corporation absent the presence of an objecting minority, and threat of public injury. In Galler, there was an
agreement to elect each other to the board, which was okay because it was signed by all of the shareholders and no
one was objecting to that system.
- A shareholder does not have the right to be an employee. You can contract for rights, but they aren’t just
assumed. Statutory corporate codes are drafted for people to contract away any rights they have; the courts
aren’t going to protect stupid parties.
- If the vote is unanimous or no one is objecting, for closely-held corporations, then the shareholder agreement
will be upheld for the appointment of individuals as officers or directors, or dividends, as long as they can make
the argument that it is in the best interests of the corporation.
- You can get rid of your shareholder right to vote (voting trust, irrevocable proxy)
- The problem is the independent duties as a director with the obligations of duty of care. As long as a director
with a duty isn’t being told what to do, you can agree who to vote onto the board.

Ramos v. Estrada: Voting agreements binding individual shareholders to vote in concurrence with the majority
constitute valid contracts. The state wants to protect the contract and the intent of the parties.
- The court held Estrada to the shareholder voting agreement (not a proxy situation). Even though the price was
low, it was still a valid agreement. Mrs. Estrada switched sides because she was told that she would be
secretary. As her attorney, tell her she is out of luck and to honor the agreement.
- To have voting agreements in larger corporations is unrealistic, but still possible, if a majority of the
shareholders sign the agreement. You cannot agree how you will vote when you are a director, but if the group
who voted you on doesn’t like your decision, they will vote you out of office. But in pooling agreement, make
sure it sates that you are only controlling the vote, as opposed to the director’s decision.

Why do courts allow this control over closely-held companies?
- How do you get money out of a closely-held company, usually? Be an employee (get a salary), get dividends,
and selling stock.
- There is not a wide market for closely-held company stock.
- Part of the reason for protecting minority shareholders is that there is no wide market for these shares. In public
companies, if a minority is unhappy with his shares, he can sell it because there’s a market for it.
- In an S-Corp, it’s a closely-held company where you get the profits after the business pays the taxes. S-Corps
have “pass through” taxation. The profits go into your individual name, and you pay taxes on them as an
- In a C-Corp, you have people getting salaries, which is deductible to the corporation, but the money is double-
taxed (once at the corporate level and again at the individual salary level).

Ch. 6, Section 4: Abuse of Control

The Wilkes line of cases shows us that if you want to protect yourself as a minority shareholder in a closely-held
company, you should contract for that protection.

Wilkes v. Springside Nursing Home, Inc.: In a closely-held corporation, the majority stockholders have a duty to
deal with the minority in accordance with a good faith standard. Under certain circumstances, you can get in trouble
if you treat a minority shareholder badly; but there is no bright-line rule as to how badly you must treat them.
- (1) Strict Good Faith: If a state follows the Wilkes line of cases, then shareholders in close corporations owe
each other a duty of strict good faith. This is a lesser standard than partnerships, where the Cardozo reasoning
says partners owe each other the “utmost loyalty.”
o Also, whereas every partner in a partnership has an equal right to manage, a shareholder has no
right to participate in the business.
- (2) Legitimate Business Purpose: If an action or behavior is challenged by a minority shareholder, the
acting/controlling group has to show there is a legitimate business reason for the action.
- (3) Burden Shifting: Even if the controlling group shows a legitimate business objective the π minority
shareholder can still prevail if he can show that the controlling group could have achieved the legitimate
business objective in a manner that harmed his interest less.
- The complication is that not all states follow this test. Plus, lawyers can usually come up with legitimate
business objectives for whatever they want to do. Do you think that Quinn wasn’t down at the coffee shop bad-
mouthing Wilkes? Clients aren’t always sophisticated enough to know they shouldn’t say something that
indicates a true intent of “freezing out” a minority shareholder rather than a legitimate business reason.

Freeze-Out Factors:
(1) Dividends: Has the company in the past always given out a $10,000 dividend every quarter, and all of a
sudden, the dividends just stop?
(2) Employment/Compensation: If all of a sudden we don’t need you anymore when we’ve always needed you
in the past, the expectation of continued employment will be an issue.
(3) Buy-Out Under the FMV: Is there a sudden offer to purchase shares at less than a fair price? That seems
to indicate acting not in good faith.
(4) Control/Access to Information [not given in class; got from old outline]
Ingle v. Glamore Motor Sales, Inc.: A minority shareholder in a closely-held corporation, who is also employed by
the corporation, is not afforded a fiduciary duty on the part of the majority against the termination of his
- Ingle tried to argue that he was not a shareholder, but that he was a co-owner, and that he had stock as an
incentive so he would benefit by making the business grow. Ingle was fired because Glamore’s sons were
getting involved in the business, and since Ingle was an employee-at-will, this is okay. The stock agreement
had a buy-back provision that said if he “ceased to be an employee for any reason” he had to sell his stock.
When you sign an agreement, you’re stuck with it!
- This is a New York case. In NY when you sign an agreement, the court will not look outside that agreement
and you will be bound by it.

Sugarman v. Sugarman: Shareholders in a close corporation owe each other a fiduciary duty of utmost good faith
and loyalty.
- Freeze-Outs: Bad faith on the part of the majority or controlling shareholder. A situation where the majority
shareholder prevents the minority shareholder from receiving any monetary benefit from their investment in the
corporation in an attempt to force the minority to sell their shares to the majority. If you are going to freeze out
a minority shareholder, you must have a legitimate business purpose. Don’t offer to buy the shares at less than
fair market value.
o Not sufficient for minority to prove that the majority took excessive payments
o Not sufficient for minority to allege majority offered to buy stock at inadequate prices
o Freeze-outs are a direct cause of action, not derivative. You are arguing that the company is doing
something to you personally. The minority shareholder of a close corporation does not have to

sell their shares before they can bring a claim for damages if they can show that a below FMV
offer was to freeze them out.

Smith v. Atlantic Properties, Inc.: Stockholders in a close corporation owe one another the same fiduciary duty in
the operation of the enterprise that partners owe to one another.
- When a company of four parties, each holding equal shares, decided that any decision would require 80% to
pass, that made any one party a controlling shareholder (because that one party could hold out and refuse to vote
for anything, and the others wouldn’t be able to pass any decision without the fourth).
- The Court held that when one of the four shareholders refused to vote for any dividends and caused the
company to incur penalty taxes, that was violating his fiduciary duty to the other shareholders.

It’s Policy Time, Boys & Girls!

Delaware vs. Massachusetts Viewpoints on Minority Shareholder Protection

- Supports the freedom of contract in that we don’t want to stick people with the “default” rule unless they
specifically want that.
- We’re not sure how we’re going to treat people in LLCs; [I don’t understand this argument]
- This is special stock requiring extra research and money to acquire, thus implying some level of monetary
ability or sophistication on the part of the shareholder that should have allowed them to figure out what
protection they wanted
- Courts don’t want to get involved where they don’t have to; they want the people to take on the responsibility of
taking care of their own interests rather than relying on the court to save them

- Efficiency. By allowing for common law to protect minority shareholders in this way, it is saving the
shareholders the time and expense of doing that themselves, when they clearly intend that to be the situation.
- Power Issue. Potential minority shareholders may not have the ability to demand this protection unless it is
provided for them.
- If we can’t show breach of fiduciary duty, we can use a direct case, allowing for individual damages instead of
only derivative cases. Derivative cases don’t usually go to trial because of the related procedural issues; direct
cases are more likely to get to issues.
- Unlike in publicly traded companies, there’s not a way to easily exit this company if you’re unhappy with the
way it’s going.

Jordan v. Duff & Phelps, Inc.: Close corporations buying their own stock have a fiduciary duty to disclose material
facts. There was an agreement that after termination, the company gets to buy stock. Jordan stayed until the end of
the year to get a better deal, but didn’t know about a potential merger that would have given him 20-30% more
money and he thinks the company should have told him of the merger.
- Easterbrook says the disclose or abstain rule should apply any time a shareholder could have responded to the
information. Jordan could have stayed in employment if he would have known about the information. But the
BOP is on Jordan to prove not only that he would have stayed, but he would have stayed based on the
- Even with at-will employment, if the intent is to squeeze him out for bad faith reasons (in a Wilkes following
state) then he still has a cause of action.
- The value used was “book value” in the agreement. Usually lower and easier to decide.
- Posner’s strong dissent is based on the fact that D&P could have fired Jordan and he would then not be able to
use this information. Disclose or abstain should only apply when the shareholder can use the information. The
terms of the agreement did not create any employment rights for Jordan (they can fire him and just because they
let him stay on til the end of the year doesn’t mean they should be penalized)

Ch. 6, Section 5: Control, Duration and Statutory Dissolution

- Each state statute provides for dissolution differently. Some provide special rules for a close corporation or a
statutory close corporation. If the shareholders don’t provide in advance for buy-out the outcome is usually not
good for them. General rule is that corporations last forever until dissolved.
- Three ways to dissolve:
(1) Shareholders agree
(2) Secretary of State can administratively dissolve
(3) Courts can order dissolution (Model Business Corp. Act § 14.30. Grounds for Judicial Dissolution)
a. Deadlock
b. Illegal, oppressive conduct
c. Waste of corporate assets
d. Just not buying back your shares is not enough for the court to order dissolution.

Alaska Plastics, Inc. v. Coppock: Majority shareholders in a closely held corporation owe a fiduciary duty of utmost
good faith and loyalty to minority shareholders.
- Two of the three directors left out one of the directors from notification of meeting and voting.
- Four ways a dissatisfied shareholder can get FMV for shares:
(1) Provision in articles of incorporation
(2) Involuntary dissolution by the court
(3) May demand statutory right of appraisal
(4) Equitable remedy when there is a breach of fiduciary duty

Pedro v. Pedro: Shareholders in closely held corporations owe one another fiduciary duty to deal “openly, honestly
and fairly with other shareholders.”
- Alfred, Carl and Eugene each owned 1/3 of company. A discovered money missing and C and E pushed him
out of the company.
- Court found that A was entitled to lifetime employment. The valuation was 75% of book value, but since he
was entitled to lifetime employment and there was bad faith, he received more than that.

Stuparich v. Harbor Furniture Mfg., Inc.: Statutory dissolution of a close corporation is not reasonably necessary for
shareholder protection on the grounds of animosity among the corporate directors.
- Malcolm Jr. got extra shares of the company that the sisters thought they had. The sisters wanted to sell out
their shares, but Malcolm Jr. refused. The furniture business which Malcolm and family ran was losing money
and the mobile home park was lucrative.
- The court did not dissolve, because the standard is what is “reasonably necessary” to protect the rights of the
complaining shareholders. Here the sisters are just complaining that they don’t get along with their brother, not
that they were being controlled to their detriment by their brother so as to require dissolution.
- Even though the furniture company was losing money, the BJR applies unless they can show a breach of duty of
care or loyalty.

Ch. 6, Section 6: Transfer of Control

- Ways to structure a shareholder agreement (which are important to help companies through transitions, even if
they don’t want them in the inception of the corporation):
(1) Right of First Refusal: Must have a bona fide offer from a third party. If you have a third-party buyer, you
have to go to the other shareholders first and allow them to buy for the same price offered by the third
party. This makes it harder to sell because you have to offer the shares to other stockholders first.
(2) Right of First Offer: “Preemptive Strike”. Ask the other shareholders for their best price and then you can
go out and “shop around” for a higher price.
(3) Russian Roulette / Shotgun Provision: When you determine the price at which you are willing to sell then
you go to the other shareholders and offer to sell them your shares at that price. They have the option to
buy or to make you buy all of their shares at their price. You need to go high enough that you aren’t being
bought out and not so high that you have to buy out the other shareholders.
(4) Tag-a-Long Right: There is an offer to buy out the majority shareholder at a certain price. The minority
shareholder then has the option to be bought out at that price. Minority shareholders want this.

(5) Drag-a-Long Right: When there is an offer to buy out the majority shareholder, the minority shareholders
must come along. Majority shareholders like this because the buyer doesn’t have to deal with the minority

Frandsen v. Jensen-Sundquist Agency, Inc.: In a transfer of control of a company, the rights of first refusal to buy
shares at the offer price are to be interpreted narrowly.
- First WI Corp. wanted to acquire Jensen-Sundquist and asked the minority shareholders to sign a waiver.
Frandsen refused to sign and wanted to exercise his right of first refusal and buy out the rest of the stock instead
of letting First WI take over the company.
- Frandsen argued that the offer triggered the right of first refusal (and usually and offer does trigger that right)
- The court held that the right of first refusal was not triggered here, because the right was interpreted narrowly,
and the court distinguished between a “sale” and a “merger.” A merger does not trigger the right of first refusal.

Zetlin v. Hanson Holdings, Inc.: Absent looting of corporate assets, conversion of a corporate opportunity, fraud, or
other acts of bad faith, a controlling stockholder is free to sell, and a purchaser is free to buy, that controlling interest
at a premium price.
- Those who invest the capital necessary to acquire a dominant position in the ownership of a corporation have
the right to control that corporation.
- Premium Price: The added amount an investor is willing to pay for the privilege of directly influencing
corporate affairs (and addition for the majority stock).
- The minority shareholders were upset that the majority was going for twice their shares and the court said that
the minority shareholders should have contracted for the rights to buy or sell their stock (right of first refusal).
NY does not support the Wilkes line of cases and is not sympathetic to minority shareholders.
- Dominating Percentage of the company does not have to be over 50%. Look at whether there is another big
block of control. Smaller individual shareholders are more likely to vote with management.

Essex Universal Corp. v. Yates: A sale of a controlling interest in a corporation may include immediate transfer of
- The general rule is that you cannot have a “naked sale.” You cannot sell the management of a company without
the stock. You cannot just sell your “office.” The policy is that persons enjoying management control hold it
on behalf of the corporation’s stockholders and therefore may not regard it as their own personal property to
dispose of as they wish.
- Judge Lumbard said that Essex did not have a majority, only 28.3%, but they did have control due to
shareholder apathy. Essex cares a lot about the company and will take on the monitoring costs where a 1%
shareholder will not investigate a company or try to get rid of directors because they don’t have enough money
invested. It is legal to give and receive management if in buying stock you wouldn’t receive control right away.
- As long as there is a control change, there can be a director change.
- Judge Clark says that the test is fact sensitive and here there can be no Motion for Summary Judgment
- Judge Friendly says that directors do owe a fiduciary duty to all shareholders, not just the majority, but to all
shareholders and corporations (and maybe creditors if the company becomes insolvent). Duty of care and duty
of loyalty are big, important duties. You must have a greater than 50% change to have a change in directors.


Ch. 7, Section 1: Mergers and Acquisitions

Structure of Mergers
(1) Stock purchase:
a. Private transaction: where you purchase the controlling interest of a company.
b. Tender offer: Public announcement that you’ll purchase shares of a company at a set price for a
set time. Tender offers will be subject to federal law and the Williams Act (we’ll talk about that
(2) Asset Acquisition: Take only the assets of a company. In theory, you can do this without the liability
transferring. Under certain circumstances, you won’t be able to avoid liability under the common law
“Successor Corporation Theory.”
a. Successor Corporation Theory: It is applied in tort context, and if you essentially take over the
running of a company, you produce the same thing, you use the same employees, there’s no real
change in how the items are produced, etc., then you will be allocated the liability in addition to
the assets.
(3) Merger: By definition, this needs to be a consensual transaction between the boards of two companies.
Three ways statutorily mergers are set up:
a. Straight Merger: Buyer and Seller. Seller is target, buyer is bidder. The “magic” of the merger
process…there are certain obligations to go through…seller shareholders usually have the right to
vote on it, except in a short form merger. Under state corp. codes and national exchanges, there
are rules saying if you’re giving out more than 20% of your stock in conjunction with this
transaction then the purchaser shareholders will also have the right to vote. If the buyer is just
buying up little local companies, then that’s not a significant transaction for the buyers’
shareholders, but if it’s so large that it dilutes the shareholders interest in the buyer company, then
they should have the right to vote. In the process, you file a simple document with the secretary of
state. Seller merges with and into buyer.

Statutory Merger: Three Types

(1) Basic Straight Merger
Buyer Seller
Seller goes away (not the surviving corporation)

Buyer is the “Surviving corporation” and Seller is gone.

Sellers’ shareholders are now Buyer Shareholders.
All the assets and all the liabilities, by operation of law, are now part of Buyer.

(2) Triangular Merger



Owned by buyer seller merges with subsidiary

Buyer forms subsidiary of which it owns 100% of the stock.

The Seller again has happy shareholders that get some consideration through the merger process, and the
Seller merges with and into the Subsidiary leaving the Subsidiary as the surviving corporation.
If you have certain types of consideration (giving more than 20% of the stock of your company) then the
Buyer shareholders might have a right to vote. If you’re just giving out cash, then the Buyer shareholders
won’t get a right to vote but the subsidiary will—and the subsidiary is the Buyer.
You can avoid having Buyer shareholders vote by structuring it this way.

Structuring it this way protects the Buyer from liability through Piercing the Corporate Veil.

Policy for Triangular Merger

- Shield parent from liability risks; to hold parent liable you have to show parent is engaging in fraud
(piercing the corporate veil) and this is not very likely. True for reverse triangular too.
- If the seller is no longer going to be in existence, the shareholders have a right to vote.
- In a straight merger, the buyer shareholders have the right to vote.
- In a triangular merger, we don’t want the buyer shareholders to have the right to vote because the buyer
corporation is the sole shareholder of the subsidiary.
- Buyer shareholders might still have the right to vote if they will be diluted.

(3) Reverse Triangular Merger


Owned by buyer

This is just like Triangular Merger with the exception of who is the surviving corporation.
Instead of the subsidiary being the surviving corporation, the SELLER is the surviving corporation.
The Seller Shareholders will not be shareholders of Seller any longer, they’ll either be cashed out or be shareholders
of the surviving corporation.
The only reason to do that is that there may be reasons to try to keep the target Seller as an entity.

Policy for Reverse Triangular Merger

- Copyright
- Alcohol licensing / gambling licensing
- Sometimes you need to keep the seller intact
- The target has bylaws or contracts that prevent it from dissolving

Appraisal Rights: Allow shareholders of a company going through a significant change to dissent from a transaction
and receive Fair Value for their shares. You could get this right through state code or through corporate
documentation. Shareholder must dissent, must give corporation notice, and then there’s a judicial process to
decide the Fair Value of the share.

Bulk Sales Laws (Article 6 of the UCC): Most states have given up on it and took it out of their statutes. You must
provide notification to the creditors if you sell more than 1/2 of your assets and this is not in the ordinary course
of business. It was meant to help the creditors. To protect tort creditors we have fraudulent transfer laws and
successor corporate liability, which requires a corporation who looks like, acts like and does everything the
former corporation did to be held liable for tort liabilities (fact-based issue developed by the courts).

Subsection A: The De Facto Merger Doctrine

De Facto Merger: The transaction is so similar to a merger that the court concludes the parties must have intended
to merge.

Farris v. Glen Alden Corporation: A transaction which is in the form of a sale of corporate assets but which is in
effect a de factor merger of two corporations must meet the statutory merger requirements in order to protect the
rights of minority shareholders.
The Appraisal Rights laws Glen Alden (Pennsylvania) List (Del.)
in Penn and Del.
Sale of Assets Appraisal Rights No Appraisal Rights
Merger Appraisal Rights Appraisal Rights

- If you set up your transaction in a certain way, you may be able to affect whether or not your shareholders get
dissenter (appraisal) rights. You have to be essentially the target company of a merger in order for dissenters’
rights to apply.
- In Delaware there was no appraisal rights if your company is basically selling all of the assets. Why wouldn’t
Delaware give its shareholders this protection? After you’ve sold all the assets of a company, you might
request the company stay in existence for a time to deal with any liability issues and maintain some insurance,
but ultimately that company will dissolve and the shareholders will get that consideration. DE thinks there is
less of a chance of cheating shareholders by selling assets because assets are easier to value than the going price
of shares.
- De Facto Merger Doctrine: We’ll look beyond the structure of this transaction to the impact, to how it really
works in practice. We’ll go beyond form and look at substance. We won’t allow you to get around giving out
appraisal rights by structuring your transaction in a way that looks like a merger but you just don’t call it that.
- You have to think you will get more money from the FMV than the price offered in the transaction. You have
to pay attorney fees. Often there is an investment company advising the board on what price offer. It is
difficult to get FMV because it is so expensive.

- Policies for allowing appraisal rights:

(1) The asset the shareholders invested in after the merger will be fundamentally different than their original
(2) We are protecting shareholders’ investments.
(3) The merger imposes on shareholders the risk of economic loss.
- Pac-Man Defense: Allowing the little company to acquire the big company
- An attorney drafting a merger or sale of assets must disclose shareholders’ appraisal rights.
- After this case, Pennsylvania abolished the de facto merger doctrine.

Hariton v. Arco Electronics, Inc.: A sale of assets involving dissolution of the selling corporation and distribution of
the shares to its shareholders is legal.
- Delaware law applies because that’s the state of incorporation.
- The transaction was structured to be a sale of assets, and ultimately one company would end up dissolving.
Hariton (π) said this was basically a merger.
- Delaware does not adopt the de facto merger doctrine.
o Doctrine of Independent Legal Significance: DE says no provision in its code is any more
important than another. If you structure your transaction pursuant to the statutory provision, then
we won’t look beyond that form to the substance of the transaction.
o Thus, Delaware is emphasizing form over substance.

Subsection C: De Facto Non-Merger

Subsection B will be covered after Subsection C.

De Facto Non-Merger: When the action is structured as a merger, we will not treat it as if it is something else.

Rauch v. RCA Corp.: A cash-out merger that is otherwise legal does not trigger any right the shareholders may
have with respect to share redemption.
- Common v. Preferred Stock:
o Common stock = voting right & usually dividends at board’s discretion.
o Preferred stock = not usually a right to vote, specified dividend every quarter of every year (if
dividend not received, then voting rights kick in), get priority if company is liquidated
- GE acquired RCA. If they purchased RCA for cash, then the preferred shareholders would have to be paid
$100 each. GE wanted to avoid paying those shareholders, so instead they did a triangular merger. They
arranged for RCA to merge into a GE subsidiary.
- Delaware will not look beyond the form of this transaction, which is structured as a merger. Therefore, the
preferred shareholders could not get their $100 redemption.
- The company could circumvent the redemption provision by structuring it as a merger.

- What’s the difference between a de facto and a de facto non-merger doctrine?
o There is no real difference. Either follow one or you don’t.
o If you follow de facto merger, you follow the de facto non-merger.
o If you don’t follow de facto merger, you don’t follow the de factor non-merger.

Benefits / Detriments of Following the Doctrines

- If you don’t follow it, then there is no uncertainty.
- If you do follow it, then there is some gray area; you don’t really know what the court will come back and say
what you should have done.
- Following the de facto merger doctrine protects shareholders. It doesn’t allow the corporate bigwigs to
circumvent a shareholder’s rights by structuring a transaction creatively.

Post-Movie Policy Discussion

Pro-Garfield (Sell Off the Company) Pro-Jorgy (Don’t Sell Off the Company)
5% of the stock was held by the employees so there is a You would have no product without the people; don’t
moral obligation to make them money by selling the take the company away from them
If a company is supporting the community, it is better
for the company. There are economic reasons to treat
your employees well.

Appraisal Rights:
- When determining whether you have appraisal rights:
(1) Do you have a vote? You cannot have appraisal rights if you don’t have a vote (a chance to dissent)
a. Purchasing company, probably not
b. Selling / Target company, probably do
(2) What is the structure of the transaction?
a. For example, in Delaware, a sale of assets carries no appraisal rights. In a merger, there are
appraisal rights.
(3) Under State law, are there any exceptions to the appraisal rights?
a. For example, some states say that if the target company is publicly traded, and they are receiving
as consideration the stock of another publicly-traded company, then there is no appraisal right.
i. The reason for this is that if you’re publicly-traded and receiving publicly-traded then
you can always sell your stock on the open market; you have flexibility.
b. For example, some states say that if the target company is publicly traded and you get cash as
consideration, there is no appraisal right.
i. The reason for this is that cash is as good as stock.

Short Form Merger: An exception to the general rule that a target company shareholder will get a right to vote.
- Depending on the state you’re in, they may call it “short form” merge or “parent / subsidiary” merger.
- The individual state codes set a particular ownership level (80% to 90%) and they say if one other corporation
or one other person owns that level of the company, then you can go ahead and merge that corporation into
yourself or another subsidiary of yourself without getting a vote of those other shareholders.
- The idea is why bother going through the process of getting a vote if we know you own 90% of the company?
- That said, your shareholders will still get appraisal rights unless one of the exceptions applies.
- You might be able to merge without getting a vote, but you still might be subject to the minority shareholders’
appraisal rights unless an exception applies.

Subsection B: Freeze-Out Mergers

Freeze-Out Merger: “Take out merger.” Merger in which remaining shareholders are bought out through a merger.
In closely held corporations a shareholder can still be there but isn’t making any money.

Weinberger v. UOP, Inc.: A freeze-out merger approved without full disclosure of share value to minority
shareholders is invalid.
- Weinberger was a former shareholder. Signal Companies (who had a controlling portion of UOP) wanted to
buy, invest in, UOP for 50.5%. Officers of Signal (wanting to pay the lowest price) and directors of UOP
(wanting to get the highest price) are doing the valuation. UOP has an investment company to do a study to
determine if the price was fair; however, they did not have sufficient time to make their determinations.
Weinberger did not use his appraisal rights: he is suing for violation for duty of loyalty and wants damages and
redaction of the merger.
- Burden-Shifting:
o π must show minimum unfairness
 fair dealing (process issues of disclosure)—specific acts of fraud, misrepresentation, or
other items of misconduct demonstrating unfairness to the minority shareholders
 fair price (requesting that the actual price be fair)
• If your only contention is that the price was unfair, then your only remedy is
appraisal rights
o Then Δ must prove entire fairness
 If you have the approval of the majority of the minority shareholders, after full
disclosure, then those unhappy shareholders have the burden to prove that it wasn’t fair
after all.
 Full Disclosure: If the minority shareholders don’t know about the process, don’t know
about everything that happened, then maybe there’s not really fairness.
- (Minor Point) Valuation: We aren’t going to rely on the Delaware block approach. We will use any generally
accepted valuation method. There are lots of methods that investment companies use and they figure out which
is best for the company. The court here used the appraisal statute to come up with value; the court can also hire
its own valuation company.
- Business Purpose Test: You had to have a valid business purpose in order to have the transaction. Delaware no
longer requires Business Purpose Test to justify business transactions. Weinberger says that the “entire
fairness” test will be sufficient; if there is entire fairness then the business purpose doesn’t matter.
- NOTE: Include in the value of a company:
(1) Merger and someone triggers appraisal rights: Delaware courts say that the minority shareholder takes the
value of the company pre-merger (without the benefit of the merger)
a. You should only get the value based on why it’s being acquired for that price.
(2) In the 2-step process of Weinberger, minority shareholders get the benefit of the initial step that creates the
controlling shareholder (valuation gets the benefit of the first step)

Coggins v. New England Patriots Football Club, Inc.: Controlling shareholders violate their fiduciary duties when
they cause a merger to be made for the sole purpose of eliminating a minority on a cash-out basis.
- Sullivan used to control the company and was ousted. He was upset, so he took personal loans to regain control
of the company. He cannot transfer the debt to the company, so he goes through a merger to get rid of all the
non-voting stock. The claim is brought by a minority shareholder who did not trigger his appraisal rights.
- Two-Step Test:
(1) Business purpose test
(2) Fairness to minority shareholders
- The business purpose for the freeze-out merger cannot be for the sole purpose of eliminating a minority on a
cash-out basis.
- Make sure your client can articulate a legitimate business purpose. The merger here happened too long ago to
rescind the merger even though the court found no business purpose for the merger. A valid purpose is the cost-
effectiveness. That it costs too much to maintain the public shareholders.

Rabkin v. Philip A. Hunt Chemical Corp.: Broadest reach of the entire fairness doctrine. Delaying a merger to
avoid paying a contractual price may give rise to liability to the minority shareholders.

- The smoking gun in this case was the inter-office memo that said that Olin planned to acquire 100% of the
company. The agreement was that Olin would pay $25/share if he acquired the company in one year and he
waited until right after the one year. Court says that it isn’t the price, but the timing which brings up the issue
of fair dealing. But this came out in favor of the Defendants.
- Entire Fairness: (1) Fair Process and (2) Fair Price.

Subsection D: LLC Mergers

VGS, Inc. v. Castiel: The managers of an LLC owe to one another a duty of loyalty to act in good faith.
- Note that if this was a member-managed LLC, Castiel (holding 63.46% interest) could have controlled whatever
he wanted to. Quinn was one of the three managers, the others being members Castiel and Sahagen.
- Castiel controlled the Board of Managers by appointing 2 managers, while Sahagen appointed 1 manager.
Unbeknownst to Castiel, Quinn (who Castiel thought had his back) agrees with Sahagen to consent to merge the
LLC into VGS, Inc. By merging like this, they diluted the interest held by Castiel enough that he was no longer
the controlling interest-holder, and he could be ousted.
- The LLC agreement, by its terms, didn’t prohibit this. The Court said they wouldn’t let Quinn & Sahagen get
away with this “slimy” behavior just because the statute didn’t expressly prohibit it.
- Delaware looks beyond the form of the transaction to the substance—this is something that they don’t usually
do (and in fact they say the won’t do it under the doctrine of independent legal significance). This makes it a
problematic case because it goes totally against every other issue we’ve seen in Delaware law in protecting the
majority interest holder who didn’t do what he needed to do to give himself documented protection.
- In this case, Delaware says that at some point, managers can overstep their bounds and breach a duty of loyalty
to the other managers.
- Delaware courts interpret the LLC statute as having a fiduciary duty of loyalty and care to the LLC, investors,
and other managers. The state legislature did not intend to allow two managers to deprive “clandestinely and
surreptitiously” a third manager representing the majority interest in the LLC of an opportunity to protect that
interest by taking an action that the third manager would surely have opposed if he had knowledge of it.
- Note that the BJR does not apply here because S & Q violated their duty of good faith and loyalty.

Ch. 7, Section 2: Takeovers

Subsection A: Introduction

- Tender-Offer: A purchaser makes an offer to buy outstanding stock under a certain price and factors. This is a
way to get around the Board and takeover the company through the shareholders.
- Hostile Takeover: One opposed by the incumbents
- Friendly Takeover: One supported by the incumbents
- Leverage Buy-Out: Using the assets as collateral to buy the company. You raise the money to make the
acquisition by borrowing a debt that is secured by the assets of the target company.
- Short-Form Merger: Authorizes a corporation that owns some specified percentage of the stock of another
corporation to merge this subsidiary into the parent corporation without a shareholder vote.

Cheff v. Mathes: A company may buy its own stock only if it has a “proper business purpose”. Corporate
fiduciaries may not use corporate funds to perpetuate their control of the corporation, because that isn’t a proper
business purpose.
- Maremont made an offer to buy (merge) with Holland, but Mr. Cheff didn’t like Maremont (bad reputation of
liquidating companies and losing jobs for the community). There is always the potential for hostile takeovers
when discussing liquidation.
- The company’s culture can be important (Holland wanted to sell furnaces, and note that Holland was selling
furnaces through fraudulent means). The company claimed that they were concerned about their employees,
concerned that they might quit and find other jobs before Maremont liquidated the company.
- The company purchased Maremont’s shares. If the actions of the board were motivated by a sincere belief that
the buying out of the dissident shareholder was necessary to maintain what the board believed to be a proper
business practice, then the board will not be held liable for that decision. BUT, if the board acts solely because
of a desire to keep themselves in office and/or perpetuate their own power, then the use of the corporate funds
for such purpose is improper—entrenching oneself is a violation of the duty of loyalty.
- A company will want to buy its own stock:
o To increase the value
o Avoid liquidation

o Give stock to the employees
o Don’t want to look “too attractive” by having a lot of money in bank accounts, so it will reinvest
that money in the business.

- Buying someone’s stock in your company for a premium to prevent them from buying out the company. Court
said that sometimes Greenmail is okay if the motive is pure. This is very broad; analyzed using the BJR so is
forgiving to the company. The court will look at the directors (insiders versus outsiders). Inside directors are in
direct conflict in these situations so they must show good reason for the duty of loyalty. Pro of greenmail:
prevents takeovers and potential liquidation of the company.
o § 5881 of the Internal Revenue Code: The IRS imposed a tax penalty of 50% on the gain from
greenmail (sale of stock that was held for less than 2 years and sold to the corporation on an offer not made
to all shareholders)
o Problems with Greenmail: (1) Don’t let market forces work; you end up entrenching directors,
and (2) who says that no one is going to see what you did (pay the greenmail) and come and try to do the
same thing to the company all over again?
o Law and Economics: If the sum of the parts of the corporation are worth more than the whole
corporation, it should be divided and sold out. Who cares that the community will be wiped clean of jobs?
Bidding wars are sometimes good for the company because they increase the stock price and shareholders
might do pretty well. If someone can come in and takeover a company and break it up and sell it for profit,
then it shows that the company’s management lacks synergy and they are not able to keep the company
- When you buyout shares through greenmail, put in a stand-still provision: “For a period of time, I will not
acquire X% of the company.” You don’t want to be financing this person’s next round of stock purchases!

The Williams Act of 1960 (§ 13(d) and § 14(d) of the 1934 Act)
- “Cycles of transactions” in mergers & acquisitions. Different types of transactions affected by lots of factors.
In the 1960’s hostile tender offers were profitable and popular and more socially acceptable.
- There are two parts of the Williams Act:
(1) Reporting Requirement: Anyone who acquires more than 5% of a firm, as an individual or as a group must
report to the SEC. Means you can’t have a “creeping takeover”. § 13(d) report (public record) requires
extensive disclosure: who owns, source of and amount of funds, purpose of acquiring the stocks, future
contract, and number of stocks. In practicality, the attorneys and clients “finesse” the language of the
“purpose for acquiring stock” and you could have a lot of different reasons for doing that. However, if
your client has an interoffice memo saying “we intend to acquire 50% and take over Company X,” then you
need to have them disclose that. Companies will help these big shareholders file these forms. You cannot
(2) Issue Related to Tender Offers Themselves: § 14(d) and part of (e). Anyone making a tender offer must
file extensive and expensive form with SEC. A lot of investors don’t care because they are there to make
money, it is for the company to decide how to respond.
a. Must hold offer open for 20 days
b. Stockholder may accept offer and revoke anytime 15 days after accepting
c. Must take share pro rata (all shareholders get treated the same). For example, if you only want to
buy 51% but 60% come forward, you need to take an equal percentage from each shareholder to
make your 51%.
d. If you increase your price during the offer, everyone gets that price.
(3) Other Parts of the Williams Act: Try to make tender offers fairer to the shareholders. If you increase your
price during your tender offer, EVERYONE gets that price. For example, upping the price because not
enough shareholders are coming in. Requires the tender offer must be held open for 20 days and allows
anyone who tenders to rescind in 15 days. If someone is going forward with the tender offer, they say that
they will buy a certain percentage if more comes in. The Williams Act says that it is not first come, first
served; you have to take these shares pro rata.
- To avoid the tender offer rules, sell on the open market, or do a two-tiered approach.
- Examples of the Williams Act in Action:

o Purchase entity that searches the internet for the lowest priced good. You can acquire 20%
“secretly,” but you have to report (within 10 days) of the purchase to the SEC.
o “Group” each buys 4% each. If it is part of a plan, then you must disclose. You cannot get around
the rule by having each group member buy less than 5% and then aggregating that.
o Tender offer: Only going to allow VUSL graduates access to the site. Depends how definite this
is when determining whether disclosure is necessary. “Materiality and certainty.”
o “Saturday Night Special”: Not allowed to offer tender offer on Friday night and then close the
offer on Monday morning. Must keep it open for 20 days.
o Only going to purchase 51%. Can’t do a first-come first-served and just stop buying after you get
your 51%. You must buy pro-rata for the whole 20 days; if 100% of the shareholders submitted
their shares, then they’d have to buy 60% of everyone’s shares.
o Consider raising the price of the tender offer, must offer that raised price to everyone, including
those who have already tendered their shares to you at the lower price.

Subsection B: Development

We know that in every case we have a duty of care/loyalty.

In some cases, Unocal comes into play and you have a 2 step test
In other circumstances, the Revlon/Maximize Shareholder Value Test applies.
Revlon is the toughest test to meet.

Unocal Corp. v. Mesa Petroleum:

- Mesa = Bidder; Unocal = Target. Mesa made a cash tender-offer that was “two-tiered.” The first purchases
would be given $54.00 cash, and if they didn’t go along with the tender offer, Mesa would merge Unocal out of
existence and give junk bonds as compensation.
- The Unocal Test: Used only when the Board unilaterally takes a defensive measure.
o Reasonable belief in threat to the company (to corporate policy or effectiveness)
 Prove this by showing good faith and reasonable/adequate investigation
o Response to the threat must be proportionate.
 Is it coercive or preclusive (coerce shareholders into going your way or precluding
them from doing anything besides going your way)?
- These hostile takeover situations are inherently problematic for the Board Members because they’re going to be
replaced if the company is taken over. Board Members are nominated by the other members of the Board.
- A selective tender offer effected to thwart a takeover is not in itself invalid. Delaware in Unocal set a new
standard for defensive measures, a stricter form of scrutiny.
- Factors to consider for defensive measures: Inadequacy of price offered, nature & timing of the offer, questions
of illegality, impact on constituencies other than the shareholder, risk of non-consummation, and the quality of
the securities being offered in exchange. Is the tender offer preclusive or coercive?
- Courts can look at the impact on constituencies other than shareholders, opening the door to look at other
- Unitren: There are a range of reasonable responses in the face of a threat
- Blasius: Must show a “compelling justification” if the response will affect shareholder voting.

NOTE on SEC Reaction and Poison Pills

- Traditional Right: Typically known as a warrant, grants the holder the option to purchase new shares of stock
of the issuing corporation. Traded as separate securities, having value because they typically confer on the
holder the right to buy issuer common stock at a discount from the prevailing market price.
- Poison Pill: Also called Shareholder Rights Plans, make it more expensive to takeover companies. Adopted by
the Board of Directors without any shareholder action. Rights attach to the corporation’s outstanding common
stock and cannot be traded separately from the common stock and are priced so the exercise of the option would
be economically irrational. There is usually a clause that lets directors get rid of a poison pill for an offer they
want to take.

- “Flip-In Trigger”: Triggered by the actual acquisition of some specified percentage of the issuer’s common
stock (20% usually). The value of the stock received when the right is exercised is equal to two times the
exercise price of the right.
- “Flip-Over Trigger”: Triggered following acquisition of specified percentage of target’s common stock and
target is subsequently merged into the acquirer or one of its affiliates. The holder becomes entitled to purchase
common stock at half-price and dilutes acquirer’s other stockholders.
- Delaware courts have said that directors must maintain control over these plans. This was a response to “slow
hand” or “dead hand” provisions. Slow hand being that the new directors had to wait 6 months to redeem the
plan and “dead hand” being that only the original directors could redeem the rights.

NOTE on “Junk Bonds”

- Junk bonds are debt obligations of a corporation that are usually subordinate to other debt (they are comparable
to a second or third mortgage on a personal residence) and bears relatively high level of risk and a high interest
- Shareholders should be concerned about the risk for two reasons:
(1) Junk bonds are more risky than common stock the shareholder already owns.
(2) You can sell junk bonds, so the only real concern is the value.

Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc.: Lockups and related defensive measures are permitted where
their adoption is untainted by director interest or other breaches of fiduciary duty.
- Pantry Pride tried to acquire Revlon. The attorney for Revlon suggested two defensive measures: (1) Company
purchase in the form of a stock buy-back, and (2) Note Purchase Rights Plan which was a poison pill.
- Pantry kept raising their tender offer price (directors kept rejecting). Directors agreed to allow a buy-out by
Forstmann, which was unanimously approved.
- Lock-Up Agreement: Can set up by K to buy particular assets or as an option agreement to buy shares at a
favorable price (under price company sold from at the end of the day). “Crown Jewels”: If you are a potential
buyer, you want to make sure you get what is best for you of the company. If it is upheld, then acquirers would
have a K right to assets but wouldn’t get the company as a whole. Makes the company less attractive.
- “No Shop” Provision: Can’t go out and look for other bidders
- “No Talk” Provision: Can’t talk to other bidders, but the board cannot breach their fiduciary duties under
- “White Knight”: Someone that the target company wants to come in; a “favored” third party bidder
- “Cancellation Fee” / “Termination Fee”: Very common. Here it was $25 million, which was too much of a
response by Revlon.
- Pac-Man Defense:
- Staggered Board:
- Stock-Redemption Plan:
- New Standard: At some point, the director’s duty switches from protecting from an inadequate bid
(preservation of the target) to trying to maximize shareholder value. At some point, it becomes clear that the
company will be bought out and the Board can’t keep trying to keep the company whole. At that point their
new duty is to maximize the shareholder’s value. Directors do not want to trigger Revlon duty.
- REVLON DUTIES TEST: Initial duty of the director is to preserve the company and make the company
profitable. Then if any of the following happen:
(1) Company initiates an active bidding process
(2) Company abandons a long-term strategy and seeks alternative transaction involving the break-up of the
a. E.g., For a long time the company has sought merger partners of roughly equal size, slowly
building themselves up…or they acquire smaller companies on a regular basis to build themselves
up, and then they suddenly decide that’s no longer a feasible strategy and instead start looking for
other transactions that would break-up the company (meaning that control would change)
(3) There is a sale or change of control
Then the duties of the directors change to maximize the shareholder value.
What are not examples?

Omnicare, where there was a merger of equals.
- In Unocal we said that we can consider other constituencies; should we consider note holders the same way?
The directors were worried about being sued by note holders, worried about personal liabilities. This is a pull-
back from Unocal: You need to focus on the shareholders. You are only allowed to consider other
constituencies if it is beneficial to the note holders.

Paramount Communications, Inc. v. Time Inc.: Directors of a corporation involved in an ongoing business
enterprise may take into account all long-term corporate objectives in responding to an offer to take over the
corporation. In Paramount, directors of Time, seeing a threat by a bid for control by Paramount, undertook
measures to defeat the takeover effort.
- Time really wanted to merge with Warner. But then Paramount showed up and offered a good price for the
shares. Time structured a deal with Warner to do a share-for-share exchange, and the Time shareholders saw
the $175 of $200 per share deal from Paramount as more attractive. Time decides to restructure their deal so
that they are buying Warner, not merging with them, such that the Time shareholders did not have a right to
vote on the deal.
o The shareholders argued that this was a situation where the company was obviously changing,
which took them into “Revlon land” and they should be trying to maximize shareholder value.
o The court didn’t agree.
- This is the “Merger of Equals” argument; this wasn’t changing the company. This is part of Time’s long-term
strategy to merge ourselves with an equal. Time argued that even though 60% of the combined company would
be owned by Warner shareholders, it was a widely dispersed shareholder base. Time argued it was not
abandoning a long-term strategy at all (one of the triggers for Revlon duties).
o When a court is examining the Revlon trigger of abandoning a long-term strategy and seeking
alternatives, the alternatives the court looks at are alternatives that will break up the company.
- Defensive Tactics: (1) Automatic share exchange agreement, (2) “confidence” letters, (3) “no shop” clauses.

Paramount Communications, Inc. v. QVC Network, Inc.: The directors of a corporation targeted by two or more
suitors may not institute tactics that favor one suitor in such a manner as to allow the favored suitor to offer less than
it otherwise would have. In QVC, directors of target corporation Paramount instituted as deterrents to an unfriendly
acquisition a no-shop clause, a “poison pill” termination fee, and a stock option agreement favoring friendly suitor
- Viacom wanted to acquire Paramount, but then QVC put out a tender offer and messed up the deal.
- Paramount, learning from the Time case discussed above, decides to talk about this as a “Merger of Equals.”
But the court doesn’t buy their argument and says they were subject to the Revlon duties. Paramount was kind
of using QVC’s offer to make Viacom raise their bid. The focus is on the third Revlon trigger, the “Change of
Control” or a “Sale of Control.”
- Note that unlike Time/Warner, there was not a widely-dispersed shareholder base in Paramount/Viacom.
Viacom did not have a widely-dispersed base. Post merger for those two companies, there would be a change
of control. Paramount would go from a widely-dispersed shareholder base to one where the company was
largely held by one guy (Redstone) who would wind up holding about 70% of the company.
- The court essentially allowed for other companies to come in and have a shot at taking over the company.
- Three defensive provisions: (1) no shop clause, (2) termination fee of $100 mil., and (3) stock option
agreement (Viacom had right to buy shares if termination fee was triggered). Highly beneficial for Viacom.
- Enhanced scrutiny of the Board is mandated by:
o The threatened diminution of the current stockholders’ voting power;
o The fact that an asset belonging to public stockholders is being sold and may never be available
again; and
o The traditional concern for action which impairs or impedes stockholder voting rights.
- Key features of enhanced scrutiny are:
o Judicial determination of adequacy of the decision making process employed by directors
(information on which they based their decision)
o A judicial examination of the reasonableness of the directors’ action in light of the circumstances
then existing.
o The board does not have to be perfect, but they must fulfill their obligations to shareholders.

- Significance of a sale or change of control:
o Under Delaware Corporate Law a shareholder can vote when there is a threat of interference with
their rights. They can vote when shares are affected, election of directors, mergers, amendments
to certificate of incorporation, etc.
o Because of the intended sale of control, the Paramount-Viacom transaction has economic
consequences of considerable significance to the Paramount shareholders. Once control has
shifted, the current Paramount shareholders will have no leverage in the future to demand another
control premium.
o Thus, the Paramount directors had an obligation to take maximum advantage of the current
opportunity to realize for the shareholder the best value reasonable available.
- The safest way to fulfill Revlon duties is to do a public auction, but there is no one way to fulfill them. There is
a sense here that QVC wasn’t treated fairly. Paramount did not maximize shareholder value because they did
not push Viacom to give a higher offer.
- Very hard to prove merger of equals; usually there is a big company eating up a smaller company. The
companies should ALWAYS have a valuation company showing that the minority shareholders are getting what
their stock is worth.

Unitrin v. American General Corp. (Note): A defensive measure approved by an independent board is permissible if
it is not “draconian,” which means that it is coercive or preclusive. The board can choose from defensive measures
within a range of reasonableness.
- This allows more flexibility than in Unocal.
Subsection C: Extension of the Unocal/Revlon Framework to Negotiated Acquisitions

ACE Ltd. v. Capital Re Corp.: A corporate merger suitor cannot prevent the target board of directors from entering
into a deal that effectively prevents emergence of a more valuable transaction or that disables the target board from
exercising the fiduciary responsibilities.
- Initially Capital loaned ACE money. Then they came up with a merger agreement which did not trigger Revlon
duties. After the merger, ACE was not the controlling shareholder.
- XL Capital, who noticed the stock price plummet, made an offer, but the merger agreement had a no-talk
provision. Language is key here. Conditions to talking to potential bidders included:
o Superior deal
o Outside legal counsel’s written advice required or would be a breach of duties (here they only got
oral advice)
- The court held that the no-talk provision in this case was not okay. The real issue was that the contract made
the board do something illegal. The ultimate decision on whether to talk is up to the board, not outside counsel.
“QVC does not say that directors have no fiduciary duties when they are not in Revlon-land.”

Subsection D: Extension of the Unocal/Revlon Framework to Shareholder Disenfranchisement

Omnicare (Supplement Case):

- NCS is financially distressed so they go out and find Genesis to come in and do a merger. NCS liked Genesis’
deal because the stockholders would be better off by not sending NCS into bankruptcy and then buying off the
- NCS and Genesis had an exclusivity agreement. They had a no-shop clause, a termination fee, a required
shareholder vote, and a shareholder lock-up.
o What is a “shareholder lock-up”? We’re worried about Omnicare coming in and messing this up,
because Omnicare was making a tender offer. The lock-up said that the big shareholders—the
directors—must agree to vote their way. Individual shareholders can agree to lock-ups like this all
the time, but it might be looked at differently when it’s considered as part of the defensive
- So we have two controlling shareholders who are agreeing to vote that way by the lock-up agreement. That’s
the problem; the deal became preclusive. There was no way the deal couldn’t go through—either the Board

votes for it, or when it goes to a shareholder vote, it goes through because those two big shareholders/directors
have agreed to vote a certain way.
- Under Unocal, there must be a reasonable belief in the threat, and that the response is proportional without
being preclusive or coercive.
o What is the threat here? Why was Omnicare a threat to NCS? They were trying to force NCS into
bankruptcy so that Omnicare could then buy up NCS’s assets at a reduced price. The threat is that
if Genesis doesn’t agree to merge with NCS, we’re going to get stuck with a crappy deal. NCS
knows Omnicare isn’t going to be generous or protective of the shareholders.
o The court looked at a lot of factors as to whether the response was proportionate. Preclusive if
essentially they can’t go in and have a different outcome.
- You have to allow your shareholders to get out of the agreement if it turns out to be a bad deal; by doing the
shareholder lock-up you’ve essentially precluded your shareholders from getting out of the deal.

Hilton Hotels Corp. v. ITT Corp.: A board has power over the management and assets of a corp., but that power is
limited by the right of shareholders to vote for the members of the board. In Hilton, when a hostile corporate
takeover was attempted by Hilton Hotels, ITT (the target corporation) proposed a Comprehensive Plan as a
defensive measure.
- Hilton made a tender offer to ITT and a proxy contest which ITT rejected. ITT decided not to hold a meeting so
Hilton sued to force them to have a meeting. ITT declared its own comprehensive plan (staggered board,
poison pill, 80% vote of shareholders to remove directors for cause). If the poison pill was triggered, Hilton
would be liable and ITT sought to approve the plan before the meeting (so the shareholders could not vote).
- The court found that ITT was disenfranchising its shareholders. If you disenfranchise shareholders, you must
show a compelling justification. This is an even higher standard than Unocal. The court will look at all the
facts to determine if this is the actual purpose of the disenfranchisement.

Subsection E: State and Federal Legislation

CTS Corp. v. Dynamics Corp. of America: A law permitting in-state corporations to require shareholder approval
prior to significant shifts in corporate control is constitutional. In CTS, Indiana enacted a statutory scheme requiring
shareholder approval prior to significant shifts in corporate control.
- Indiana law was challenged under the Williams Act and the Commerce Clause. Dynamics held 9.6% of CTS
(to avoid short-swing profits problems) and announced a tender offer for 30% of the company. If Dynamics hit
one of the target % (20, 33-1/2 or 50) in the Indiana statute, then the shareholders get to vote on whether the
shares acquired by Dynamics get voting rights. Dynamics has to call a special meeting for the shareholders to
- Williams Act: Provides the procedures and reporting requirements for tender offers under federal securities law
is acquiring over 5% of the shares.
o If states legislate around the Williams Act and they are in conflict with it, then the Williams Act
preempts the state law.
o Compared the Indiana statute to the Illinois statute in MITE which was held to be preempted by
the WA.
o The court said that the Indiana statute was no different because in MITE there was an indefinite
delay of tender offers and in IN it was not indefinite (only a 50-day delay). Plus, the IN statute is
worried about IN corporation and requires that the statute only apply to public corporations in
Indiana, or who have their principal place of business in Indiana, or have 10% or over 10,000
shares held in Indiana. The purpose of the statute is to put the shareholders on notice and make
tender offers fairer.
- Commerce Clause: The court held that there was no commerce clause violation because the statute did not
discriminate against outside corporations; it applied to any organization acquiring an Indiana corporation.
- Potential other defenses: Poison pill, lock-up, no-shop, no-talk, termination fee, crown-jewel provision, and
staggered board.

Note on Other State Anti-Takeover Legislation:

- Delaware: Allows companies to opt-out. Delaware is pro-incumbent management. The “moratorium statute”
kicks in if the bidder acquires at least 15% of a target’s stock. After that, the bidder cannot engage in a
“business combination” with the target for three years (e.g., merger). Three exceptions:
(1) If the bidder gets 85% or more, the ban does not apply.
(2) If the target board approves the tender offer before the bidder acquires 15%, the ban doesn’t apply.
(3) If the target board approves a merger after 15% is acquired and 2/3 of shareholders approve, the ban
doesn’t apply.


Ch. 8, Section 1: Introduction

Ways a Corporation can Get Money:

(1) Shareholder private offering
(2) Venture capital company (give them an ownership interest)
(3) Initial public offering (underwriter, lawyers, restrictions on when you can sell your stock as an insider)
(4) Stock splits (enables the stock to be sold more easily)

Ways a Corporation can Get Debt:

(1) Banks: very good at getting security interest in the debt they give to the company
(2) Privately through shareholders or others
(3) Purchased by the public. Usually in long-terms. Need a line of credit for the company to function; the
banks set this up.

Debt Holders Have Rights:

(1) Debenture: long-term, unsecured debt obligation
(2) Bond: long-term, debt obligation secured by the property of the debtor
(3) Indenture: sets out contract between debt-holder and the debenture
(4) Trust Indenture Act of 1939: Protects bond holders
(5) Negative Pledge Covenant: Prohibits a debtor from mortgaging specified assets to any lender without
providing “equal and ratable” mortgage protection to the obligations covered by the covenant.

Shareholders—But Not Debtholders—Have the Right To:

(1) Vote for board members
(2) Share equally in profits / dividends
(3) Make shareholder proposals
(4) Access certain financial information and shareholder lists

Covenants between Shareholders and Debt Holders:

(1) Maintenance of Property: In good condition, repair, insure, and pay taxes. By keeping the value of the
company / property high, there is a better chance the bondholder will get paid.
(2) Restrictions on Payment of Dividends: Major source of conflict between bondholder and stockholder.
The stockholders don’t care if the company will be alive and well in 20 years—they want a dividend
today. The bondholder is concerned with the longevity of the company. Sometimes restricts the
amount and timing of the agreements.
(3) Incurrence of New Debt: I the company goes and gets more debt, the company will be paying out more
interest and then cannot invest in the company. “Leverage” is the debt to equity ratio.
(4) Negative Pledge Clause: Can’t have any other debt come in with security interest having priority over
my debt. “Senior debt” gets paid off first. “Junior Debt” gets paid off after all senior debt has been
(5) Restrictions on Mergers or Changes of Control.
(6) Claim Dilution: Stockholders don’t care if bondholder will have lower priority.
(7) Required to Maintain Ratio of Assets to Debt: Cash flow.
(8) Stay in the Same General Business: Another source of conflict (asset substitution). Stockholder has an
advantage of substitution of assets or changing business because it could be lucrative in the short-term.

But these changes are potentially risky. Bondholders don’t like risk as they are in it for the long term.
Short-term profits may hurt bondholders.
(9) Company Has Option to Buy Back Bonds: The company could save money if the interest rates drop.
(10) Limitation of Optional Redemptions of Debt. Two Options:
a. Time period in which the corporation can redeem; or
b. Can never redeem. Debt holders do not like corporations to have an option because it will redeem
when the value goes up (when the corporation can pay a lower interest rate on other debt). If the
bond interest is 10% and the market rate is 15%, the bond’s value goes down.

Sources of Conflict Between Shareholders and Debt holders:

(1) Dividends
(2) Claim dilution
(3) Asset substitution
(4) Under investment (if do not put money back into the corporation, then the bond holders are less likely
to get paid). Bond holders want the company to be as strong as possible.

NOT in the Covenants:

(1) Day to day activities
(2) Executive compensation
(3) Employee benefits
(4) New products

- Generally, a corporate trustee is appointed to enforce the terms of the indenture, but they have certain conflicts
of interests. They might be a part of the bank which loaned money and the trustee needs to attract new
- The company may have a right to redeem the bonds before maturity date (a call feature) to wipe out the debt by
paying the bondholder the face value of the bonds, plus any accrued interest, plus a small premium (call

Ch. 8, Section 2: Debtor’s Sale of Substantially All Its Assets

Sharon Steel v. Chase: A clause in a debt instrument preventing accelerated maturity in the event of a sale of all or
substantially all the debtor’s assets is inapplicable if the assets are sold piecemeal. In Sharon Steel, the company
contended that certain debentures issued by a corporation whose assets it had purchased were not due and payable
because of a clause that exempted accelerated maturity if all or substantially all of the assets were sold.
- UV has three businesses and was going through liquidation: Federal, Oil and Gas, and Mueller Brass. Sharon
Steel was buying Mueller Brass and the bondholders wanted to be paid off right away instead of allowing
Sharon Steel to assume their debt (their locked-in interest rate was lower than the market). So the bondholders
needed to show that the liquidation triggered the right to get out: “Successor Obligor Clause.”
- The Successor Obligor Clause states that the surviving entity will assume issuer’s debt if they take on a
substantial amount of the assets. It did not seem that Sharon Steel was taking on a substantial amount of the
assets because Oil & Gas and Federal were worth more than Mueller Brass.
- Interpretation of an indenture clause is a matter of law: the judge gets to decide, not the jury. The court held
that the successor obligor clause was only triggered when all or substantially all of the assets of the company
are being assumed at the time the plan of liquidation is determined.
- The purpose of the covenant is to enable UV industries to do merger or consolidation and allow taking-over of
the company. There is protection of the lenders because if the acquirer takes substantially all of the company,
they take the debt too.

Ch. 8, Section 3: Incurrence of Additional Debt

Metlife Insurance Co. v. RJR Nabisco, Inc.: The assumption of additional debt by a bond issuer in an LBO which
results in a downgrading of the bonds does not constitute a breach of the covenant of good faith and fair dealing. In
Metlife, Metlife held bonds issued by Nabisco, and contended that a downgrading of Nabisco’s credit rating due to a
leveraged buyout (which made the bonds less marketable) constituted a breach of the implied covenant of good

- The CEO of Nabisco wanted to do a leveraged buyout at $75/share and MetLife is upset because they are
saying that Nabisco will have too much debt, but Nabisco doesn’t think so. The court thinks that MetLife is a
sophisticated investor and should have contracted to protect themselves (plus there is a smoking gun that says
this debt might be a problem—big oops for MetLife!).
- MetLife argued that Nabisco violated an implied covenant of good faith, but Nabisco did not violate the terms
of the indenture and MetLife could have provided for this problem—no win. The court says that where
contractual rights have not been violated, there can be no breach of an implied covenant. But the court does not
say that there can never be a covenant of good faith in indenture agreements.

Ch. 8, Section 4: Exchange Offers

The federal Trust Indenture Act of 1939 prohibits the alteration of “core” terms—including interest payment,
principal amount, and duration—without unanimous consent of the holders.

Katz v. Oak: An exchange offer and consent solicitation made by a corporation seeking to maximize the benefit to
its stockholders, at the potential expense of its debt holders, does not constitute a breach of the directors’ duty of
loyalty to the corporation.
- Oak was in bad financial condition and was going to be acquired by Allied-Signal. But to accept the offer,
Allied Signal wanted some changes to be made to the debt: lower interest rates and minimum amounts of each
class of debt securities be tendered.
- Exit-Consent Procedure: We will buy your note, but you have to vote to get rid of the protective covenant
(parallel this with shareholder sale where the board would modify the poison pill, but bondholder has the right
to modify here). Since certain portions of the indentures cannot be changed due to the Federal Trust Indenture
Act, Allied-Signal wants to change the protective covenants:
o Not to incur more debt
o To keep a certain amount of capital
o Debt to asset ratio
- The court held that the exit consent procedure was not contrary to the language of the contract or the
expectations of the parties. Oak did not violate an implied duty of good faith and fair dealing. Note however,
that exit consent procedures are coercive measures so that the bondholders will tender for a premium. For
Hillary’s Choices
Don’t Confess Confess
Bill’s Choices Don’t confess 1yr/1 yr 0 yrs/20 yrs
Confess 20 yrs/10 yrs 10 yrs/10 yrs

Ch. 8, Section 5: Redemption & Call Protection

Morgan Stanley & Co. v. Archer Daniels Midland Co.: An early redemption of debentures is lawful where the
source of funds originates directly from the proceeds of a common stock offering.
- Interest rates were declining in the market and the company wants to get debt a lower rate, but there is a
provision in the indenture agreement that says you cannot do this (protecting the bondholder).
- Trace / Source Rule: If you can trace where the funds come from to pay off the debt then you can use the funds
to buy lower debt and sell the higher debt. Note: You cannot use the lower debt to pay off the higher debt. If
you can show the direct source of the funds for the stock is not the redeeming of the debt, you can redeem the
- The court looks beyond substance of the transaction and looks to the form.

Problem, Page 898:

- 1986: $10 million 15% debentures issued
- 1988: $18 million short-term bank loan
- 01/20/89: $18 million 12% debentures issued / deposited in special account
- 01/21/89: Repay bank loan from special account
- 01/25/89: $10 million from sale of plant deposited into general account
- 1989: Redeem 15% debentures from general account

- X Corp. did NOT violate the provision. As long as you juggle special accounts and watch your timing, form
over substance rules.