Sie sind auf Seite 1von 124

Business Associations Outline

(1) Small firms first question - differences between modern RUPA, UPA and partnerships and LLCs (probably planning questions about OAs suggest what should be in it) or a litigation question (badly put together small business you figure out who gets sued) a. Default rules: why they should modify them and which of the small entities we should use (2) Large firms second question a. Exam distinguish civil, criminal and derivative actions; get through proxy fights


Someone who is controlling the company or under common control of some other company An agreement by one person (an agent) to act for a principal at the principal s direction and control Someone who is authorized to act on behalf of the principal Own Stock: Buy stock in IBM and get it from Merrill Lynch you are owner of the beneficial title, while legal title is still owned by Merrill Lynch Someone who gives consideration, acts in good faith, and who is not on notice of an adverse claim Any corporation that hasn't elected the status of an S corporation Can be redeemed at the option of the issuer Productive capacity: tangible assets (equipment and buildings), intangible assets (intellectual property and human capital), money Residual interest in a corporation: including the right to elect directors and receive dividends and distributions Affiliate Someone who is controlling the company or under common control of some other company Doctrine that prevents personal liability for an obligation entered into in the name of a non1



Beneficial title

Bona fide purchaser

C Corporation Callable


Common stock

Convertible Corporation by estoppel

existent corporation Method of voting where each shareholder multiplies the number of shares owned by the number of seats on the board and can distribute those votes all to one candidate or spread them among several candidates, allowing minority shareholders to be represented on the board A partially formed corporation that protects shareholders from personal liability; it can only be attacked by the state A corporation sufficiently formed to be recognized as a corporation for all purposes, even though there may have been a few small flaws in its incorporation A situation where shareholders factions can block corporate action; often arises when there is a split between two factions over electing directors A distribution to shareholders out of earnings If SH is an (1) officer and (2) a creditor of firm and misbehaves debts subordinated to those of all other creditors; Disregard the registered legal entity becomes a General Partnership or Sole Proprietorship Ownership interest in a business venture, equal to assets minus liabilities plus amounts due to senior securities The date when it's too late to purchase shares of publicly traded stock and still receive a previously declared dividend Stock options (warrants) put and call options are 3rd party bets (original derivative); company can get in the business as writer warrants with one exception if writing for CEO they are compensatory options (bonus plans)

Cumulative voting

De facto corporation

De jure corporation



Equitable subordination


Ex dividend

Executive stock options

Fiduciary duty

A fiduciary duty is a legal or ethical relationship of confidence or trust between two or more parties, most commonly a fiduciary and a principal. Tax vehicle all partnerships, LLC, S Corps. A partnership in which all partners are general partners A business entity that has the limited liability benefits of a corporation with the tax benefits of a partnership A type of general partnership with some limitation of liability under state law A publicly held open end investment company which will redeem its shares at net asset value at any time Rights that give existing shareholders the chance to buy part of a new issue of shares before the general public can, thus protecting them from dilution of value and control Shares that have preferential rights to dividends or distributions over common stock The person owed a fiduciary duty This is a person who brings together labor, capital, and management to start a business enterprise Written permission to have another shareholder vote on your behalf A shareholder may send a proxy agent to vote on his or her behalf pro rata A proceeding to determine "by what right" someone holds a corporate office Real estate investment trust

Flow-through General partnership

Limited liability corporation

Limited liability partnership

Mutual funds

Preemptive rights

Preferred stock Principal Promoter


Proxy agent

Quo warranto

REIT Officers Partnership PIC Poison pill Registered form Respondeat superior Revised Model

Business Corporation Act Rule 10b-5 Security title Servant-agent Shareholder derivative action Shareholders Sole proprietorship State court receivership Stock transfer books Straight debt Straight voting Subchapter C Subchapter K Subchapter S Suretyship Tender offer

Business Associations Law

y y y y Formation: Formation, operation and dissolution of business entities Legal Issues: Rights and obligations of the participants; Internal v. External: Key is to distinguish internal and external participants Topics Covered: o (1) Agency Law o (2) Small Business Entities o (3) Corporations

Coverage of a Firm
Internal: Business Associations
Investors: Provide capital y Equity (ownership) y Debt (Loans) Managers: Provide skills y Top y Sub-managers Employees: Provide labor y Coverage is limited; Labor and Employment Law

External: Other Courses

External: Customers Suppliers y Fraud and Consumer Law Antitrust and Other Competitors; Regulatory Authorities like Public Utilities, Banking, Insurance and Environmental Consultants: Investment bankers, Accountants, Lawyers

y y y Agency Defined: People act on behalf of the business to bind the business in relationships to 3rd parties; o Law: The rights of others against each other Formation: Consent of both parties, unless agency is equitably implied by the courts Agency v. Debtor/Creditor: Creditor s promises to 3rd parties create apparent authority and management of debtor s business affairs establishes control over debtors, leading to an agency relationship.

Agency Law
1. Defined: Body of law that defines the legal rights of those affected by Business delegations of power to act 2. Three Basic Parties: (P) Inve stors a. (1) Principal Le gal (owne rs) Entity (P) b. (2) Agent: independent contractor Third Parties or employee (servant) c. (3) Affected third party: contracts Managers (A) with agent or is injured by agent 3. Sources: Common Law and Restatement Law => Rights of Each Against Each Other of Agency (2nd and 3rd) a. No statutory codes b. Specific statutory provisions for those agents with checkered past
(m on ey) C apital return B en efits Hires Lab or C us tom ers S up pliers C on su ltan ts C on trac ts

Creating Authority: Agency

1. Two Basic Elements for Creations: a. (1) Consensual (Contract): Oral or written agreement (manifestation of consent of one and consent by the other that may be express or implied either ex ante (before act) or ex post (ratification; after the act and relating back) b. (2) By Matter of Law (Equity): May have apparent authority (constructive) or authority by estoppels (cannot deny) 2. Creating Authority: An act a. (1) written or spoken works or other conduct of the PRINCIPAL which is b. (2) reasonably seen to CAUSE THE AGENT to believe that the principal wants agent to act on principal s account 3. Creating Apparent Authority: An act created as to a 3rd person a. (1) written or spoken words or other conduct on principal

b. (2) reasonably seen to CAUSE 3rd PERSON to believe the principal consents to have the act done on his behalf by the person purporting to act for him

Agent s Power: Source to Subject Principal to Torts

1. Consensual Agency Relationship a. Distinguish gratuitous bailee b. Distinguish independent contractor 2. Within Scope: Agency must acts with scope of employment to create injury 3. Actual: Ex Ante or Ex Post a. Can be express OR b. Implied in fact (Jenson Farms) 4. In Equity: Implied in Law or Constructive Agency Court over looks lack of actual authority a. Apparent Authority (Nogales Service Center) b. Agency by Estoppel c. Hybrid: Inherent Authority (by title)

Gorton v. Doty: agency arising from use of car

1. Facts: G was coach driving team to play in other city and offers car to use to help take plays to game. G was in accident in s car and player s father ( ) sues on behalf of son s injuries. Jury awards $5,000 to . 2. Issue: Was G an agent of while driving her car? 3. Held: Yes. Evidence showed that the relationship of principal and agent existed between and G. was an independent contractor not a gratuitous baliee. 4. Reasoning: An agency relationship results when one person allows another to act on her behalf and subject to her control. a. Control consented to G acting on her behalf because she volunteered the car with express condition that G drive it; didn t say anything about G LOANING the car and did not say anything about BORROWING it b. Precedent ownership of a car alone, regardless of presence, establishes a prima facie case against the owner because there is presumption that driver is owner s agent c. In order to establish an agency relationship benefit is not specifically required 5. Incentive to Insure: Know your hit by lawsuit for letting someone borrow your car, shift liability onto insurance company.

Agency: Analysis of Question

1. Key: Necessary to determine when an agent can bind the principal, when the principal is liable for the wrongful acts of the agent and what duties obligations of agents are to their principals and vice versa. 2. Analysis: Determine three types a. (1) Is the problem between the agency and principal? b. (2) Does it involve a 3rd party trying to hold the principal to an agreement based on the agent s conduct or an express agreement? 6





c. (3) Does it involve a third party trying to hold a principal liable for the agent s tort? Proving Agency a. Burden: Person claiming there was principal-agent relationship has burden b. Intent: Whether an agency relationship has been created is not dependent on intent of parties involved; can arise even if the parties do not intent to be in relationship and may not arise even if the parties do intend to be in it if certain conditions arise c. Formation: Factual elements are key, must be an agreement between parties that the agent will undertake some act on behalf of the principal, with the understanding that the principal is to remain in control of the undertaking Fiduciary Relationship: Every agent is a fiduciary and owes a high standard of care to her principal. Must avoid conflicts of interest, self-dealing, disloyal acts and so on; similar to duty a trustee owes her trustor and beneficiaries. Gratuitous Agents: Agents who perform their services without gain and cannot be compelled to perform the duty they have undertaken; the principal still may be liable for the torts of gratuitous agents Principal s Duty to Agent: Under duty to compensate agent, including paying back for expenses, unless contract out of it also has duty to cooperate with agent and aid in performing duties assigned

Who is an Agent?
1. Relationship Defined: Fiduciary relationship that results from the manifestation of consent that one person (agent) shall act on behalf of subject to control of another person (principal) 2. Manifestation of Consent: Objective a. Does not matter what intentions of principal may be depends on what the agent believed the principal intended b. May arise even where the principal subjectively intended no relationship and without true mutual consent 3. Creation of Relationship: Several different ways a. (1) By agreement b. (2) By ratification: occurs where principal accepts benefits or affirms the conduct of someone purporting to act for the principal, even though no actual agency agreement exists c. (3) Agency by estoppels: principal acts in such a way that a 3rd party reasonably believes that someone is the principal s agent

Gay Jenson Farms v. Cargill: creditor control over debtor

1. Facts: Jenson, , large global grain dealer, has K with Warren in MN (grain elevator, small business). loans money to W and W appointed grain agent with CCC. has right to 1st refusal. W gets money and paid back from drafts drawn on through MN banks. Imprinted with both s and W names and money went to . W gives yearly reports, keep books. W has problems says reports were fake. W fails and 86 farming s sue to get $2M in payments for

grant from BOTH W and . Jenson was claimed as principal with W as agent and was jointly liable for W s debt. Jury finds W was s agent. 2. Issue: Is liable as principal on contracts made by W by virtue of its course of dealing with W? 3. Held: Yes, they were principal with W acting as agent. a. Control and Influence: s control and influence over W made them principal with liability for deals of agent. It is OK to prove relationship with circumstance evidence showing a course of dealing between two parties. b. Creditor v. Debtor: Creditor who assumes control of debtor s business may become a liable principal for the acts of debtor in connection with business; whatever the terms of K are, when creditor takes de facto control over debtor, he becomes a principal. c. Control and Continuous interference with internal affairs: (1) W needed permission to make capital improvements, declare a dividend or buy stock; (2) continually reviewed W s work and expenses; (3) recommendations that certain actions take place; (4) gave W drafts and forms with s name on them; (5) held right of entry to W premises with intent to carry on period checks and audits d. Consent: Principal must be shown to have consented to the agency relationship consent occurred by directing W to implement its operational recommendations; W fulfilled its part by acting on s behalf in obtaining grain. e. Buyer-Supplier: To show non-agency, must prove that a supplier has an independent business before it can be concluded that he is not agent. Evidence shows that W entire operation was financed by and that W sold almost all grain to there was no independent business.

Key Issues: Jenson v. Cargill

1. Other Potential Causes of Action: Refusal to Fund Line of Cases a. Breach of implied contract to continue to fund bankruptcy trustee as standing in shoes of W (getting for farmers as creditors) b. Misrepresentation: if reps to farmers (we will back W) farmers as s (e.g. held itself out as guarantor) 2. Effects of Decision: Nullified because there was unique fabric in the relationship and Court says this case is unique, special and one of a kind a. (1) Fewer lender control provisions in loan agreements less monitoring of elevator operators, which means lenders would pull plug faster on elevator loan defaults farmers left as unpaid creditors and loans would be more risky b. (2) Cargill owns elevators or stipulates that independent elevators are agents and controls all prices for grain lower grain prices? 3. Mistakes of Jenson Court: Evidence and finding of effect of Cargill Representations to farmers is missing what did the farmers reasonably believe? They had to reasonably believe that W was an agent of Cargill. a. Control equals responsibility: a false premise (corporations have limited liability) and even so how much day-to-day operational control was in evidence because Cargill didn t approve W grain purchases from farmers not approve excessive expenses 8

Transactional Lawyer: Lender Liability

1. Goal: Lower the interest charge by giving lenders control without liability 2. Solutions and Instructions for Client: a. Stipulations: require W to stipulate it is not an agent and to include disclaimers of agency in all W documents seen or signed by farmers b. Name: do not let W use Cargill name in deals with farmers c. Payments: no direct payments from Cargill to farmers 3. Risky Advice: Distinguish Jenson case a limited to grain merchants and not for bank loans; if so, then case doesn t affect customer financing in supply contracts and bank financing

Distinguish Actual from Apparent Authority

1. Actual: Conferred by contract; Apparent: conferred in equity 2. Close Case: Distinguish implied in fact actual authority from apparent authority a. Both cases principal may be honestly surprised b. Point of reference is key: distinguish reasonable view of agent (contract) from reasonable view of third party (equity)

Liability of Principal to Third Parties in Contract

1. Authority: after establishing agency, 3rd part wanting to hold the principal liable must show the scope of the agent s authority to act for the principal 2. Actual Authority (Mill Street v. Hogan): May be expressly conferred OR reasonably implied by custom, usage or conduct of the principal to the agent a. Express Authority: actually contained within the agency agreement b. Implied: Comes from words or conduct between principal and agent; often labeled on how it arose (1) incidental to express; (2) implied from conduct; (3) implied from custom and usage and (4) implied from emergency. 3. Apparent Authority: Results when principal manifests to a 3rd party that an agent is authorized and the 3rd party reasonably relies on the manifestation a. Holding Out: must be some holding out by the principal that causes a third party to reasonably believe the agent has authority and the 3rd party MUST reasonably rely on the principal s manifestations 4. Inherent Agency Power (Wattau v. Fenwick) : Thought to be similar to doctrine of respondeat superior in torts a. Authorized Harm: It is inevitable that in course of performing duties, either by mistake, negligence or misinterpretation of instructions, an agency may harm a 3rd party or deal with one in an unauthorized manner b. Arises even in absence of actual or apparent authority or by estoppels from designation by the principal of a kind of agent who usually possesses certain powers c. Reasonable Foreseeability Test: Test is whether the principal could reasonably foresee that an agent would take the action she did

Mill Street Church of Christ v. Hogan: Implied In Fact Authority from Past Conduct
1. Facts: Elders of Church, , hire BH to paint church. BH done many jobs for church in past and had hired his brother, the , for them often. Painted most portion was high, spoke to elder and asked for help. says hire G, but said it may be hard and never said MUST hire him. BH hired brother instead and he worked for a while until fell and hurt arm. BH reported accident and paid them both for hours worked. says was not an employee and that BH had no implied or actual authority to hire him. 2. Issue: Did BH have authority to hire as an assistant? 3. Held: Yes, BH reasonably believed that the principal wished him to act in the scope of the way he had acted. a. Must determine whether the agent reasonably believed that principle wished him to act in a certain way or to have certain authority Hogan reasonably believed he had authority to hire to help him finish even though asked to hire GP but didn t require it b. Prior dealings between principal and agent and nature of the task are factors to consider did it before, church even paid for the short time he had worked before the accident

Dweck v. Nasser: Apparent Authority

1. Facts: N, CEO, fired D, President, and members of board for operating competing businesses out of their officers. After cannot settle suit D hired Wachtel to help, although N had Heyman on record, Shib. (another attorney for N for 20 years) executed settle on N s behalf requiring D to pay 52.5% of profits and another $1.05M to N. N was to pay D for 30% interest in Corp. N says not bound since Heyman didn t execute it. 2. Issue: Did Shiboleth have authority to bind Nasser into a settlement Agreement? 3. Held: Yes. Court says attorney had actual authority, implied authority and apparent authority. a. Actual: because of 20 year relationship; N told him to do what he wants with K and both S and H testified N granted authority to S to settle. b. Implied: course of dealings over 20 year period of time including S settling many cases for N before and N allowing S to speak on his behalf and directing to him to settle action c. Apparent: because N knew S was working with H on settlement and S thought he had the authority to act on N s behalf

Three-Seventy Leasing Corp. v. Ampex Corp.: Apparent Authority to Accept Contract

1. Facts: sues Ampex for breach connecting to sale of computers. J owns and was only employee. K was salesmen of and fired of J. J meets with K and M, K boss, to talk sale of six computers from to . M tells J could sell computers if could pass s credit requirements. Negotiations continue K submits documents outlining sale to J for $100,000 each with $150K down and rest in 5-years. Two signature lines, one for and . s line was blank when J saw it K sent J letter confirming delivery. claimed no contract but only an offer which required acceptance and. 2. Issue: Did , through conduct of agent K, show acceptance of the contract? 3. Held: Yes, affirmed.


a. On face, document doesn t show that had intent necessary to form a contract in that the signature line was blank for s. In order to have valid contract, must find some act of acceptance on part of , which comes in form of K s letter for delivery dates. b. says only supervisors have authority to contract for company non-issue because this fact was never conveyed to , nor were any other facts giving any reason to believe that K did not have the authority to speak for and contract for . K was salesmen. c. Apparent Authority Scope: An agent has apparent authority to do those things that are usually and proper in the conduct of the business he is employee to conduct; in this case it is reasonable for a third party to believe a salesmen has the authority to bind his employer to sell

Watteau v. Fenwick: Inherent Authority

1. Facts: H owned bar called Victoria Hotel and sells to but still managed bar liquor license was always in H name and had H name painted on door. Under contract with , H only had authority to buy bottled ales and water for bar. Over years delivers cigars and other supplies, which H orders, sues to get payment for these. was liable. 2. Issue: Is an undisclosed principal liable for the acts of an agent taken in the ordinary course of business even if the principal did not authorize the agent to act, nor held the agent out as his agent? 3. Held: Yes, even without apparent authority. a. Generally when person carries out business through manager, he holds out his own credit and is liable for goods supplied even if manager exceeds authority (need proof of agency in fact in order to make the principal liable) b. Distinguished here there was not holding out by the principal and the business was carried out in agent s name and supplied on agent s credit c. Complications of Undisclosed Principal: indicated that he gave credit to H alone and had never heard of (had only heard of Humble) so actual authority is not workable 4. Rule: Principal is liable for all acts of the agent that are within the authority usually confided to an agent of that character regardless of limitations put on that authority by the principal. a. 2nd Restatement of Agency: undisclosed principal is liable for acts of an agent done on his account if usual or necessary in such transactions, even if they are forbidden by the principal. An undisclosed principal who entrusts his agent with management of his business is liable to 3rd parties with whom the agent enters into deals in the usual course of business even if the agent s actions are against the principal s directives

Practical Issue: Lack of Express Authority

y y y Attorney of Record Confusion Actual/Implied Confusion Implied/Apparent Confusion s Lawyer: Principle is Bound If: 1. General Direction Only: Specific power implied in fact. Actual authority 11

2. Explicit Reservation of Authority Disregarded (No Implied Authority): Must show apparent or inherent authority a. Inherent Authority = Undisclosed principal (Watteau) 3. Contractual Formalities Fail (Authorized Agent doesn t sign): Cannot use actual authority a. Must show apparent or authority of employee (Ampex) Transaction Lawyer: Recommendations - What should a lawyer tell a client to do to control oral promises by employees? 1. Develop customer forms for use by employees that contain limits 2. Develop info packets for customers that disclose limits and disclaim oral agreements 3. Develop procedures to monitor employee contracts Litigator s Problem: When do I have the authority to settle? Good Practice: 1. Rarely, if ever, sign or agree, on behalf of client; time pressure or availability? 2. Normally I will present whatever we negotiate to my client for a final approval. Lawyer represent he has authority to pass on bargaining positions (notify other side if client is fickle?) 3. Can lawyer promise to recommend it to my client to judge or opposing counsel?

Distinguish Actual from Apparent Authority

Actual Authority How Conferred? Point of Reference By Contract Distinguish reasonable view of agent y y y Apparent Authority In Equity Distinguish Reasonable View of Third Party

y y

Actual or real contract y Apparent authority May be oral or written y Estoppel Situations May be express of implied in y Ratification fact Close Call: Distinguish Implied in Fact Actual Authority from Apparent Authority Key is Point of Reference: Reasonable view of who? o Agent: Contract o Third Party: Equity

Ex Post Authority: Ratification

1. Ratification: Principal affirms and agrees to be bound by past acts of otherwise unauthorized agent professed to be done on principal s behalf. a. May be express or implied in fact 2. Situations: A person may affirm or ratify a prior act supposedly done on his behalf by another that was not authorized at the time it was performed. 3. Effect: Causes the agent s act to be treated as if the principal had authorized it at the outset 4. Requirements: Intent and full knowledge 12

5. Examples of Ratification a. Express: if agent of corporation makes a deal outside scope of employment and corporation still takes the money from the deal, the corporation has expressly ratified the agent s authority in the deal and are liable b. Implied in Fact: did the principle impliedly agree to ratify the deal?

Botticello v. Stefanvicz: Apparent Authority by Ratification

1. Facts: Husband and Wife, s, own farm as tenants in common and makes $75K offer to buy. Wife tells should couldn t sell for less than $85K and then and husband agree to $85K for lease with option to buy. Agreement prepped by husband s lawyer and signed by and Husband. s attorney didn t perform search on property and was unaware of wife s interest. Husband never indicated to or attorneys that he was acting as wife s agent. took possession and improved it. Attempted to use option to buy and s refuse to honor. sues for special performance. Court finds for . 2. Issues: a. (1) Do the facts and law support a finding that husband acted as an agent for his wife? b. (2) Did wife ratify the contract by her subsequent conduct? 3. Held: (1) No, not an agent. (2) No, judgment reversed no ratification. 4. Rule: Existence of an agency relationship is a question of fact and cannot be proved merely by marital status, nor by joint ownership. For agency, must be shown that a. (1) the principal consented to the agent acting for her b. (2) that the agent accepted the undertaking c. (3) that the parties understand that the principal would be in control of the undertaking. 5. Agency Applied: s admit to sale, wife s statement of selling for no less than $85K is not the equivalent of an agreement to sell for that amount. Even if husband handled business matters for family, he never signed any document before as agent for wife because wife had ALSO consistently signed any deed, mortgage or note in connection with the property they held jointly. 6. Ratification Applied: Ratification requires acceptance of the results of a prior act with an intent to ratify and with full knowledge of ALL the material circumstances. a. Here facts do not establish that wife had intent required to ratify or full knowledge of terms in contract. Even though wife saw using property and improving it and got payments from , it is not enough to show she had full knowledge of all the material terms of the agreement b. No Ratification by Inaction: Because husband had power to lease undivided interest in property and nothing to show that wife had any reason to believe was for anything more than that. may proceed against husband for specific performance damages but not wife.

Implied in Law Authority: Estoppel

1. Distinguished from Apparent Authority by Detrimental Reliance AND a. (1) Cause OR 13

b. (2) Knowledge and failure to correct c. Apparent authority makes the principal a contracting party with the 3rd party with the rights and liability on BOTH sides d. Estoppel only compensates the 3rd party for losses arising from the 3rd parties reliance and creates NO enforcement rights in the principal against the 3rd party 2. Elements: A principal is estopped from denying the agent s authority, when he a. (1) negligently or intentionally b. (2) causation: causes a 3rd party to think his agent has authority to do an act that is actually beyond his authority AND c. (3) detrimental reliance: the 3rd party detrimentally relies on the principal s conduct

Hoddeson v. Koos: Estoppel by storeowner s negligent surveillance

1. Facts: shopped at furniture store. Approached by man assumed was salesmen and placed order for $168 without receipt, the goods were never delivered and when called store they had no record. Store claims that man was not agent but imposter salesman operating without knowledge or . 2. Issue: Circumstantially, can be liable for acts of imposter even if the imposter was not s agent? 3. Held: Yes, wins. a. Burden: when a party seeks to impose liability on a principal for a contract made with an alleged agent, the burden is on the to prove the agency relationship. b. Apparent Authority: imposter obviously didn t have express or implied authority to sell and couldn t prove that appearance of authority was created by the manifestations of the alleged principal. c. Appearance of Authority: created by the manifestations of the imposter salesperson alone and failure to prove this element of agency requires a reversal of the judgment. d. Duty of Care for Store: store has duty of care for safety and security of customer which extends to reasonable care and vigilance to protect the customer from loss by deception of imposter operating on premises. Tortious dereliction of duty to an invited customer. e. Fact-Based Analysis: Sale took 30-40 minutes, through s lack of reasonable surveillance and supervision, imposter operated as fake for lengthy time.

Agent s Liability on Contract

1. General Rule: An agent is not liable on contract executed on behalf of principal but is ultimately depends upon the status of his principal 2. Status - Disclosed Principal: An agent who purports to contract for disclosed principal is not personally liable on the contract. a. Example agent negotiates the contract in the name of the principal and agent is not a party to the contract. b. Intent - Parties intent is that the principal be bound. 3. Status Undisclosed Principal: An agent acting on behalf of an undisclosed principal is personally liable on the contract. 14

a. (1) Doesn t know acting as agent AND b. (2) Principal s identify are not disclosed. 4. Status - Partially Disclosed Principal: Agent acting for partially disclosed principal is personally liable on contract UNLESS otherwise agreed to. a. (1) Know Agency - 3rd party knows that the agent is acting as an agent b. (2) Doesn t know identity - BUT doesn t know the identity of the principal.

Atlantic Salmon v. Curran: Partially Disclosed Principal and Personal Liability of Agent
1. Facts: AS and S were salmon sellers and s. bought from s and sold to wholesalers. represented him as rep. of BISE and paid with BISE name, using designation Treasurer. placed ads for BISE in magazines saying established in 1982, while never existed. formed MD to sell cars s sue when learn BISE didn t exist to get $250K for sales. says agent of MD and they are liable. 2. Issue: Is an agent who makes a contract on behalf of a partially disclosed principal personally liable on the contract? 3. Held: Yes. must pay. 4. Reasoning: Partially disclosed because s knew was supposedly acting as an agent for a corporate principal but didn t know the principal s identity. a. Even though had certificate for MD stating it was doing business as BISE, had dealt with s using the name BISE before the certificate. b. Not Duty of s to Seek Identity of Principal: It is duty of agent, like , to fully reveal it. Fact that s could have determined the name of the principal by searching the city clerk s records is irrelevant c. Avoid Personal Liability: Agent MUST DISCLOSE BOTH that he is acting in a representative capacity and the identity of his principal.

Transaction Practice: Disclosure of Agency

1. Contract Documents: Spell out liability of agent and include contingency clause on entity dissolution or failure to form 2. Due Diligence: check legal status of opposing document signatory 3. Inform: tell client how to periodically check financial status of opposing party

Practical Signature Issues

1. Personal Agency: X as agent for and acting on behalf of Y a. Additions: X is personally not a party, nor bound personally to perform on the terms of the contract; attached is a copy of X s authorization to sign on behalf of Y 2. Signing on Behalf of Entity: X, CEO of Y, Inc., as agent and acting on behalf of Y, Inc. a. Attached is a copy of the board of directors resolution empowering X to sign on behalf of Y, Inc. and a copy of Y, Inc. articles, bylaws, cert. of incorporation, and current statement of annual fees to Sec. of State or counsel opinion that X has authority to sign and Y, Inc. is in good standing 3. Bad Signature Problems: Personally bound? Y bound? Both bound? 15

a. X, CEO of Y, Inc. b. Contract interpretation problem: intent of parties

Vicarious Liability: Principal Liable to 3rd Party

1. Vicarious Liability: Without Proof of Fault of Principal 2. Distinguish: a. Vicarious v. Direct Liability b. Employer-Employee v. Independent Contractor 3. Personal Duty: Principal will breach a personal duty to the victim and will be at fault if a. (1) Direct or Primary Liability: Direct agent is told to do a specific injurious act (tells driver to run over man) or the principal is negligent or reckless in hiring the employee or in supervising the employee b. (2) Indirect or Secondary Liability: Aids and abets or conspires with employee (usually requires intent) 4. Policy Argument for Vicarious Liability a. Principal has right to control employee which makes her the least cost avoider of the tortious act b. Save time and errors at trial employer in most cases is at fault somewhere c. Risk on injury on those with more wealth d. Incentive to hire independent contractors

Vicarious Liability: Independent Contractor v. Employer

1. Master-Servant (Employer-Employee) Relationship: Principal liable for acts of employees within scope of employment even if principal doesn t specifically order, direct or intent employee s torts nor breach a personal duty to the victim a. Respondeat Superior: An employer is liable for all torts committee when employee is acting within the scope of employment; injured party can proceed against both employer and employee (employee directly liable and employer vicariously); imposes strict liability on the employer b. Limits: (1) Non-agents v. agents; (2) Independent Contractors and (3) Inside v. Outside Scope Kind, Time, Motive and Space of Tort 2. Independent Contractors: When a principal retains person to do certain job or get specific objective a. Right of Control: principal retains no right of control over the independent contractor as to how the work is performed and the contractor may determine on own how they will achieve the goal b. Respondeat Superior Inapplicable: Certain limited situations an employer may be liable under tort, but RS never applies in liable cases, liability is based on employer s own negligence or matter of public policy c. Potentially Liable: negligence in selecting an independent contractor OR if the contractor is to perform highly dangerous acts like blasting 16

3. Controls or Has the Right to Control: Direction vs. Advice is key distinction? a. Problem: When is advice mandatory when backed by termination power. If so, advice is always followed. b. Termination power alone is enough? Right to Control, absence of exercise control not definitive

Humble Oil Refining v. Martin: Liability is Question of Fact

1. Facts: L left car at gas station owned by for service and before anyone there touched car, it rolled down hill and struck and daughters. sued L for negligence and jury gives damages. says it was not liable because service station was operated by independent contractor, S. 2. Issue: Do the facts indicate a relation of master-servant between S and so can be liable for negligence of S and other service station employees? 3. Held: Yes, S was an employee of not independent contractor facts show. 4. Question of Fact: Contract between and S, s exercise of control over operation of station, both show Humble Oil v Martin that S was an employee. a. Contract as Proof: Shows owned station, had financial control, set hours, provided its own Liability?? Humble Oil Hired auto products for sale and set the price of those Schneider products; Also paid 75% station s public utility Hired Service Station bills, gave equipment, ads media and products Schneider paid commissions Manis on products; kept repair fees; and paid a lot of operating costs. Tort Products Repair paid some rent Held: Yes b. Employee Actions: No business discretion Public except as to hiring, firing and payment of a small amount of employees.


Hoover v. Sun Oil: Independent Contractors

Hoover v Sun Oil 1. Facts: was hurt when car caught fire while being filled with gas at station owned by and operated by B. Sun Oil Liability?? Accident was due to negligent of employee, S. sues , Owned B and S. Lease 2. Issue: Was B an agent of such that could be liable Service Station Barone Rent $ for negligent actions of B s employees? Hired 3. Held: No, fact based. Smilyk 4. Facts Proving B to be Independent Contractor: B made Rent payments depended on gas sales inside a Tort minimum and maximum. no written reports to and alone assumed risk of profit Held: No or loss in business operations; he independently set the station s hours of operation, pay scale and working conditions of his employees. a. Typical Relationship: B and had typical company-service station relationship. B advertised and sold gas and other products with s label. s sales people occasionally came to station to take orderly, look at restrooms and talk about any problems B had.


b. Suggestions v. Obligations: made suggestions to B to improve sales and marketing BUT B was under no obligation to follow the advice.

Miller v. McDonald s: Franchisor Liability (Oregon, 1997)

1. Facts: sues McDonalds ( ) for injuries she got when she bit into stone while eating burger. That McDonalds was owned and operated by franchisee, 3K. 2. Issue: Was there an agency relationship and 3K that could make liable for s injuries. 3. Held: Yes. Franchise agreement created agency. a. Agreement Facts: Laid out detailed instructions on how to operate the restaurant. Periodically sent inspectors to ensure conformity. b. Jury could find that reasonably retained sufficient control over 2K s daily operations such that an actually agency relationship existed 4. Test for Apparent Agency: Whether the putative principal held the 3rd party out as an agent and whether the relied on that holding out. a. Everything about appearance of McDonalds owned by 3K identified it with the and common image it has created by national advertising, common signage, menus and uniform. b. said she went to restaurant under belief that it would have same quality of service and care as other McDonald s around the country

Murphy v. Holiday Inns: Slip and Fall Litigation(VA, 1975)

1. Facts: fell on sidewalk outside of BMH Corp. owned hotel. BMH entered into license with Holiday Inn to use name subject to terms. provides name, quality assurance, national advertising and system of operation in return for fees for BMH. 2. Issue: Did exert control over BMH to extent that it would constitute an agency relationship? 3. Held: No, No principal-agent or master-servant relationship exists even with specific requirement in franchise contract. 4. Reasoning: The franchise agreement was only to standardize the business identity, commercial service and only for the benefit of both parties. never had control over day-to-day operations, maintenance, rates, wages, etc. BMH has retained all power that an owner and operator of business have.

Practical and Policy Questions: Compensation

1. Distinction between Murphy and McDonalds: Person though McDonalds built, owned and operated as part of business a. Ignorance of 3rd Party allows it to sue because they do not know about agency or apparent authority b. Ignorance sets up apparent authority v. protection of franchisor question if let all these people sue, franchisors will not come to state 2. Distinguish Murphy/McDonalds v. Humble and Sun Oil: Oil companies owned the stations, while BMH and 3K owned their business just had contract


3. 4.



a. Contract does not control must look to details of control in contract to see if agency relationship exists Does law discourage company ownership of retail outlets in favor of franchises? a. Yes, because they already do. If you have control, you lose apparent authority Does this discourage active involvement: a. Yes, if you are a franchisor and show up and tell franchisee what to do you may be liable (clean the bathroom liable); cook burgers right are you liable? b. Business incentives are created by law When is control plus liability less expensive than no control and no liability? a. Control reduce accident, absorb costs that occur, better marketing, more product sale b. No control leave accident reduction to operator, avoid liability costs, suffer sloppy local practices (unclean toilets), fewer product sales c. Business Decision: What would make me more money? Transactional Lawyer Issues: a. When is a supplier or franchisor liable for torts of distributor? When controls day-today, maybe, or subjective test. b. Can a supplier or franchisor limit liability for control agreements at the margin of the legal test? Make sure documents are in franchisees agreement, make ads mention franchisees c. How do we cut off apparent authority? If local customers think McDonalds controls a local franchisee, are they liable? Use objective test. Real control (sent to clean and they cleaned) v. Right to Control (had power to inspect but did not)

Scope of Employment Defense

1. Defined: For Respondeat Superior to apply, the employee must have committed the tort within the course and scope of employment. 2. Elements: A reasonably foreseeable act that a. (1) Must have engaged in work for the employee of a type that he was employed to perform b. (2) during work hours 3. Factors: (1) authorization of act by employer; (2) time; (3) place; (4) purpose of act, (5) common practice; (6) extent to which interest of employer or employee was involved, etc. 4. Intentional Acts: Liability extends to intentional acts if the act is related to carrying on the employer s business a. Recovery for employee s assault may be within scope of employment b. Serious crimes excluded c. Miller v. Federated Dept. Stores: interfering with agent s duties to principal; agent responding to interference d. Issue: Is an employer liable for injuries to a victim of an employee s assault. e. Rule: To relieve himself of liability for injuries from an employee s assault, the employer must show that the assault was in response to the s conduct which was presently interfering with the employee s ability to perform his duties successfully. 19

If a jury could have found that conduct interfered with agent s ability to perform his duties effectively and the ineffectiveness caused the harm, then must go to jury 5. Assumptions: Assume agency and employment relationship liable? a. Scope of Employment Test b. Frolic (no) v. Detour (yes, Clover v. Snowbird Ski skiing during CLE injury)


Ira S. Bushey v. US: Reasonably Foreseeable Acts

1. Facts: US Coast Guard, , had ship in dry dock owned by while repairing it. One night, servicemen came back crunk and messed with some stuff causing the boat to fall off blocks against the dry dock wall. sued to repair. 2. Issue: Did the court err in holding response for acts of its drunken sailor? 3. Held: No, the act was within reasonable foreseeability of employment. 4. Reasoning: Conduct of a servant is within scope only if it is actuated, at least in part, by purpose to serve the master. a. Here turning wheels was no way to help master but was liable based on doctrine of respondeat superior, claiming that opposite ruling would result in effective allocation of resources; allocation of resources rationale b. Reasonable foreseeability conduct of sailor was not so unforeseeable to make it unfair to hold response because after going out, returned as requirement to employer; sailors get crunk, can be foreseeable they ll come back crunk and it is immaterial that sailor s precise action could not be foreseen. c. Risk of crunk sailors coming and going from boat to damage boat is enough to make it fair to punish

Arguello v. Conoco: Statutory Torts

1. Company Owned and Operated Stores: Scope of Employment Defense. a. Held: Conoco s Motion to Dismiss and SJ Denied. 2. Company Franchised Stores: No Agency defense. If agency, independent contractor defense. a. Held: motion to dismiss granted, no agency relationship existed. 3. Facts: Group of Hispanic and black consumers ( s) sue Conoco for employee discrimination when they tried to buy gas at s stations. Many incidents. In Arguello incident, woman got gas and father went to pay asked for ID and gave OK license. Smith told her out-of-state license was no good and Smith insulted her racially and obscenely. Locked the doors when tried to reenter and kept yelled racial shit on intercoms. Two other incidents. a. Company owned and operated stores; scope of employment defense 4. Issues: a. (1) Was it incorrect for court to say that no agency relationship between and the Conoco-branded stores? b. (2) Did the court err in granting SJ for on the issue of if Smith acted within the scope of employment? c. (3) Did court err in dismissing disparate impact claims? 5. Held: (1) No; (2) Yes, question of fact for jury. (3) No. Motion to dismiss and SJ denied. 20

a. No agency relationship defense b. If agency, independent contractor defense c. Held motion to dismiss granted; no agency. 6. Reasoning: did not control the day-to-day operations of the Conoco-branded stores and no agency existed. must show an agency relationship between a and 3rd party to impose Section 1981 liability on a for the racially discriminatory acts of a 3rd party. a. Petro. Marketing Agreements state business should be consistent manner with standards of and that customers should be treated fairly and what not guidelines for operation with name BUT do no establish that has any participation in or control over daily operations of the stores b. Without agency, cannot be liable for events no agency exists when Smith (nonowner) acted outside the scope of employment. c. Even though Smith did depart from normal methods of making a sale by shouting racist shit, it doesn t necessary lead to conclusion that her actions were outside the scope of employment and there is no evidence in the record as to whether could have reasonably expected Smith s conduct jury question

Independent Contractor Defense

1. Non-delegable duty: exceptions to the defense a. Dangerous activities plus negligence of agent b. Special relationship to victim (fiduciaries, social guests) c. Ownership of land (effect on known users) 2. Liability for Torts of Independent Contractors: Employers of independent contractors cannot be held liable on respondeat superior theory but can be held liable for own negligence or public policy reasons a. Example an employer may be held liable if he is negligent in selecting an independent contractor or if they are performing highly dangerous acts

Majestic Realty Associates v. Toti Contracting: Nuisance

1. Facts: City of Patterson Parking Authority hired independent contractor, Toti, to demolish buildings for new lot. owned building next to one set to be taken down. During course, large debris caused hole in roof of s building. 2. Issue: Can Parking Authority be held responsible for negligent acts of an independent contractor if the work was a nuisance per se? 3. Held: Yes, it was a highly dangerous act. 4. Reasoning: Generally, not liable but this is a highly dangerous situation, nuisance per se. a. Nuisance: inherently dangerous can only be carried out safely be exercise of special skill and care and it involves grave risk of danger to persons or property if negligently done (like razing buildings in a busy, built-up section of a city) b. Principal negligent when selects IC with insufficient assets or insurance to cover anticipated liability


Effects of Vicarious Liability on Business

1. Ideally: Employers will a. Buy comprehensive insurance to cover 3rd party injuries b. Take extra care to hire, train and monitor employees c. Educate 3rd parties on risk and business relationships 2. At Margin, Legal Incentive to: a. Us independent contractors rather than employees (outsourcing?) b. In relationships with independent contractors want to relax monitoring of business operations and rely on dealers (spread) ather than brokers (commissions) OR pay by the job and avoid hourly rates 3. Effect on 3rd Parties: Frequent large business operations rather than small independent owners operations a. Deliberate ignorance of business relations among those who license trade names may prove to be beneficial b. Rely on business operator s insurance for liability coverage more casual about personal insurance coverage and relaxed standards or personal vigilance and care when dealing with a large business operation

Fiduciary Obligation of Agents to Principals

1. Duties During Agency: An agent is a fiduciary and, as such, owes his principal the obligation of faithful service. Requiring the agent to notify the principal of all matters affects the agency. a. Core of Corporate Law: The duty of managers to the firm itself and to the firm s investors b. Duties: Care, Loyalty, Candor 2. Liability Occurs: a. Breach of contract b. Restitution Actions in both Law and Equity unjust enrichment, constructive trust, indemnification and contribution 3. Remedies for Principal: Enforceable in equity and tort. a. Damages: Agent may be liable to principal in tort for breach of fiduciary duty. b. Action for Secret Profits: When agent breaches fiduciary duty and profits from it, principal may recover the actual profits or property held by the agent. c. Rescission: Any transaction that violates the agent s fiduciary duty is voidable by the principal. d. Accounting: Imposition of a constructive trust on property the agent obtained in violation of his fiduciary duties e. Others: Injunction, Breach of Express Trust.

Fiduciary Duties
1. Duty of Care: Restatement Section 379 a. Standard (reasonable) care and skill for task and profession 22

b. Obey directions and act only as authorized 2. Duty of Loyalty: Restatement Section 387 a. Agent must not compete with his principal anything that an agent obtains as result of his employment belongs to that principal, barring the retention of secret profits, advantages and benefits without the principal s consent 3. Duty of Candor: Restatement Section 381 a. Duty to give information, keep and render accounts

Reading v. Regem: Secret Profits and Duty of Loyalty

1. Facts: was UK sergeant in Egypt would board truck with unknown contents each week and escort them through Cairo in uniform. Passes civilian police without inspection and paid large sums for work. Military finds activities and take money from for crown. Sues to get back. 2. Issue: Is entitled to recover money he made outside the scope of his employment? 3. Held: No, crown justifiably took money. 4. Reasoning: If a servant unjustly enriches himself by virtue of his service without his master s sanction, the law says he should not be allowed to keep the money and it should be given to his master. a. Because got the money SOLELY by reason of position he occupied as servant of the crown uniform and position as servant to Crown were only reasons he was able to obtain this money which is sufficient to cause him to forfeit it

General Automotive Manufacturing v. Singer: Duty to Disclose Information

1. Facts: was employed by as general manager with contract requiring he not engage in any other business during his employment and that he not use or disclose any info concerning for own benefit or to s detriment. Duty as GM was to get work for machine shop he was successful. Then, took on orders he didn t feel had capacity for and didn t inform that he would hire another shop to do the work at a lower price than he quoted and would keep the difference. 2. Issue: Did breach his fiduciary duty to by failing to inform of the existence of orders may not have been able to fill? 3. Held: Yes. Breach. 4. Reasoning: was acting as broker for his own profit in a field where he had contractual duty to work only for . had fiduciary duty as an agent of to exercise good faith and loyalty BUT instead acted in self-interest and adversely to . a. Failure to Disclose by failing to disclose the existence of the secret orders, he was in violation of fiduciary duty to act solely for benefit of and liable for profits earned

Termination of Agency and Grabbing and Leaving

1. General Default Terms: a. Terminable at will of either party b. Otherwise end of reasonable term or when specific act is performed c. OR on violation of duty 23

2. Stipulations: if parties stipulate a set term by time or by task a. Either can breach principal revokes or agent renounces b. Remedy limited to damages, no specific enforcement or injunction 3. Grabbing and Leaving: Post-termination competition with a former principal is allowed BUT former agent cannot disclose trade secrets or other confidential information during his employment solely because he was agent

Town & Country Home v. Newberry: Soliciting Former Employer s Clients

1. Facts: was cleaning business and worked for for three years. After leaving, set up own cleaning business to directly compete and solicited s clients. brings action for injunction and damages dismissed. 2. Issue: Can enjoin s from soliciting its clients? 3. Held: Yes, the only trade secret that could be involved in a case like this was s list of customers. a. Ex-employees solicitation of employer s customers, obtained at considerable cost, was breach of duty of loyalty b. Conspiracy theory of Apellate Court en masse departure

Microsoft v. Google: High-Tech Industry

1. Facts: Computer engineer Lee left Microsoft to work at Google and Microsoft sued under one year non-compete clause and confidentiality clause in the Microsoft employment contract. 2. Disposition: Case settled, while dirty laundry was aired. 3. High-Techs generally have employees sign multi-layer confidentiality and non-compete agreements to stop from giving away trade secrets


y y y y y Three Major Partnership Issues: (1) Formation; (2) Modification and (3) Dissolution RUPA v. UPA: RUPA will apply to ALL partnerships old or new after 1/2010 and all partnerships formed after 1/2009 and applies to all who voluntarily opt in Not Nonprofit or Created by the State: A lawful partnership cannot be formed for nonprofit purposes nor can be a state entity (must be private) Distinguished from Sole Proprietorship: partnerships and joint ventures have multiple owners Creation: by state certificate; Limited Partnership/Limited Liability Company/Corporations companies

Comparison with other forms of doing business

1. Agency: partnership is more complex extension of sole proprietorship, which incorporates many of the principles of agency law in structuring how the partnership will function 2. Joint Ventures: association of two or more members, agreeing to share profits usually more limited than partnership and formed for a single transaction for example. Rights and liability of partners and joint venturers are usually the same and courts generally apply UPA to joint ventures. 3. Other unincorporated associations: business trusts, for example, are not partnerships

Sources of Partnership Law: UPA and RUPA

1. Common Law: equity side, until 1914 2. Uniform Partnership Act of 1914: UPA was adopted by all states, so that the provisions governing partnerships are usually a part of state statutory law, rather than common law 3. Revised Uniform Partnership Act of 1997: adopted by growing number of states (OH just passed it) a. Applies to all partnerships formed after its adoption in any given state b. Continues many of the rules of UPA extends ideals

Joint Ownership: Default Rules

1. All Owners (Partners): Are a. (1) liable as principals under RUPA 305 and 306 and are jointly and severally liable for the debts of the business b. (2) Are general agents of partnerships and owe fiduciary duty to each other (Meinhard) RUPA 301 c. (3) Share equally in control RUPA 401(f) & (j) 2. Entity and Aggregate Characteristics: Treated both as a separate entity from its partners for some purposes and as though there is no separate entity but merely an aggregate of separate, individual partners a. Aggregate Theory: Partners jointly and severally liable for obligations of partnership 25

Tax Example: for tax purposes, income and losses of the partnership are attributed to the individual partner the partnership itself doesn t pay taxes although it does file an information return b. Entity Characteristics: some purposes, partnership is treated as a separate entity apart from individual partners i. Capacity to sue or be sued: jurisdictions vary as to whether partnership can be sued in own name e.g. if federal question is involved then it can in own name in federal courts ii. Ownership of property: can own and convey title to real or personal property in its own name without all partners joining in the conveyance (UPA 8) c. RUPA 201 (Simplification): unlike the UPA, RUPA expressly states that a partnership is an entity and simplifies many partnership rules like those on property ownership and litigation


The Decision to Form a Partnership and Split Equity

1. Case Example One: You have capital and need labor, skills and management a. Option 1 pay an employee (sole proprietorship) b. Option 2 Split equity partnership (moneybags to pay worker bee) 2. Case Two: Have labor but need money a. Option 1 borrow money (sole proprietorship) b. Option 2 split equity partnership 3. When to split equity: Lowest contracting cost business decision

Partnership Formation: Default Rules

1. Defined: Partnership is a voluntary association and there must be an express OR implied agreement in order to form one 2. Actual RUPA 201: Real or by consent a. Affirmative: co-owners of a business for a profit b. Negative: not a tenancy in common, employer/employee relationship (sole proprietorships) or lendor/debtor relationship c. Factors: sharing of profits, not gross returns proxy for control? 3. By Law RUPA 308: Implied in Law a. Equity b. Partnership by Estoppel (holding out) 4. Formalities: If the partnership is continued beyond one year, Statute of Frauds states that it must be written 5. Duration: if no term is specified, then the partnership is terminable at the will of any partnership 6. Capacity: persons must have capacity to contract to be partner some states hold that corporations cannot be partners 26

7. Consent of Other Partners (UPA 18g): a prospective partner must have consent of ALL of the other prospective partners 8. Intent of Parties UPA 7: If there is any question, the intent of the parties involved is determined from all of the circumstances a. Factors: sharing of profit of the business, etc. not the gross returns

Fenwick v. Unemployment Compensation: Employees Compared to Partners

1. Facts: opened beauty shop in NJ in 1936 later hired C as cashier and receptionist year later. About year after C asks for raise and agrees if shop makes more cash. Written agreement, by attorney, providing that association of partnership. Agreement C makes no capital investment, continues at job but gets 20% bonus for net profits, alone is liable for debts and non-compete. Ended in 1942 when C asks to stop working. 2. Issue: Do the agreement and the conduct of the parties show a partnership? 3. Held: No. This was an employee relationship. 4. Reasoning: To first determine if partnership exists, court considers intent of the parties; if agreement is inconclusive, then look elsewhere at other evidence. Since inconclusive testimony of that C just asked for raise and was unsure if warranted, so wrote agreement because didn t want to lose her as an employee. a. Intent provide C the chance of an increase in pay and keep her services if the business couldn t afford it; after agreement parties continued to operate as before (no change) b. Other Factors - Share in Profits right existed here but not conclusive for existence of partnership; obligation to share losses; ownership and control of property and power of administration c. Problems with Written Partnership Agreement: share of losses, power to manage, right to property on dissolution are missing. d. Unusual Case: written partnership agreement share profits, file partnership tax returns often enough 5. List of Factors: (1) Intent; (2) share in profits; (3) obligation to share losses; (4) ownership and control of property; (5) power of administration; (6) conduct of parties toward 3rd parties; (7) rights of parties upon dissolution.

Transaction Lawyer: Drafting a Better Partnership Agreement

1. How could deal lawyers have respected deal points and drafted a partnership agreement that stood up in court? a. Clearly expressed rights to ownership and control of property (20% of profits) in agreement and upon any dissolution; conduct toward 3rd parties (show held themselves out, letterheads with partnership names on them, etc.) 2. Draft an independent contractor agreement? Would that have been respected?

Martin v. Peyton: Lender or Partner?

1. Facts: KNK partnership for securities was struggling with money. H arranges for a loan of some securities from P and friends ( s) which were used as collateral for bank loan to KNK. 27

2. 3. 4.


Agreement says no partnership is intended, until loan was repaid, Des were to get 40% of KNK profits; collateral was given to s in form of speculative securities owned by KNK; all dividends on securities loaned by s were to be paid to s ; s were to be consulted on all important matters and had power to inspect and veto assigned interest and had option to join firm at anytime. Each KNK partner had given letter to resign which could be accepted at anytime by s. s couldn t initiate any actions or binds firm for their actions. Issue: Has a partnership been formed? Held: No this is a lender-lendee agreement and unpaid creditors cannot collect from s. Reasoning: Sharing of profits is considered an element of a partnership, but not all profitsharing arrangements show that a partnership agreement exists. a. Language saying no partnership is intended is also not conclusive b. Must look to entire agreement to make the determination and all features of the agreement are consist with a loan agreement, not a partnership agreement. c. Return 40% profits capped at $500,000 with minimum of $100K; option to buy up to 50% of firm d. Protective covenants; collateral; substantial management rights; assignment; right to control loaned securities Organizational Note: If KNK had organized as a Corp., LLC or LLP, the s would have avoided any risk of liability. Under those forms, as equity investors, s could not have been held personally liable for the firm s debts.

Loan Covenants
1. Danger: Martin and Cargill cases show danger of overly aggressive loan covenants 2. Martin result: maybe different if trustees had been aggressive in monitoring KNK under covenants? a. Different if the trustees had vetoed investments, fired partnerships, run all distributions through a controlled bank account? b. Potentially different because of difference between right to control and exercised control

Transaction Lawyer: Creditors and Lenders

How could Peyton lawyers have better drafted deal agreements to reduce litigation risk and still accomplish business goals? 1. Use Limited Liability Vehicle 2. Use more Traditional loan covenants on management rights trust indenture a. Can be very powerful veto rights a. There are grave dangers to novel deal terms

Debt/Equity Distinction: Introduction

1. Tax Effects: interest deduction v. no dividend deduction 28

2. Liability Effects: Assume Insolvent Firm a. Partnership: in creditor pool claiming share of left-over assets v. paying all unpaid creditors as well as losing investment contribution b. Limited Liability Entities: Asset distribution priority creditor pool v. residual equity pool

Southex Exhibitions v. Rhode Island Builders: Service Contract or Partnership?

1. Facts: s entered into agreement with SEM, predecessor-in-interest to s regarding future of s shows in RI arena. Agreement stated that wishes to participate in shows as sponsors and partners and have 5 year fixed terms, renewable by mutuality. agrees to sponsor and endorse only SEM, to persuade members to have exhibits at SEM shows and to allow SEM to use name for promos. SEM agreed to obtain licenses, leases, permits, etc., indemnify for show related losses; could accept/reject any potential exhibits, audit show income and advance necessary capital to finance shows. Mutually determine show dates, prices, bank. 2. Issue: Does a partnership exist between the parties? 3. Held: No. Not a partner, totality of the circumstances test and lack of dissolution rights (renewal obligation) showed non-partnership. a. Producer absorbed all losses; management rights uneven b. Also no public self-identification (e.g. no partnership tax return; no partnership contracts with third parties) 4. Reasoning: Evidence of profit sharing is prima facie evidence of partnership, and failed to show any enumerated exceptions, BUT without any intent to form a partnership a finding of one is not compelled.

Lawyers: Renewal Rights

1. Normal Situation: This is a more normal situation than Fenwick 2. Good Litigator: suggests to client after-the-fact that a partnership structure is possible and has litigation advantages a. Client that s good, we were partners, then. b. Contemporaneous self-declaration is think because no partnership tax returns, no name or title sharing. Court sees through it. 3. How could Southex better protect renewal rights? a. Contract language on good faith b. Renewal expectations in agreement leave little open to interpretation

Partnership by Estoppel
1. Liability of Alleged Partner: One who holds self out to be partner, or who expressly or impliedly consents to representations that they are partner, is liable to any 3rd person who extends credit in good faith reliance on such representations (UPA 16) a. Example A represents to C that she has wealthy partner in B in order to get credit; B knows of the representations and does nothing to tell C she is not partner; C makes loan for purposes of the loan, B will be held to be a partner with A but has no other rights to participation in A s business 29

2. Liability of Partners who Represent Others to be Partners: If in above example A were part of actual partnership, then she would make B an agent of the partnership by her representation that B was also a partner in this case, B could bind A as though they were factually partners but only those other partners of A who made or consented to A s representations would be bound

Young v. Jones: Liability of Affiliated Company (DSC, 1992)

1. Facts: PW-B is Bahamian general partnership and PW-US is NY GP. s invested $550K in SAFIG based on unqualified audit letter on SAFIG by PW-B. After funds disappeared and s learned that SAFIG faked statements s allege that two are partners by estoppel because of letterheads and signatures and similar names. 2. Issue: Do a US firm and its foreign affiliate operate as partners by estoppel when the foreign affiliate uses the firm name and trademark, and the US firm makes no distinction in its advertising between itself and foreign affiliates? 3. Held: No, case dismissed. 4. Reasoning: Two firms are organized separately, there is no partnership in fact. a. UPA 16 says that a person who represents himself or allows another to represent him to anyone as partner in an existing partnership or with others who are not actual partners are liable to anyone whom relies on this representation in good faith b. An exception to the rule that persons who are not actual partners as to each other are not partners as to 3rd parties c. This case s do not contend they saw the PW-US brochure or that they relied on it in investing nor does it say that affiliated entities are liable for each other s action. Must show actual reliance.

Partnerships: Governance, Dissociation, Dissolution and Liquidation

1. Governance and Default Rule UPA 401(j): Majority of partners have power to make all business decisions within the ordinary course of partnership business a. Minority dissenting partner cannot opt out, even by informing third party of dissent b. Third party cannot rely on authority of minority; dissenting partner to bind partnership c. Problem: apparent authority? 2. Dissociation, Dissolution, Winding Up and Liquidation - Default Rule for At Will Partnerships (RUPA 801(1)): Any partner can walk and force liquidation absent other circumstances (partnership agreement denies option/bad behavior) a. Duty of Confidentiality b. Duty to Account Survive c. Defaults: problem for modern business too easy to leave without no capital lock up; leaving means that remaining equity owners must reconstitute entire business 3. Dissociation Wrongful or Not Wrongful?


a. Not wrongful: at will partnership RUPA 601(1) no term or task Death, Bankruptcy, Court Order b. Wrongful: breach of partnership agreement (even if partnership is at will) OR short of agreed term of task 4. Effects of Wrongful or Not Wrongful Distinction: Can remaining partners continue partnership or may partnership dissolve? RUPA 801. a. At Will Partnership Dissociation: Liquidation unless wrongful or plus, kicking out on proper grounds by unanimous vote or on more general grounds by court order, bankruptcy of partner, death or incapacity must liquidate b. Term or Task Partnership: special rules c. Damages?

Meinhard v. Salmon: Duties with Regard to Outside Opportunities

1. Facts: G leased hotel to for 20 years; with agreement, had to spend $2M in improvements shortly after, entered joint venture with to pay1/2 of money needed to alter and manage property receiving 40% of net profits for 5 years and 50% after. had sole power to manage, interest in lease never assigned to . End of deal tried to put deal together to level all property to put up large building but failed and asked to enter new lease for 80 year renewal period. found out about it and demanded it be held in trust as asset of their joint venture. 2. Issue: Does the new lease come within s fiduciary duty to his joint venture partner as a joint venture opportunity? 3. Held: Yes. was entitled to interest in the new lease and must assume responsibility for of obligations. 4. Reasoning: Joint venture partners have highest obligation of loyalty to partners including and obligation not to usurp opportunities that are incidents of the joint ventures a. Close Nexus: there was a close nexus between joint venture and opportunity that was brought to manager of JV as it was essentially extension of subject matter b. controlled gets 51% and should get 49% 5. Punctilio Paragraph: Not honestly alone, but the punctilio of an honor the most sensitive, is then the standard of behavior. a. If a court cites this case, the will lose, if the court uses the term punctilio, the will lose big. 6. Correct Decision: a. Yes Salmon is greedy and secretive, this is just a renewal when they had the expectation of sharing. b. No Would parties have negotiated to the holding ex ante probably not, this is a huge change in operations and 50/50 split with a passive investor doesn t make sense; Meinhard had right of first refusal in financing better approximation 7. Rebuttal and Penalty Default: Rules force the party with the information about future opportunity (Salmon) to disclose that information to the other party (Meinhard) to avoid an undesirable result. It is not the rule that the parties would have contracted for ex ante. a. Problem: after Salmon disclosure, they do not agree and M sues, who wins? 31

Partner s Fiduciary Duties: Defaults

1. RUPA 404: Only (without RUPA 403) on old Duty of Candor (information) left out a. Duty of Care: Business Judgment Rule (gross negligence rate of agreement, grossly means that 9 of 10 people would agree) b. Duty of Loyalty: account, conflict of interest, non-compete (may be waived in 103) c. Duty of Good Faith and Fair Dealing: added to RUPA 2. RUPA 103: Agreement May NOT a. Unreasonably restrict 403(b) information b. Elimination duty of loyalty except for (1) categories of acts if not manifestly unreasonable or (2) cleansing vote c. Unreasonably reduce duty of care d. Eliminate Duty of Good Faith/Fair Dealing but may prescribe standards if not manifestly unreasonable

Duties after Dissolution of a Law Firm

1. Duty of Care: Bane v. Ferguson terminates on end of partnership ex-partners as creditors BJN introduced - RUPA 404(c) 2. Duty of Loyalty: Meehan v. Shaughnessy procedure for soliciting firm clients a. Held: breach on the facts no candor; client notice and other communications not proper b. Duty to Account for Fees from partnership clients serviced by Ex-Partnerships (later in Chapt.)

Lawyer Leaving Firm: What Actions to Take

1. What should do: sit down with the firm and tell them you are leaving jointly negotiate a letter signed by both firm and you; then cut a deal on how the clients will get approached a. Clients have the choice on who to go to cannot just say that will not give them the file 2. Reality - Firm will kick you out in reality write your letter after you already are packed and give it to them

Perretta v. Prometheus: Opting out of Fiduciary Duties

1. Facts: Prometheus PIP and PDC were partnership to manage two apartment complexes PDC is 100% owned by DNS. Peretta was limited partner in partnership between POP and PDC, PD notified limited partners that it would merge into PIP Partners-General, which was owned by DNS and daughter of DNS. Proxy statement sent to LPs with terms and asking to approve it said PIP would vote neutrally. Peretta alleges merger was self-dealing transaction in violation of PDC s duty of loyalty by setting an unfairly low price 2. Issue: Can we count votes? 3. Held: The partnership agreement controls. Partners weren t harmed at expense of partnership; ratified it properly, so not in breach.


a. Majority vote is sufficient for ratification but ALL potential votes must be included to determine percentages and ALL votes were not included; need plurality, majority was not achieved. b. Nonvoters included in calculation counting interested LP votes is manifestly unreasonable RUPA 103(b)(3)(ii) doesn t include the language 4. Limited Partnership: LPs are passive investors, give money, expect return but have limited management rights; do not want to be too involved or it would be General Partnership (like Mutual Funds private equity funds, leveraged buyout firms, vulture firms) a. General Partnership unlimited liability for GP runs company, personally liable for all debt to the partnership; no limited liability 5. Effects: GP willing to take some passive LPs in business but only if able to cash them for fair value at GP s option not with LP s approval a. CA cannot in merger; GP exercise of options may be manifestly unreasonable if he could use call options included in sale of LP interests b. On LPs forget the LPs and get funding else, just don t let them in; borrow the cash

Expulsion of a Partner
1. RUPA Rules: Partners want to kick partner out and continue business 2. Without express term in Partnership Agreement: a. (1) by decree o court RUPA 601(5) b. (2) in very limited circumstances by unanimous vote RUPA 601(4) 3. Under Specific PA procedure 601(3): Change from UPA 31(6) bona fide and include Duty of GFFD in RUPA 103(5) and 404(d); change from UPA 38(1) and 41(6), too.

Lawlis v Kightlinger & Gray: Expulsion of Partner

1. Facts: Lawlis became senior partner at firm in 1975 with PA saying compensated by participating in partnership profits according to # of units assigned to them each year by partnership. 1982, became a drunk. And a year later firm found out and made new agreement that there is no second change. He did again firm did give him second chance to meet conditions to return to full partnership status. Under this PA, involuntary expulsion of partners was decided by majority vote of Senior partners. Came back 100% but then was fired by majority vote almost immediately after, only his voted against. Gave severance. 2. Issues: Did the notification that the Committee intended to recommend severance in the future and removal of files from office two days later constitute an expulsion in contravention of the terms of the PA? Was expelled in bad faith? 3. Held: No, expulsion was proper. Bona Fide in UPA; No cause guillotine procedure is bona fide if no wrongful withholding of money or property legally is due to the expelled partner at the time he is expelled. 4. Reasoning: When a partner is involuntarily expelled from a business, his expulsion must be bona fide or in good faith. 33


was fired to improve our lawyer to partner ratio and facts showed that productive when an alcoholic and initially concealed problem b. There was no real issue the firm acted in good faith to kick him out

was less

Partnership Property
1. What is it: Issue is whether property is partnership property of the individual property of a partner; all property originally brought into the partnership or subsequently acquired, by purchase or otherwise, for the partnership is partnership property UPA 81(1) a. RUPA 203: partnership holds property as an entity separate from partners 2. Intent: Where there is no clear intention expressed courts consider all facts related to the acquisition and ownership of asset a. Factors: (1) How title is held; (2) partnership funds used in purchase; (3) used to improve; (4) central to partnerships purpose; (5) frequent and extensive is partnership s use; (6) accounted for in financial records of partnership 3. Partner s Property Rights in RUPA 501: a. (1) Right to use specific partnership property RUPA 401(g) tenancy in partnership b. (2) Owns a partnership interest RUPA 501, personal property c. (3) Right to participate in management

Putnam v. Shoaf: Conveyance of Partnership Interest

1. Facts: FJ Gin Co. originally operated as equal partnership between EC, LC, LP, and CP in agreement, CP succeeded her husband LP after death. CP decided to sever relationship and relief from debt liability owed by gin to Bank. Shoafs agree to take over position and assume personal liability for all debts if CP and Cs each paid $21,000. FJ Gin has negative $90K agreement. All Gin assets and land held in partnership s name and CP conveyed her interest to Shoaf by quitclaim deed. In 1977 bookkeeper leaves and find out he embezzled money banks pay $68,000 into court. sum paid to C and other to dispute to S and CP 2. Issue: When a partner conveys her partnership interest to another, can she later claim an interest in a recovery resulting from a chose in action unknown to the parties at the time of conveyance of the interest? 3. Held: No, partner can only convey interest, legal claim of the partnership asset. There was no existing interest by the exiting partner. 4. Mistake: Right result but wrong reasoning a. Court treats agreement as partnership assignment under UPA 27 but assignment doesn t dissolve partnership itself; need court decree under UPA 32(2) and interest can be conveyed, pledged, subject to execution b. Interest portion of profit and surplus minus cash flow c. Agreements were in fact a voluntary dissolution under UPA 31(1)(c) because Putnam held assets as tenant in common and conveyed all title to S secured release from major credit and assumption from S; still secondary liable on some debts if creditor without knowledge of dissolution 34

Problems: Capital Contributions and Free Riders

1. Major Problem: when firm needs more money but some partners don t want to give it or have enough to give (no requirement to give cash in default rules game of chicken) 2. Start Up Capital Equity S1m; Loan $9m 3. New Capital Default Rule: No obligation to contribute, no new partners without unanimous consent; majority of partners can agree to borrow or accept new capital contributions from existing partners a. Free Riders: let other take risk of putting in new money and sit on initial capital contribution 4. Agreements: Pro Rata Agreements: pro rata equity call, penalty dilution, pro rata loans, sale of shares to new partners, promoter must make loan (default rules don t allow without unanimous vote of all the existing partners) a. Private Equity Funds: equity calls with caps, refuse, penalties (option in manager to sell interest or dilute interest) 5. Free Rider Problem: Partner s Choice $25K cash paid a. If make loan to partnership of $12.5K, $37K now at risk b. If no loan and keep $12.5 cash; $25K at risk and same return if someone else loans an extra $12.5 c. Answer: Collective action, we all make loan or no one does; game of chicken and who can bluff better

Partner s Management Rights: Defaults

1. Equal Rights: in management RUPA 401(f) 2. Disagreements: majority on ordinary matters; unanimity with veto on major changes to partnership in UPA 401(j) 3. Effects on Agency Powers RUPA 301: a. Power to Bind Partnership in the ordinary course: of the partnership business unless no actual or apparent authority b. Power to Bind in Extraordinary Matter: only if authorized by all partners 4. Stalemate Problem: Two partners disagree on deal, can one partner bind the partnership to the deal? a. If ordinary: YES, RUPA 301 controls as default; no partnership decision to change default rule is effective

National Biscuit v. Stroud: Cannot Escape Responsibility

1. Facts: and F enter partnership to sell groceries under Stroud s name. No restrictions on management functions of either. told s that he would not be responsible for additional bread delivered. F still orders $171 more bread from . and F then dissolve partnership and was responsible for the winding up; refuses to pay.


2. Issue: Without restrictions in the PA as to authority, can an equal partner escape responsibility for obligations by notifying a creditor that he will not be responsible for partnership debts incurred with that creditor? 3. Held: No, third party knowledge of disagreement does not affect actual authority to sign bread delivery contract. a. Acts of partner within the scope of partnership business bind all partners. b. A majority of partners can make a decision to inform creditors and then will not be bound but acts of minority in contravention but there is no majority here. 4. Dissolution: Had dissolved the partnership and given notification prior to order by F, would not have been personally liable for the partnership debt to . 5. Why not allow Stroud to opt out by notification? RUPA allows it, but it protects partnership from hold-up power of minority partners. 6. How can Stroud protect himself? a. Ex ante partnership agreement b. Ex post dissolve partnership and notify 3rd parties that he is not liable; F s agency survives in the winding up period, however

Summer v. Dooley: Majority Resolutions

1. Facts: and entered into partnership, operating trash business. Both worked, each providing and paying for sub when couldn t. asked to hire a 3rd person and refused, hired one anyway and paid him with own funds. When found out, he objected. sues for reimbursement. 2. Issue: In a two-person partnership, can one partner, over the objection of the other partner, take action that will bind the partnership? 3. Held: No, no actually authority to hire employee. Either not ordinary or not reimbursable between partners under UPA 18(b) distinguish third-party cases. a. When one of two partners refuse to consent to hiring a third person and objects upon finding out hiring there is no sitting idly by and acquiescence in the actions and it would be unjust to allow to recover

Partnership Tort Liability

1. Rule: partnership liable for partner s wrongful act in ordinary course of business or with authority of co-partners RUPA 305 2. Indemnification: There is no indemnification against partner causing injury (default)

Moren ex Rel v. JAX: Indemnification

1. Facts: M, partner in JAX, one day M brings in son, , to restaurant while she worked; sat and rolled dough while pressed hand in roller. 2. Issue: Does have indemnity right against Nicole Moren? 3. Held: No, there is no right to indemnification against partners.


a. Distinguished from Agency: partnerships are distinct entities from their partners and must indemnify a partner for injuries occurring in the ordinary course of the partnership business b. No corresponding right for indemnity for the partnership against the partner 4. Conduct Serving Interests of Partnership: Conduct was in ordinary course of business a. Liability for M s negligence rests with the partnership, even if her conduct partly served her personal interests, she was acting for the benefit of the partnership at the time of the injury even though she was also acting in her role as mother

Day v. Sidley Austin: Law Firm Management

1. Facts: Day was partner at SA with long history in DC office entitled to % of firms profits. Wants sole control of DC office, sued firm for breach and fraud. 2. Issue: Was s resignation precipitated by any illegality? 3. Held: Firm wins, no. 4. Keys: Rare to get a public glimpse of large firm PAs, practice often deviated from agreement a. New partners don t see agreement b. No votes of partners c. Power of the Executive Committee: Limited ratification by majority of voting percentages; voting percentages depend on participation units (older and more senior have more); and members of Exec. Comm. Are technically selected by majority vote but just faade (heaviest draw rights are EC) 5. Need for continuing amendment contract right adding new or dropping old partners dissolves the partnerships without one a. RUPA allows for you to add new partner or drop partner with vote without dissolving and reforming the partnership

Partnership Termination: Procedure

1. Major Changes from RUPA to UPA: RUPA allows for non-dissolution 2. Any change in identity of partners is: a. UPA: defined as a dissolution b. RUPA: may be dissolution but isn t necessarily one in 601 3. Problems: a. (1) Technically very tough, doctrinally tough b. (2) All in case book are still under the UPA close but not same as RUPA and we should look to RUPA now

UPA Partnership Dissolution

1. Basic Form: Dissolution any change in identity of partners 29 a. Winding Up: Turning assets into cash 30, 33, 35, 37 b. Liquidation: distribution of cash 38 and 40 c. Termination 37

2. Alternative Form: Dissolution, Buy-Out; Termination; New Partnership Formed among continuing partners a. Requires Agreement: Ex ante buy out provision in Day or Ex post with consent of exiting partner 41(3) gap filling rules b. OR Wrongful Withdrawal 38(2) 3. Triggers Withdrawal Per Agreement a. Ex ante buy/sell agreement b. Ex post settlement after disagreement with full or partial consent of withdrawing partner; partial let the court decide price; full price agreed 4. Triggers Unilateral Actions: Withdrawal a. Involuntary: Death or Bankruptcy 31(4) and (5); UPA D ol t o Tr gg r Co b. Voluntary: at will 31(1)(b) or Breach 31(2)  Unilateral Action : E xpulsion

Rightful Withdrawal Under UPA


Per Pr oced ur e in Ag reem ent. UPA 31(1)(d )

1. Rights of Any Partner if No Buy-Out App lica tion for Judicial Dissolution. UPA 32 (luna tic, incapa ble, g uilty of wrongful Agreement conduct, brea ch of a gree ment, not 2. Demand Liquidation: Yes, but SPLIT reaso na bly prac ticable to carry on business ) compare Dreifuerst in Wisconsin to Distoll Wrongful: Freeze-Out, Page v. Stiltner in Arkansas  Business Failure: UPA 32 a. If so winding up: partner can keep business going by selling to former partners in the liquidation might need unanimity? b. Safe harbor: judicial supervision of sale and winding up 37 (Prentiss) c. If final then distribution Kovacik v. Reed: Each partner is entitled to an equal share of the partnership profits and is chargeable with a share of the partnership losses in proportion to the partner s share of the profits; d. RUPA 401(b) expressly cites and rejects Kovacik and states that losses are shared even when one or more partners do not contribute any capital 3. Withdrawing Partner Consents to Continuation of Business: a. No full settlement: value determined by court 42 and RUPA 701 b. Full settlement: agreement determines buyout price

Breach or Expulsion under UPA

1. Breach: Wrongful withdrawal withdraw in violation of partnership agreement for a term or task (Owen can breach implied term) 2. Procedure: Remaining partners can choose between winding-up (liquidation) or continuing business 37 and 38(2) a. Liquidation: exiting partner pays damages b. If business continued: exiting partner receives value of interest minus damages and excluding good will 38

c. RUPA: does not exclude good will

RUPA: Dissociation
1. Dissociation: change in partner s identity or legal status 601 2. Numerous types: (1) Withdrawal; (2) death or incapacity; (6) insolvency; (3)(4)(5) Expulsion, (4)(8)(9)(10) Partner is legal entity other than individual and entity is terminated a. Some type require (2)(3) agreement (3) unanimous vote of other partners and (5) court order 3. Critical Issue Schism in Agreements: a. Some enable leaving partner to force winding up and liquidation: partnership dissolves b. Others only require a buyout and partnership continues on without dissociating partner 4. Wrongful? a. If YES, dissociating partner pays damages (netted with buy-out or liquidation distribution) b. If YES, cannot force liquidation c. Most happen in partnerships for a term or task: can delay paying you until term or task is over and when you walk out before term if over or task is done screwed hard 5. Buy-Outs: Partnership buys dissociated partner s interest at share of firm value on dissociation a. Equal to: higher of sales assets in liquidation or sale as ongoing business (without dissociated partner) MINUS damages AND b. Must tender cash within 120 days if no agreement dissociating partner can accept or sue in 120 days c. Prices Capital account, plus 3 years of average annual profit; other methods appraiser, multiplier (cash flow times multiplier); game theory; lawyer s error is often to use book value 6. Winding Up on Dissolution: partnership continues only to wind up a. Wind-Up: sell assets of partnership, pay creditors, distribute surplus to partners b. After distribution of all payments terminated and liquidated 7. Dissociating Partner Returns to Court: Asks court to (1) Determine buyout price 701(i) OR (2) Supervise wind-up on application for cause 803 a. Holds an auction for entire business and approves private sale to old partners (distress price?) b. Parties now bargain over true price in shadow of court decision

RUPA: Examples of Dissociations

1. Partner: I m leaving. Sell everything and pay me my share. a. Voluntary exist from at will partnership; no express agreement can force liquidation if exit not wrongful (can force close of business as long as not wrongful) 2. Spouse: Partner s dead. Pay me her share. a. No express agreement: can force buyout not a liquidation (can force the buyout of your share cash from partnership) 3. Other Partner s: You idiot, get out. 39

a. Expel per agreement: (3): if no agreement, requires court order for cause (5) even for at-will partnership liquidation rather than buy-out depends on agreement, otherwise requires court order.

Transactional Lawyers: Dissolution

Draft Partnership Agreement to Include and Distinguish: 1. Who has redemption option? a. Call firm can buy, leaving partner must sell b. Put leaving partner can sell, firm MUST buy 2. Buy-Out Price Options: Distinguish valid withdrawal and wrongful withdrawal or expulsion (net of damages) 3. Price-Calculations in Buy-Out: a. Fixed: capital account; book value b. Open: appraisal procedure; arbitration?

Default Rule Problems: Dissolution

1. Easy to dissolve partnership no capital lock-in 2. Once dissolved, opportunities for opportunistic claims a. Person who knows what they are doing can really stick up to anyone else 3. Hold-Up Power: Any leaving partner other than the expelled or wrongful withdrawer can force liquidation; leading partner has all the leverage can demand even his other partners to pay more or give him a higher draw a. Wrongful withdrawal grants any other partner right to liquidate b. Courts: Continuing partners gain bargaining advantage through us of a sympathetic court threaten to sue and take to court who favors the wronged 4. Dividing losses that eat into capital contributions a. Sharing of losses includes lost capital contributions; very hard on worker in worker/moneybags partnership RUPA does not follow Kovacik 5. Example: Moneybags has 50% at $100K and worker has 50%, when firm is doing poorly and worker wants to leave; Moneybags tells him that he cannot just walk and must him $50K (worker s share)

Causes of Dissolution and the UPA

1. Expiration of Partnership Term: fixed term of extension of term (extend with partnership at will on same terms) 2. Choice of Partner: any partner can terminate the partnership at will because it is a personal relationship which no one can be forced to maintain a. Where it is for term or even where it is at will if dissolution is motivated by bad faith, it may be breach


3. Assignment: Not an automatic dissolution, nor is the levy of a creditor s charging order against a person s interest but an assignee or the credit can get a decree to dissolve on the expiration of the partnership term or at any time in a partnership at will 4. Withdrawal or admission of a partner: Most Pas provide that losing a partner or getting one will not result in dissolution a. New Partners: may become parties to preexisting PA by signing it at the time of admission to the partnership 13(7) b. Old Leaving: usually provisions for continuing partnership and buying out the partner who is leaving 5. Dissolution by Court Decree: A court may use discretion in certain situation to dissolve a partnership a. Examples insanity of partner, incapacity, improper conduct, inevitable loss and or whatever is equitable 32

Consequences of Dissolution and the UPA

1. Distribution of Assets: Partnership[ debts must first be paid a. Capital Account: Amount are applied to pay the partners their capital account (capital contributions plus accumulated earnings MINUS accumulated losses) b. Current Earnings: If there is anything leftover, receive their agreed share of current partnership earnings 40 c. Distributions in Kind: Where there are no debts, or where debts can be handled from cash account, assets may not be sold but they may be distributed in kind to the partners d. Losses: where liabilities exceed assets, partners must contribute their agreed shares to make up the difference 18(a) 2. Rights of Partners: Violation v. No Violation a. No Violation of PA: assets are distributed as set forth above and no partner has any cause of action against another b. Violation of PA: innocent partners have a right in addition to those listed i. Right to damages: innocent partners have right to lost profits due to dissolution, etc. against the offender 38(2) ii. Right to continue business: right to not sell off and distribute assets, etc. by buying the offender s interest in the partnership 38(2)(b) posting bond and begin court proceedings Alternatively, innocents may simply dissolve and wind up, paying the offender her share, MINUS damages 3. Effects of Dissolution: Parties are liable until debts are discharged a. New partnership remains liable for old debts when there has been death, withdrawal or admission or new partner and business is continued, new partnership remains liable for old debts incurred by old partnership ( 41) b. Retiring partner s liability for debts incurred by partner s continuing the business ends power of a partner to bind the partnership except to the extent necessary to wind up his affairs 33; if 3rd parties do not know of the dissolution, contracts entered into with partner bind the partnership thus, retiring partner must make sure that prescribed 41

procedures are following to terminate any chance of liability for partnership obligations UPA provides notice of withdrawal or dissolution may be in newspaper or generally circulated

Judicial Help in Dissolution: Decrees of Breach

y y y Significant disagreements Incompetence Implied terms

Owen v. Chen: Significant Disagreements

1. Facts: and had oral agreement to become partners in bowling alley didn t state duration. advances $7K to partnership to buy equipment knowing he was taking out loan repaid out of profits of partnership. Disputes cause negative profits. 2. Issue: Was a decree of dissolution warranted? Proper for s loan to be paid from proceeds of the sale of assets when the PA provided the loan would be repaid through profits? 3. Held: Yes to both, in CA the Court may order dissolution if disagreements between partners make it so they cannot act in confidence and harmony, or if one partner, by his misdeeds, materially hinders carrying on the business. a. Although a party to a contract may limit his right to receive payments to a specific sources - Where the other party s conduct rendered it impossible for the partners to carry on the business from which the payments would be made, it would be inequitable to enforce that part of the agreement

Collins v. Lewis: Breach of Agreement

1. Facts: and have PA where puts up money to build and equip big caf and would supervise and manage it. Lease. would be paid back from net income and then they would profit share. Estimate $300K and eventually costs $600K with delays. Agreement provided that would repay $30K of s investment 1st year and $60K each year after. indicated that there were costs that were being paid out of the operating revenue rather than by as promised. 2. Issue: Does have the right to dissolve the partnership? 3. Held: No, the money partner failed to contribute the final $60K. a. had the right to dissolve the partnership but not the right to do so without damages since his conduct is the course of the partnership problems and amounts to a breach of the PA b. can either continue to the partnership and perform on the agreement OR dissolve and subject himself to possible damages for breaching agreement 4. Collins Declares Dissolution: Breach Agreement and becomes Wrongful Withdrawer a. Victim (Lewis) has Options: Can continue business for term by paying Collins (value excluding good will minus damages or posting bond to pay at end of term 38(2) OR can liquidate (cannot afford bond); Collins pays substantial damages (failure of business) out of his share and continues to put in funds per agreement


b. RUPA does not deduct good will and no payout or bond until end of term unless undue hardship

Page v. Page: At Will Partnership

1. Facts: and partners in linen supply. supplies essentials and PTS owes him $47K also was managing partner each $47,000 Leven Supply Ptn. Credit contributed $43K in capital; no written $43,000 $43,000 agreement; 8 year losing money then starts to make profit sues to dissolve for Plaintiff Defendant implied term partnership saying would end when money was paid back. 1948-1957: Lost $62,000 1958-1959: Made $6,000 2. Issue: Was the partnership for a term rather than at will? Can plainti di lv partnership? Held: Yes, at will ; could be liable for breach of fiduciary duty 3. Held: No term, but fiduciary duty to not however. Effect? Implied term, long enough time to recover capital investment; or Generous uy Out Price. appropriate new prosperity a. said there were no understandings about continuation for a term or until money was paid back some cases do hold that PTS shall continue for necessary term to repay debut but only if there is evidence showing this intention b. No evidence of intention here instead it reveals at will partnership; had power to dissolve the partnership upon express notice to c. If dissolves in bad faith he may be violating fiduciary duty as partner and would have to pay damages in a separate action but a partner is not bound at will to remain in a partnership just because it is profitable

Page v. Page

Prentiss v. Sheffel: Winding-Up Problem of Bidding for Assets

1. Facts: s and s were three partners to buy Center s filed suit to dissolve saying was derelict in duties and failed to pay balance of his share of operating losses. Seek permission to continue business and request value be placed on s interest. counterclaims seeking winding up as well as appointment of receiver and said he was wrongfully excluded from PTS in violation of rights. Court appointed a receiver to protect the partnership property until it could be sold, a partition made and assets distributed. At auction, s buy assets from court. 2. Issue: Should two majority partners in 3-man PTS, who have excluded the 3rd from management and affairs, be allowed to buy the PTS assets at a judicially supervised dissolution sale? 3. Held: Yes, his exclusion was not done for the wrongful purpose of buying the PTS asset in bad faith but rather was result of failure to relate in harmony for benefit of

Pav-Saver v. Vasso: Wind-Up Problems and PA

1. Facts: owned PST and patents. Majority SH, Dale, invests SLP. M owner and sole SH of . Dale and formed PSMC for sale of PSM. Sale agreed to contribute his service to venture patents and trademarks are contributed and M agrees to financing. Drafts PA approved by s 43

president. Dissolved and replaced with identical one between and eliminating individual partners. 2. Issue: What is the effect of the wrongful dissolution? 3. Held: The business can survive, the innocent may keep his patents and receive the agree upon penalty in the PA that was poorly drafted.

Kovacik v. Reed: Sharing of Losses in the UPA

1. Facts: asks to be his superintendent and estimator for kitchen job in SF. said would invest $50k and share profits on 50-50 if would do it. Never talked about loss obtained jobs and was super with giving all financing. told venture lost $ and that had to pay portion. refused sought account and recovery. 2. Issue: Is a party who has contributed only his services and not capital to a joint venture liable for a portion of the venture s losses? 3. Held: No, generally it is presumed that partners and joint venturers intended to share equally in profits and losses BUT a. Capital v. Work: Exception is that when one partner contributes the capital when the other contributes skill and labor neither is liable to the other for losses b. Rationale: where one party gives money and other services, in event of loss each party loses the value of his own capital or contribution

Distribution Problems: Default Rules (RUPA)

1. Marshall Cash: pay cash in order, UPA 807 to (1) creditors; (2) partners and loans and (3) partners for capital contributions 2. RUPA 401(b): Partners equally split for profits; expressly rejects Kovacik and states that losses are shared even when one or more partners do not contribute any capital 3. Deficiency in 1, 2 or 3? UPA 401, 807 (c) and (d) each partner pays suffers losses in same proportion as split of profits (default equal payments) 4. Surprises: Capital Contribution Gross Up a. Capital contribution proportion not reflected in default split rule (50/50) b. E.g. A gives $1,000 and B gives $5,000 split on profits and losses 50-50; absent an agreement otherwise c. E.g. MB contributes $1,000 in capital; worker contributes labor; 50-50 on profits; If business insolvent must worker give MB $500; NO in Kovacik and YES in others.

Law Firm Dissolutions

1. What is the effect on fees collected after dissolution from old clients? 2. UPA 21 Default: New fees, net of expenses, allocated under old agreement as partner assets. a. Duty to Account b. Deduction for reasonable overhead expenses c. No partner salaries


3. Wrongful Withdrawal: New fees received by leaving partners subject to offset for damages in breach of duty case a. If clients would have left with proper conduct pay fair charge b. Pay fees net of overhead and fair charged (double charge) c. Note that breaching partners lost claim on new fees obtained by continuing firm from old clients who stayed with the firm

Jewel v. Boxer: Law Partnership Dissolutions without Agreement

1. Facts: s and s dissolved law firm 2 and 2 split. No written agreement as to fees from active cases allocate. Former went to new firms and hired 3 associated who had been employed by older firm. s had many cases and s handled most of rest. Sent letter to each after dissolution. Clients executed and return the forms and new firms represented the clients under fee agreements of old firm. filed complaint for accounting of fees. 2. Issue: Upon dissolution of a law partnership, are attorney s fees received on open cases upon dissolution to be shared according to the former partners rights under the former partnership agreement regardless of which former partner provides the legal services? 3. Held: Yes. UPA says dissolved partnership continued until unfinished PTS business is wound up. Without agreement to contract, those are default a. Unfinished business is allocated among partners according to their respected interests in the former PTS. b. Unless partner is the surviving partner, UPA expressly stops receipt of extra compensation and no partner can get more than value of interest regardless of level of participation in winding up.

Meehan v. Shaugnessy: Enforcement of Agreement

1. Facts: Same facts as above. 2. Issue: Do a partnership agreement s provisions regarding dissolution supersede the applicable UPA provisions? 3. Held: Yes. s partnership agreement provided specific means for handling dissolution of firm when partners left and they overrule UPA defaults. a. Burden of proof on s to show that the clients who left would have consented to leave even if there had not been a breach of fiduciary duty; if cannot reach burden must account to the firm for any profits received from these cases plus must pay firm the fair charge called for by agreement b. Damages allowed are only those CAUSED by s actions share of current income and return of their capital contributions


Limited Partnerships
1. Modern Limited Partnership: Entities created by modern statutes to protect from liability a. Used: Private equity funds like hedge funds, venture capital funds 2. Purpose: developed to facilitate commercial investments by those who want a financial interest in a business but not all the responsibility and liabilities of partners a. May carry on any business that a partnership could carry on (ULPA 3) 3. Limited Partnerships before 1976: most states had adopted the ULPA and in 1976 was revised to make it applicable to large PTSs and to reflect new business practices; most states now have adopted the RULPA in 1985 a. New revision of ULPA was drafted in 2001 and adopted by a few states 4. Liability: LP has no personal liability for PTS debts and max loss is amount of her investment in the LP; ULPA 1 a. EXCEPT: when a LP takes part of the management and control of the business, she becomes liable as a GP RUPA 303(b) 5. New Act: RULPA (ULPA 2001) overlays RUPA (UPA 1997) and sometimes explicit in the statute, otherwise by duplicative language on duties; a. RUPA applies unless a RULPA provisions changes the rule

Limited Partnerships: Generally

1. Defined: an LP is partnership formed by two or more people and have as its members or more general partners and one or more limited partners 2. General Partner: the GP assumes management responsibilities and full liability for the debts of the PTShip 3. Limited Partner: makes contribution of cash, property or services rendered to the PTFship and gets an interest in the PTS in return, but is not active in management and has limited liability for PTS debts RUPA 303(b) a. Rights of LPs: substantially same as those of a partner in ordinary PTS, except no substantive right with regard to management; rights to access books of PTS, to an accounting as to business and to dissolution and winding up by decree ULPA 10; may also lend money to, or do business with, the PTS (ULPA 13) b. Assignment Interest: unless provided otherwise vests in the assignee all rights to income and distribution of assets of the PTS but unless and until cert. of LP is amended with consent of ALL other parties, assignee is not entitled to inspect books, accounting, etc (RULPA 702) 4. Person as Both: possible, in such a case the partner has, with respect to her contribution as a LP, all the rights she would have if she were not also a GP

Forming Limited Partnerships

1. Formation: Formalities are generally not required; certain things must be met


a. (1) must execute a certificate setting forth the name of the PTS, character of business, location of principal office, name and address of each partner and their capital contributions, GP or LP designation, and rights and priorities of any partners b. (2) Copy must be in country of principal place of business ULPA 2 but may be amended or canceled by following similar formalities ULPA 25 2. Certificates: Three issues a. False Statements: If included, anyone who suffers a loss by reliance upon them can hold all of the partners liable, both GP and LP (ULPA 6) b. Purpose: to give all potential creditors notice of the Limited Liability of the LPs c. Substantial compliance of good faith: required, if there has been no substantial compliance, the purported LP may be held liable as a GP; the purported LP can escape GP liability if when seeing the mistake promptly renounces her interest in the profits of the business or other compensation by way of income

Holzman v. de Escamilla: Limited or General Partner?

1. Facts: HF, Ltd. was a business created as LPh with de Escamilla as the GP and R and A as LPs; Later it went bankrupt and H was trustee appointed. sued saying R and A were liable as GPs to creditors because they had taken control of the business. 2. Issue: Are purported LPs who controlled the finances o the PTS business and controlled the actions of the GP liable as GPs? 3. Held: Yes, LPs can be recast as GPs if they take part in the control of the business of the firm. Change from ULPA 303 to RULPA 303

Limit d Part

r hips

rtner ( C r .?)



Li ited



M nagement/ e e Sli e f r fit


/Sli e f r fit

Gener l


y Distinguish: Federal and State Law

Legal Types of Corporations

1. State Law Distinctions: General/Close (OH ch. 1701; OH 1701.591) a. Non-Profit Corporations (OH ch. 1702) b. Oddballs: Professional Associations, (L)Pas (OH ch. 1785); Other states Professional corps., PCs); take specific cemetery associations 2. Ohio State Types: a. Unincorporated Associations ch. 1745 b. Statutory Business Trusts ch. 1746 c. Real Estate Investment Trusts ch. 1747 d. Cooperatives ch. 1729 3. Federal Law Distinctions: a. Tax Code: Subchapter C/Subchapter S b. Securities Laws: Public/Private (closely-held) 4. Problems: mix with state and federal law; some states have close corp. small corp. you can opt into corp. a. Two sets of default rules (1) General Corporation Act and (2) Close Corporation Act

How to Choose Which Corporation Type?

1. Save Cash (Tax Issues): avoiding the double tax on business earnings a. E.g. firm earns $1, tax 35% and keeps .65 cents - firm gives cash out to investors who are taxed 15%, they only receive .55 cent 2. Attract Capital (Lower Cost): Offer Limited Liability to investors 3. Enable Managers: Optimal structure 4. Individuals: pick up LLC distinctions if you are your own law firm and hide the personal assets from lawsuits and liability in loss 5. Avoiding the Double Tax: Firm Level OR Minimize tax at the investor level a. Option 1 at Firm Level: Use a flow through tax vehicle (all partnerships, LLC and S Corp) b. Option 2 at Firm Level: firm never shows a profit (expenses like salary, fully offset revenue) c. Option 1 at Investor Level: Pre tax cut limit firm distributions (dividends and redemptions), keep earnings, stock appreciates in value, sll stock to generate cash to pay capital gains tax d. Option 2 at IL: hold stock in tax sheltered plans; nonprofits, pension plans, ect.


Policy Question: Why Have a Double Tax?

Pre-Bush Corporate Tax 39% Income Evil Bush 35% Obama Rich only tax-cut repeal then because only help rich:

Personal Tax: Dividends

39% Income

15% - do not have to sell the share; still 15%

Personal Tax: Capital Gains

25% Gains

1. 2. 3. 4. BUT?

Old tax is good tax (corporate income taxes pre-date Personal Income Taxes Corporations are Wealthy: Not fair for janitor to pay income tax and Microsoft escape it Corporate Investors are Wealthy: Just a hidden progressive tax Lawyers and Accountants need money: huge amounts spent on tax planning

5. Why do most all of the rest of the developed countries of the world (including those with a more socialized system) reject the double tax? 6. Why are LLCs not morally offensive? 7. Do we need a tax penalty based solely on business legal structure (and not income type)? Not based on anything else (e.g. taxing the rich high, etc.)

Small Business Rule of Thumb

1. Small business (> 35 investors) presumption in favor of an LLC (with operating agreement written); if business grows, convert to a C corporation. o Rebutted by industry specific common practice (VCs as LPs) o Rebutted if net profits are zero (use a C Corp.) 2. Medium to large businesses (likely to be publicly held): C Corporation

Source of Law on LLCs

1. State Statutes: Old and New a. Old: Designed to satisfy a tax regulations see Konstant b. New: Very open textured (DE); parties can create what they want; minimum of mandatory rule; default rules based on what most parties to an LLC want and expect and easily modifiable (OH amendments coming because it is a mess) c. Elect: Local OH Gen. Corp. L. ch 1701; Other DE Gen. Corp. L. tit. 8 (Supp.) d. Model: ABA s MBCA (Supp.) constant revisions; 30 or so states have various versions OH is not an MBCA state 49

e. Federal Securities Law: SOX 2. Model Acts: Uniform Limited Liability Act (ULLCA, 1996) and the DE LLC Act a. Question use contract or general fiduciary duty doctrines of reasonableness b. DE uses general fiduciary duty doctrines; OH uses contract doctrines DE better

The Corporate Form

1. 2. 3. 4. 5. 6. 7. 8. Legal Person: or entity Indefinite life: since shares cann be transferred Limited Liability: of investors Free Transferability: of ownerships (equity, stock or shares) interests Centralized: specialized management Oversight Board: elected by equity investors Powers: can sue, be sued, contract and own property like legal entity Limited Liability: belong to corp. itself and normally incurs debts and obligations in own name that are not responsibility of the SHs (owners); same time not responsible for debts and obligations of owners (SHs) Exceptions and Piercing the Veil: a. (1) Fraud or injustice where maintenance of the corp. results in fraud/injustice to outside parties; b. (2) Disregard of corporate requirements where SHs do not maintain the corp. as a separate entity but use it for personal purposes (records not maintain, meetings required not held, money commingled between individuals and corp., etc.) then can pierce c. (3) Undercapitalization: prime piercing exists where the corp. is undercapitalized given the liabilities, debts and risk it reasonably could be expected to incur d. (4) Fairness: may pierce is any other situation where it is only fair that the corporate form be disregarded


Limited Liability of Investors: Policy

1. Owners (SHs and Passive Investors): have no personal liability for debts or obligations of the corporations; their risk of loss is limited to excess of the amount they invest a. Risk on their capital contributions b. Original owners risk only their capital contributions c. Subsequent purchases of the stock risk the purchase price on the secondary market 2. Benefits a. Ease of valuation cannot have secondary market without it and with unlimited liability, you d ignore law probably during disasters and financial status of co-owners b. Enables secondary trading markets check on managers from market 50

c. Specializations: firms can tailor risk to segment investor market, investors can diversify, high tech firms get funding d. Increase incentive of debtors (banks) to monitor firm actions 3. Efficiencies and Controversies of the Corporate Form: a. Operational: Free standing legal entity with power to act; centralized and specialized; Too powerful - Should not have Constitutional rights, are unaccountable, anti-social b. Attractive to investors: limited liability and free transferability (liquidity premium); Opposition enabled avoidance of responsibility for tortuous conduct, share market gambling, cons and greed 4. Allow Private Arrangement for - economies of scale and technology advances require mass scale a. Diffuse ownership: need large pools of investor capital

Creation of a Corporation
1. Articles or Certificate of Incorporation: Incorporator files Articles for (RMBCA; OH) or Certificate (DE) 2. Records: Sec. of State records the filing and it will be effective on filing date (unless specifically delayed) 3. Organizational Meeting: new Corp. holds one to adopts BYLAWS (regulations in OH) that empower agents a. DE Meeting: If Board of Directors isn t listed in articles, Incorporators meet, accept stock subscriptions, issue stock, adopt bylaws, elect initial directors who appoint officers and then filing (one page application, no one knows who the owners, directors and promoters are unless publicly owned) b. New SHs meet, elect next board of directors and often ratify acts of prior board and promoters c. Ohio Common Practice: Incorporators meet and elect directors (no initial Board); initial Board meets and accepts stock subscriptions, issues stock, appoints officers and adopts regulations (if meeting within 90 days of formation) d. Ohio Rare Practice: Incorporators accept stock subs and issue stock no initial Board listed; new SHs meet, elect Board and adopt bylaws; SH elected Board meets and appoints officers 4. Analogy: Cert. and Bylaws (constitutional documents), board regulation (legislation) and executive decisions (Presidential or agency order)

Corporate Charter: Articles/Certificate

1. Mandatory Provisions: a. Name b. Registered Agent c. Purpose d. Authorized Amount of common (voting) stock 51

e. DE and OH par value: archaic practice specify how many shares will issue and the par value of the share or check no par value (complex) 2. Discretionary Provisions: Customized and Optional a. Complex capital structure: preferred stock, two-tier voting stock b. Complex governance provisions: board terms of up to 3 years; staggered; class voting; bylaw amendments by board or lower majority

1. Defined: Someone who says they will form a business or corporation but not unless they can get people to throw money in; wants firm commitments (Agency Law Controls Rest.Ag. 320 and 326) 2. General Rule: If promoter contracts in the name of and solely on behalf of, the corporation, he cannot be held liable if the corporation is never formed. If contracts in his own name, then may be held liable. a. Intent of parties and other factors will enter into the determination of the letter b. YES Liable: Contract, unilateral offer to corporation. Quasi-contractual if corp. repudiates contract, still liable for value of anything that it makes use of; adoption by implication rule is that ratification is retroactive and adoption is not. c. NOT Liable: Contract with promoter; for good faith efforts to get corporation adoption; until corporation affirms then the promoter is released; survives corporation affirmation promoter bound and has secondary liability d. BUT Novation: new K with corporation replaces old deal promoter usually released but novation language in everything 3. Can unincorporated (or defectively incorporated) firm sue on contract: a. YES De facto corporation: has complied strictly with all mandatory provisions for incorporation cannot be attacked by any party (even state) mandatory and directory is matter of judicial construction of state b. YES Corporation by Estoppel: when a corporation is not given de jure or de facto status, its existence as a corp. may be attacked by any third party BUT there are situations where courts will hold that the attacking party is estopped to treat the entity as other than a corp.

Southern-Gulf Marine v. Camcraft: Conduct of Parties

1. Facts: Pursuant to Letter of Agreement, , company not formed yet became obligated to buy boat from for $1.3M; given authority to begin buying components to buy boat. Later parties executed boat building contract and was listed in a preamble as a corp. organized under TX law with B as Pres. One condition said was US citizen within meaning SA of 1916. B tells BM, s Pres. That had finally be incorporated a year later but in the Caymans. BM accepts and agrees. defaults on building boat and sues for breach. 2. Issue: Should a party to a contract be permitted to escape performance by raising an issue as to the character of the organization to which it is obligated if its substantial rights are not affected?


3. Held: No. If party contracts with entity it acknowledges to be and treats as a corp., and incurs obligations in its favor, and later sued it is generally estopped from arguing lack of corp. existence as defense. a. was De Facto Corporation: Both parties relied on the K; financed and began no evidence that s substantial rights were affected by the s de facto status

Fiduciary Duty of Promoters

Fi Pr
$ "! #  " # "! $# 

i r
" $" 

t t r
 " " " "! "  !  " 

  "  "

Corporate Bylaws or in Ohio, Regulations

1. Operating Rule for the Corp.: Empowers board to open bank account, buy and sell land, ect. 2. Amendments: Compare with Charter Amendment - Board must recommend and SH must ratify them (2/3 in OH); Exceptions: No SHs; OH no prejudice to SHs and name change 71, etc. a. Shareholders: ratify absolute majority (2/3 if by written consent) b. DE Board Alone: if certificate gives Board power to amend OH must be SH except emergency exceptions e.g. .11(C) c. Limits on SH Bylaw Amendments: Current debate no takeover defenses?

Vocabulary and Equity: Corporate Finance and Shares

1. Corporate Finance: Rights, duties, terms for people who give money to a corporation 2. Types: preferred/common, classes, controvertible a. Three types of Corporate Distributions: (1) Dividends; (2) Liquidating Dividends and (3) redemption b. Class A and B: common for a few selected areas of industry 3. Authorized/Issued/Outstanding: Like treasury shares 4. Primary Secondary market sales






Di tinction?? Y i in ame po ition ex po t in bot tran action ? t procedure matter . Sale to X before/after ale of land.


Y Form Corp C, CEO C Corp. ll C tock to X, t Y imm i at ly t r aft r ll p r o ally l land to C, acc pting a CEO, at p r onal profit. Y m t di gorg profit on land r al nl Y di clo d to X p r onal profit (and X ratifie ??). Y Form C Corp, take C tock in exc ange for land, immediately ell per onally- eld C tock to X at a profit. No di clo re of per onal profit. Violation? (Split: US no; Ma . ye )
" ! &  ! &     %  & &  %  "       " %  " & &

Y Must: disgorge profits on land resale unless Y disclosed to X personal profit and X ratifies it Y forms C Corp.: takes C stock in exchange for land, immediately sells personally-held C stock to X at a profit, no disclosure? Potential violation Distinction: Y is in same position ex post in both transactions but procedure matters sale to X before or sale of land


1. Equitable Title: Property rights original inheritance and trusts, split ownership o Own Stock: Buy stock in IBM and get it from Merrill Lynch you are owner of the beneficial title, while legal title is still owned by Merrill Lynch 2. Convertible: option in the hands of the holder convertible into common; take a preferred share and convert it into common (sometimes won t be better than preferred) 3. Authorized/Issues/Outstanding - Treasury Shares: o Authorized must be in Cert. of Incorporation that board is authorized to issue X# of stocks common (authorized in charter, issued by resolution and when sold to people outside company they are outstanding in the public) o When repurchase used to become treasury shares held in the treasury of the corporation go back by law now, canceled shares o Can hold on books as treasury shares or can cancel them but now majority of the states say they are automatically cancelled 4. Primary Market: company to public sell shares to the public (highly regulated if publicly regulated; private then not as much but still careful) 5. Secondary Market: when public starts sharing with each other stock exchange o Regulation of Secondary Market 34 Act

Par Value Statutes

1. Balance sheet: asset, liabilities and equities a. Equity column sell cash to public, then balance cash invested, equity is balanced (paid in capital) b. If speed equity then you must subtract the value if par value state 2. Create Three Sub-Accounts in the equity Section of the Balance Sheet: a. (1) stated capital b. (2) capital surplus and c. (3) Accumulated Retained Earnings 3. Traditional: dividends limited to amounts in capital surplus and accumulated retained earnings account (cannot invade stated capital NY and OH) a. Exception: DE, Nimble Dividends, Cal. Modified, Retained Earnings Test. 4. Par Value Column: Whatever number in equity column just limits your ability to give dividends a. Unlimited liability to the company to make up the difference in the Par Value Account instant malpractice and unlimited manager liability if you make a mistake b. To pay out of the par value column very big issue c. In OH or DE set minimal amount of par value stock (don t use no-par option); only place when do not want par value would be when selling preferred stock 5. No-Par Option in Capital Jurisdictions: Board issues no-par stock, declares a portion of the price to be state capital for the distribution rules; must declare the amount no-par stock is not an exemption because board must do a lot of stuff that is done automatically if you have par value stock 54

a. DE: Board can, on own, lower stated capital designation on no-par stock (no OH/NY) 6. Dividends: Two tests a. (1) Balance sheet and (2) Par Value Test

The Stated Capital Accounts

1. Step One: Set par value per share of stock assume $10 2. Step Two: Sell shares. Assume price of $1, sell 100 shares. 3. Step Three: Calculate Accounts a. Stated Capital: 100 (outstanding shares) X $.010 (par value) = $10 b. Capital Surplus: 10 X $0.90 (price MINUS par) = $90 c. Accumulated Earnings: profits not yet distributed

Law and Centralized Management

1. Seeking Optimal Balance of: a. Positive efficiency gains b. Negative (agency costs): managers misbehavior, shirk or misappropriate earnings promised to owners as return on capital (incentive) 2. Too heavy handed: no flexibility, lose positive OR Too lenient: too much misbehavior 3. Penalty of Heavy Hand: international competition 4. Current Legal Balance in Board: Strong Default Option a. Republican form of decision-making; board has primary power to appoint and monitor officers and initiate major corp. decisions b. Control devices: election and termination, lawsuits for breach of duty, stock market prices 5. Major US Issue: a. Empowering SHs as voters b. Less sycophantic boards (non-state law fixes): more independent? More power audits like SOX? More power to nomination and compensation committees like TARP? c. More honesty in top management problems: cooking the books (false, hidden statements) and excessive compensation (golden parachutes and severance and options) 6. Potential Solutions a. (1) More effective criminal prosecutions: complex trials and juries with major questions of criminal intent b. (2) More efficient and focused private prosecutions: fewer strike suits (false positives) and swifter and less pricey meritorious suits (false negatives)

Limited Liability and Corporations: General Rule

1. Investors: Losses limited to capital contributions or to price paid for stock in secondary market a. Not liable for corporate creditors b. Corporate creditors must look solely to corporate assets 55

2. Distinguish Agency Problems of Executives: a. Executives as agents bind firm on contracts; agents are not personally parties (or personally liable) unless agreed upon b. Liable for PERSONAL wrongful acts not liable for wrongful acts of other agents (absent some form of participation)

Shareholder Personal Exposure and Piercing the Veil

1. Equitable Subordination: If SH is an (1) officer and (2) a creditor of firm and misbehaves debts subordinated to those of all other creditors a. Disregard the registered legal entity becomes a General Partnership or Sole Proprietorship 2. Disregard the Entity: SH (1) Dominates firm and (2) Acts unjustly towards creditors a. Evidence of Domination: commingling of corporate and personal funds, lack of observance of necessary entity formalities (board and SH meetings) note that OH lack of meetings is not factors b. Courts Vary what is unfair or unjust?

Exceptions to Limited Liability

1. Compare by Contract: execute a personal guarantee with 2. Compare by Law: Disregard the entity or pierce the veil forms a. Vertical SHs liable on firm obligations b. Horizontal - sister corporations liable on firm obligation (enterprise liability) c. Reverse piercing corp. liable to personal creditors of SH 3. Contract v. Tort: Major difference between tort and contract cases is that in contract cases, the had chance in advance to investigate the financial resources of the corporation and had then chosen to do business with it. THUS, in contract cases, the intention of the parties and knowledge of the risks assumed in entering into a contract are factors to be assessed in making a determination as to whether the corporate veil should be pierced.

Walkovszky v. Carlton: Liability Insurance as Evidence

1. Facts: was hurt in taxi and sues driver, corp. owning cab and who owned corp. and 9 others, each with minimum of $10K of liability insurance coverage required. Complaint said corporations operated as single entity and constituted on fraud on public. 2. Issue: Does complaint state a cause of action because the companies were underinsured and undercapitalized? 3. Held: No. Dismissed. Courts will pierce the veil when necessary to stop fraud or achieve equity. a. Nothing wrong with one corp. being part of larger enterprise (like subsidiary);

Marchese Employee

vszky v arlt
Tort Walkovszky Jud ment?

(min. required insurance)

Shares Carlton O ner

1 1 0

Can Walkovszky brin suit a ainst Carlton? A ainst the nine other cab companies? Held: Motion to Dismiss Granted

Seon Cab: 2 cabs

Jud ment?

9 other Cab Companies



4. Question: issue is if business is really carried on in a corp. form but by and for another entity or person with a disregard of the corporate formalities? 5. Undercapitalization: state has set minimum insurance people driving cabs have taken out minimum; insurance is OK unless state has legislated higher bar.

Parent and Subsidiary

1. Is SH control OR domination enough for disregard of entity/piercing? a. No, US v. Bestfoods. 2. Distinguish: Disregard of Entity Other Theories of SH Liability a. Direct Liability: Direct intervention or participation In re Silicon b. Indirect Liability: Corporation is agent of SH (respondeat superior)

Sea-Land Services v. Pepper Source: Cannot Differentiate Between Corp. and Individual
1. Facts: was ocean carrier who ships peppers on PS behalf. PS refused to pay freight bill and sues. couldn t obtain recovery because PS dissolved and then sues PS sole SH and the other corporations owned. 2. Issue: May the corporate veil be pierced when the court can no longer different between the corporate and the person and it would be unjust to protect the person? 3. Held: Yes. A corporate veil may be pierced if two requirements are met (1) must be such unity of interest and ownership that the separate personalities no longer exist and (2) circumstances show that adherence to the fiction of separate corp. existence would sanction fraud or promote injustice a. Four Factors: (1) Failure to comply with formalities; (2) commingling of corp. assets; (3) undercapitalization and (4) one corporation s treatment of another corporation s assets as its own b. Here used same office, phone, expense account to run majority of corps. None of them ever held a meeting. Borrowed funds for personal expenses and corporations borrowed from each other. Did not even have a personal bank account. c. Promote Injustice: failure to pierce would result in some wrong that lies beyond the fact that a creditor may not be able to recover e.g. that a party would be unjustly enriched ( has burden to show the wrong)

Roman Catholic Archbishop of San Francisco v. Sheffield: Liability between Subsidiaries

1. Facts: When in SUI, visits church of RC contracts with PC to buy dog for $175 payable. Dog shipped to LA made two installments but didn t get the dog. told wouldn t be shipped until all paid and additional fees for trip to deliver dog. told he couldn t refund. sues RC, Pope, Canons and FC.


2. Issue: When a parent corporation controls several subsidiaries, is each subsidiary liable for the actions of all other subsidiaries? 3. Held: No, not domination, no injustice. No alter ego theory. 4. Rule: must show that not only is influenced and governed by the other entity but also that there is such a unity of interest and ownership that the individuality or separateness of each has ceased and the facts are such that an adherence to fiction of separation would promote injustice and allow fraud. a. No respondent superior between subagents. Even though RC is an alter ego of the Church doesn t show that the RC is an alter ego of ; had no dealings with the church.

In re Silicone Gel Breasts: Liability of Parent to Subsidiary

1. Facts: is sole SH of breast implant MEC, had 3 directors Implant on board. Two were s execs and MEC president evidence revealed MEC prepped reports for and had P ub lic S a re ho ld er MEC submit 5 year plan MEC submits budgets, kept monitoring of . MEC was highly involved in personnel, ia ble? ri to l 100% auditing, review, name and logo were with sale and Product Lia bility ME C P la in tiff communications. s exec VP suspended MEC sales and Held: No S.J. for Bristol. Distinguis h Bris tol s situa tion from MEC stopped ops later that year selling with s Dow C he mical s. approval and turning proceeds over to . s bring products liability. 2. Issue: Is the parent corporation liable for product torts of a subsidiary? 3. Held: Yes. They had control, the subsidiary was underfunded and undercapitalized. a. Control: A parent corp. is expected to exert SOME control over its subsidiary BUT when a corp. is controlled to such an extent that it is merely the ALTER EGO or INSTRUMENTALITY of its SH, the corporate veil should be pierced in interest of justice b. DE can pierce without finding fraud or misconduct if a subsidiary is found to be an alter ego or mere instrumentality; many states that do require fraud do only in contract cases not torts c. Vouched: since MEC funds may be insufficient to pay for damages, and may have induced people to think was vouching through actions in support allow finding

In re Silicone Gel rea t

Frigidaire Sales v. Union Properties: No Improper Actions

1. Facts: contracts with CI, an LP. s were LPs of CI, as well as officers, directors and SHs of CIs only partner, Union. s controlled U and through control had day-to-day management and control of CI. CI breaches and sues. 2. Issue: Do LPs incur general liability for the limited partnership s obligations because they are directors, officers, or SHs of the corporation s general partner? 3. Held: No, LPs are not personally liable as GPs. 4. Rule: In WA, parties may form an LPship with one corp. as

ne Per on: Many Hat

r l rs/Offic rs / ir ct rs: M & xt r

Commercial Investors, LP
M & xt r Li bl s r l p rt rs??

l :




7 87 7 6

Gen eral Part ner : U i Pr p rti s , I c.

7 @ @ 8 78 7

Limited Partn ers: M & xt r





3 4

its only GP if that GP is inadequately capitalized, a creditor is protected under the corporation law doctrine of piercing the corporate veil. a. Mere undercapitalization is not a reason to open liability to LPs who control the GP b. was never misled into thinking s were acting outside their corporate capacity kept the corp. affairs away from personal affairs and did not defraud or create injustice upon parties in dealings separate entity should be respected; c. No evidence thought they were GPs, knew they were LPs

Likelihood of Court s Piercing the Veil (Best Chance to Worst)

1. By Structure a. Individual/Wholly Owned Close Corporation (Controlling SH/Close Corp.) less likely with more SH b. Parent/Wholly Owned Subsidiary less likely with more minority SHs c. Public Corp. very rare d. Sister/Brother Corps. very rare 2. By Claim: Contract > Tort 3. By Reason: Unfairness Commingling of funds (confusions of accounts) undercapitalization and lack of formalities 4. Highly Unlikely to Disregard the Entity Situations: a. (1) Public Corps. b. (2) Against Passive SHs (3) Against Minority SHs c. (4) All Corporate Formalities are Observed, business is real and not a sham

Lawyer: Observing Formalities

1. Client Doesn t Observe Formalities: e.g. not held director of SH meetings, has not even issued shares 2. Do NOT back date: a set of formal documents it is MALPRACTICE 3. Forgeries: backdated documents are forgeries and it is not an excuse that they represent what was true or CLOSE to true according to the memory of an old person

Policy: LLCs and Tort Claims against SHs

1. Advantages of LLCs: investor incentives pro-investment; holding companies specialized investment; most contract claimants assumed the risk 2. Disadvantages (Involuntary claimants; Tort victims): Incentive to inflict injuries without internalizing costs e.g. run a borderline solvent gold mine on the top of a mountain in CO; Yale no LL for torts, force or require corporations to carry adequate insurance 3. Torts against SHs: a. Victims cannot rely on the creditworthiness of the firm when acting b. Victims cannot negotiate with the firm for contractual protections from undercapitalization may be unaware of firm itself c. BUT victims can protect themselves with personal insurance 59

4. Can stock trading market survive the Yale position? No. a. Difficulties of administration stock must be indistinguishable; equities distinguish pass/active SHs b. Worth caring? There are alternatives personal protection and governmental protection

Shareholder Lawsuits

Shareholder Suits 1. Distinguish: Derivative Actions/Direct Actions (class actions) to whom is duty owed? cash ompany &/or Shareholders a. Classic breach of fiduciary duty by board irect; derivative (Cohen personal enrichment) as a class b. Direct: Classic violation of Federal Securities cash ompany erivative Third a rty: Laws; State law voting rights violation ecutives or (Eisenberg problem for s, no cash) Shareholders: on behal o company 2. Effect: Procedural hurdles FRCP Rule 23/23.1 a. Who collects damages? 3. Direct and Derivative Suits: a SH may sue to enforce management s duties a. Derivative: If claim is that management s breach reduced the residual value of the business (shirking, self-dealing), file in name of corp. b. Direct: if claim is that breach deprived the SH of some other right (other than her contingent right to that residual value) e.g. right to inspect SH list, file in own name (may be brought as class actions) 4. Threat of Derivative Strike Suits: a person with a small stake in the residual value of a business may be tempted to bring a derivative suit for the primary purpose of bring bought off a. Reduce temptation by requiring s to make payment to corp. for the complaining SH b. Attorney is generally real interest obtain fee from the corporation and legitimately demand some payment in connection with a settlement 5. Limits to Derivative Action: Pretty much all corporations limit the SH who may bring these suits many states have laws requiring the -SH in a derivative suit to post a bond or other security to indemnify the corp. against certain of its litigation expenses in the event the loses the suit a. When security must be posted: great variety some says if owns less than % of stock; some discretionary by court and demanded only when reasonable possibility the action could benefit the corp. b. Entitled to Security: most state only the corp. may demand security and only for expenses to pay some states allow officers and directors to demand it c. Covered expenses: usually all expenses, including attorney s fees, are covered maybe expenses the corp. must pay the directors and officers because it has indemnified them (may indemnify them for actions in good faith and business judgment but not for fraud)




Cohen v. Beneficial Industrial Loan Corp.: Application in Federal Diversity Cases

1. Facts: Cohen s decedent, , brings SHs deriviative action in Federal Ct. in NH against and managers and directors. Alleged that since 1929 s had conspiracy to enrich themselves at corp. expense. owned about .0125% of the shares. After began, NJ made law requiring 5% ownership unless those shares have a value over $50,000 to be reasonable for expenses and attorney s fees of the defense if the suit fails. Has to post bond of $125,000. 2. Issue: Must a federal court sitting in diversity apply a state of the forum state providing for the posting of security for the corporation? 3. Held: Yes. A SH who brings derivative action assumes a position of fiduciary nature sues as a rep of a class that did not elect him as rep as they elected the corp. director/manager state has power to regulate and promote accountability, responsibility and liability a. Reasonable Expenses: law that requires liability and security for only reasonable expenses doesn t violate Due Process or Equal Protection by classification basis on financial interest only serves to insure some good faith b. Federal Courts in Diversity: must apply substantive law of forum state while following federal rules of procedure

Eisenberg v. Flying Tiger: Statute Applicability

1. Facts: , DE corp., organized subsidiary in DE called FTC organized subsidiary, FTL, month later. Three DE corps then created plan to reorganization, subject to SH approval, where would merge into FTL approved by 2/3 vote. Merger, stops operating and FTL takes over ops. s shares Eisenber v Flyin Ti er ine convert into equal FTC shares then FTL changes name to FTLI, resulting in all business operations being lainti ; Shareholder confined to a wholly owned subsidiary of a holding company whose SHs are the former SHs. sues to Flyin Ti er mer e stock enjoin the reorganization and merger stating purpose sub e chan e Flyin Ti er orp to dilute his voting rights. removes to NY motion sub for order that comply with 627 of the NYBCL saying ir Frei ht orp lainti bjects to er er in derivative suit against corp. must post security for ond eld: o the corp. costs. 2. Issue: Is an action asserting that SHs have been deprived of any voice in the affairs of the company derivative for the purposes of the statute? 3. Held: No. Even if DE law, which has no security requirement, control the merits of the case, this court must look to the NY law regarding the issue of security. a. 627 Applies only to derivative actions claims he and his fellow SHs have been deprived any voice in the operation of their company; not challenging the management of the company on behalf of the corp. b. THUS s action is personal and not derivative within the meaning of 627

Security for Expenses Statutes in Derivative Actions

1. NY and NJ: Deposit bond unless 5% SH or shares > $50K (Cohen) Two way expense shifting 61


q g cc

b p

2. MBCA: omitted in 1982 shift expenses to if court finds proceedings without reasonable cause or for an improper cause 3. OH: No law one way shifting (firm to on success) 4. Incentive to Sue: SH collective action problem a. Gain to any one small SH of success not worth cost of prosecuting suit b. Solution: firm pays s attorney s fees on success (settlement or judgment) 20% or 30% c. Problems: agency costs - attorney s and s are both agents of SH and can misbehave d. Applies to both class/derivative actions 5. American Bounty Hunter System: Expense shifting is an exception to the American Rule each side bears its own litigation costs a. E.g. derivative suit against top 3 execs of CA; settlement return $500m in stock to firm; attorney collected $50m; attorney s out of pocket expenses - $250K

Shareholder Suits in Practice

1. Collusive Settlement Problem: a. Corrupt managers collude with s lawyers (double agency) to make cosmetic changes and buy off lawyers i. Error managers should pay and do not b. Tamer managers collude to settle nuisance litigation and buy off lawyers i. Error managers should pay and don t 2. Value of Settlement: determined by surviving summary judgment motions 3. Problem of Supervision by Court: a. Judge wants settlements no parties in court opposing settlement; love fest. 4. Incentive to Sue: depends on size of recovery size depends on D & O Insurance Coverage a. Best Rule: induce some suits that decrease firm value and fail to induce suits that may increase value b. Lodestar Formula: hourly fee with multiplier c. Auction: among attorneys low ball, settle 5. Other Incentive Problems: a. Interrelated: obvious solution, control fees b. Procedural fine-tuning: early decisions (1) pleading particularity (Grimes and PSLRA of 1995); (2) named control who is real party interest and intervention by large SHs; (3) higher burden of proof (clear and convincing) c. Substantive Law: higher hurdle for s on legal standards distinguish best practice from legally required

Real Party In Interest: Standing in Derivative Actions

1. Federal Rule of Civil Procedure 23.1 2. must have been SH at time of wrong 3. must be SH for duration of action 4. must fairly and adequately represent the other SHs 62

Derivative Action Burden: The Demand Requirement

1. Demand on Board Requirement 2. If Board disinterested must make demand (board s decision control) actual demand waives claim of excuse (Grimes) 3. If Board interested (conflicted) demand excused because futile a. Delaware: reasonable doubt would have to allege particularized facts that would create a reasonable doubt about the independence or disinterestedness of the board or whether the challenged transaction is otherwise the product of a valid exercise of business judgment b. NY (three part test) Grimes The Demand Requirement compared to Marx: (1) not sufficient  Sharehol ers Must Make a Demand on the Board to to merely name a majority of the Sue (Majority of Board Disinterested) directors as parties with conclusory Boards Choices: It Agrees to Sue, Refuses to Sue, or Defers to Shareholder Suit. allegations of wrongdoing or control If Refuses: Shareholder Suit Dismissed; Sue Board, by wrongdoers Wrongful Refusal? G rimes: BJR unless conflict or lack of due care c. Universal Demand in MBCA 15  Demand on Board Excused states around a notice rule, make Board Creates a Special Litigation Subcommittee (SLC): SLC Defers or Files a Motion to Dismiss demand, if board doesn t sue, SHs On Motion to Dismiss, Court Review on NY or Del test sue (BJR/compelling interest) 4. Effect: prefer securities class actions over derivatives 5. Other Options: (1) SH must hold more than 2% or $500,000 Rule 14a- 1% or $1,000; (2) PSLRA of 1995: for class actions only largest disinterested SH willing to intervene takes over a. State courts may use the rule who fairly and adequately represents 6. Legal Standards a. When is demand excused: Aronson (DE), Grimes, Barr (NY), Marx b. If not excused, board refuses, sue board for refusing; BJR Grimes case (DE), Spiegel (actual demand waives claim of excuse) c. If excused, special litigation committee files a motion to dismiss; SCL decision evaluated under BJR Shaw (NC), rule of deference, Auerbach (NY) or compelling corporate interest, Zapata (DE)

Grimes v. Donald: Abdication

1. Facts: is SH in DSC claims board failed to use due care, commits waste, approved excessive compensation and unlawfully delegated by entering to agreement with CEO unreasonably interfered with s management of the company was agreement. Seeks declaration that the provision of delegation was invalid. 2. Issue: May a SH proceed directly on an abdication claim when he seeks only a declaration that an agreement between a board and its CEO is invalid?


3. Held: Yes, whether a claim may proceed as a direct or derivative suit depends on the nature of the wrong alleged and the relief sought. Claims seeking injunctive or prospective relief, such as s, are more likely to qualify as direct a. Focus on nature of relief sought consistent with the idea that the function of the SH derivative claim mechanism is to avoid the problems of fashioning compensatory relief that would plague a class action claim

Marx v. Akers: Futility Exception

1. Facts: Without making demand on IBM board, s, Marx files SH derivative suit alleging that the board wasted assets by awarding excessive compensation to execs and to outside directors. Complaint alleged that during a 5 year period, s increased compensation rates from $20K plus $500 per to $55,000 plus 100 share of IMB. 2. Issues: Excessive compensation? Outside directors? Relation? 3. Held: Having a majority of a board of outside director, does not excuse from making a demand in connection with claims of excessive compensation to execs. a. With majority outside directors on board, futility excuse excuses from making a demand in connection with claims of excessive compensation to outsiders. b. Demand Requirement: (1) Creates a form of alternative dispute resolution to allow corp. directors with chance to correct abuses; (2) helps insulate directors from harassment by litigation on matters within discretion; (3) discourages strike suits began by SHs for personal gain not benefit of corp. c. Exception: permits SHs to bring claims on behalf of the corp. when it is evident that the directors will wrongfully refuse to bring the claims d. Qualify for Exception: (1) majority of board are interested by self-interest or control by self-interest director; (2) board didn t fully inform themselves about deal to the extent reasonably appropriate under the circumstances; OR (3) deal was so bad on its face couldn t have been product of sound business judgment of board

Auerbach v. Bennett: Special Litigation Committees

1. Facts: GTE management looks into chance that co. or subsidiaries made improper payments board determines that $11m had been bribed and that 4 of 15 s had been personally involved. SH brings derivative suit on behalf of corp. against bribes. Board creates SLC of 3 disinterested directors who had joined the board after bad deal happened. SLC found that it was not in the best interest of the corp. for the action to proceed. 2. Issue: Does BJR stop inquiry into the disinterested impendence of SLC? Is SLC allowed to determine whether suit may go on? 3. Held: Courts may inquire into the disinterested independence of the members of the board who are chosen to pass on whether the derivative suit should be dismissed or not. To require the people outside the board to investigation would require that board abdicate its fiduciary to the corp. to manage affairs. Good faith inquiry. a. Decision of SLC: substantive decision may not be looked into by court; only the composition of the Committee (Substantive is within BJR) 64

b. Court may: look into methods selected and prosecution of those methods, which go to whether they acted in good faith (here hired outside counsel, reviewed prior work for audit committee, held interviews, questioned directors and accounting firm, etc. OK)

Zapata Corp. v. Maldonado: Termination by an SLC

Demand Exc sed: Spec al L gation

1. Facts: was SH of and held derivative suit Committees for breach of fiduciary duty by 10 of s officers  Form a t a di g ommitt of isi t r st d without demand that board bring it on ir tors, l gat s A sol t is r tion grounds of futility because all were named.  ommitt ir s a op Law Firm, ot on R tainer, to Investigate the Allegations Years later board appoints SLC when 4 of s  S b ommittee etermines are off board and remaining appointed new S it is o t in est Interests of o rporation Arg e Legal e rits and onomi al e ( amage to Rep t ation) outsiders. Recommended dismissal. Files a o tion to ismiss 2. Issue: Did the SLC have the power to cause  Court Review: Independence of SLC this action to be dismissed? Merits of e cision?? i stinguish e l. (de novo) .Y. (no oversight), & . C. (normal J R, presumption). 3. Held: Yes. A SH does not have an individual right, once demand is made and refused, to continue a derivative suit unless it was wrongful the decision of the board will stand as BJR. a. Excusing demand does not strip the board of its corporate power may be circumstances where suit, although proper, would not be in best business interests b. Balancing Point: bona fide SH power to bring corp. causes of action cannot be unfairly trampled on by board but where corp. can stop detrimental litigation. c. Two-Step Test: (1) Court must recognize that the board even if tainted by self-interest, can legally delegate authority to an SLC then court may inquire on good faith/independence of SLC and if satisfied on both counts (2) apply own business judgment as to whether the motion to dismiss should be granted. d. Suits Heard: when corp. actions meet criteria of the first step but where the result would terminate grievance worthy of consideration

Special Litigation Committee: Procedure in DE

1. Court Review: independence and procedures of the SLC burden of persuasion on the SLC 2. Reviews: reports and court uses own Business Judgment: a. Zapata may consider matters of law and public policy b. Joy v. North calculate NPV of suit; business decision c. Which of the two is better? Deterrence? 3. Shaw and NC: Takes intermediate approach and applied BJR to SLC; which of three tests? a. Depends on one s view of inherent taint of SLC: Necessarily appointed with approval of interested directors (CEO/Chair); will concern of outside directors over reputation of independence counter taint? 4. Definition of Independent Director: a. Common Law: Concern of salary, job or business relationship, without more, not enough to claim interest 65


y yxwu y w

b. Statutory: MI ongoing business relationship may disqualify OH 1701.59 clear and convincing evidence needed that director salary concerns defeat good faith c. NYSE: listing requirements similar to MI d. DE: common law test evolving

In re Oracle Corp. Derivative Litigation: Burden on SLC

1. Facts: SHs of Oracle bring derivative on insider trading by 4 of board Ellison, H, L and B; Forms SLC to look into and determine best course 2 board Ms G and G were named to SLC joined after events and both were Stanford profs. Hourly wage paid but agreed to waive compensation if a court deemed it necessary to maintain impartiality. 2. Issue: Has the SLC met its burden of persuasion and shown there is no material issue of fact calling into doubt its independence? 3. Held: No. Did not disclose Boskin was also Stanford professor that L had made donations to Stanford and that one donations was used by G for personal research. Failed to disclose that B taught G when PHD, two are good friends in Stanford Committees. L is well known Stanford alum. Third E was Stanford contributor and wanted to make it best. a. Social Influences: may also influence and be motivating factors can use them to show SLC did not meet burden to show absence of material factual question about independence


s Suits against Corporations

1. DE Supreme Court: views in Martha Stewart a. Burden: directors in Oracle had the burden of demonstrating their independence for purposes of their motion to dismiss the derivative action. In contrast, b. In Beam ex rel Martha Stewart Living Omnimedia, Inc v Stewart, which was also a shareholder derivative action, the PTF had the burden of alleging sufficient facts to raise reasonable doubts about the independence of directors. 2. Distinguish: should we look at structural bias v. social circle bias personally beholden 3. Oracle: personal and familial, collegial as well as economic interests count 4. Standard: too substantial and guided by a general sense of human nature a. Higher than standard for demand excuse: Martha Stewart (implied)

Plaintiffs Lawyer: Derivative Strike Suits

1. File and Plead with Particularity: a. First choice: A class (direct) action securities law; vote or dividend related b. Second Choice: Derivative Action, plead that demand is excused first choice: breach of duty of loyalty, second choice bready of duty of care (hopeless) 2. Under both actions, expect and defeat a. Motion based on the named s failure to adequately represent SHs b. Motion on failure to plead with particularity 3. IF Class Action, Expect and Defeat Summary Motions: Motions to dismiss and a motion for summary judgment on the merits; if lose, settle for peanuts; if win, settle for millions 66

4. IF Derivative Actions: a. Expect and beat motion based on failure to make a demand; if lose, make demand and start second suit for wrongful dismissal (hopeless?) b. Expect and beat a second summary motion filed by an SLC c. Expect and beat a third summary motion on the merits defense just a duty of care case then BJR applies d. If lose, file appeal and settle for peanuts or take risk of appeal Settle for Millions: take 20-30% of the cash and collude with lawyers and sell the settlement to the judge; who must approve. If successful buy naming rights to a law school.

Demand Excused: Aronson v. Lewis (DEL) and Barr v. Wackman (NY)

1. Aronson v. Lewis: Test a. Specifically plead one of two claims: reasonable doubt or belief that directors are (1) majority interested or dominated by interested party OR (2) otherwise unable to exercise independent judgment in evaluating SH demand (procedural/substantive tests of due care) 2. Barr v. Wackman (NY): Marx in NY a. Majority of board interested pecuniary interest or controlled by someone who has pecuniary interest b. Directors not informed OR c. Decision egregious on its fact; directors didn t exercise sound business judgment

Primary Duties: Board of Directors (and Appointed Officers)

1. Duty to Whom: To the firm collectively, to maintain firm health not to individual SHs or individual constituencies 2. Measuring Firm Health Legally: a. SH Value maximize residual profits long/short term; stock market price inaccuracies b. Total firm capital value SHs returns PLUS bondholder returns c. Total firm value return to investors plus income value to workers d. Total social value firm is better off in the long run if society is healthy?? 3. Corporate Powers: Express Powers a. Generally: Most states have provisions to allow corporations to sue, be sued, own property, make gifts to charity, borrow money, get stock and redeem or purchase stock b. Limitations: most have limits e.g. transfer of substantially all of corporation s assets normally require approval of majority of voting power of the SHs 4. Corporate Powers: Implied Powers a. Reasonably Necessary: most corporations have power to reasonably do what it is necessary for the purpose of promoting their purposes (firm health) and help express powers unless they are expressly prohibited by common or statutory law. 67

b. Broad Power: Trend is to construe broadly what is reasonably necessary

When can a Board Favor Non-SH Constituencies:

1. Facts Patterns: a. (1) Gifts to Charities AP Smith; b. (2) Distributions of extra cash, higher wages or dividends Dodge; c. (3) Community, culture and tradition over profits Shlensky v. Wrigley 2. Potential Answers: a. Never tie all decisions to shareholder welfare do not do it at all (Friedman); controversial but it has been the legal rule for almost 150 years b. Yes, a bit but only if amount is small and promotes the Good and Ethical (ALI) c. Yes, Full Board Discretion to Act Board may discretionary choose to act in a socially responsible manner [Ohio Statutory Rule 1701.59(E)) Board of Directors of OH Company has no duty to follow Shareholder Primacy Rule (unlike DE) 3. Objective of Corporation: What extent may a corporation may act in a way that is not intended to maximize profits? a. Social Responsibility: Early days broad power to contribute; now more of a debate b. Arguments key objective to get best possible returns and not other legal standard is enforceable; others says they have social responsibility and must balance with SHs interests and public at large

AP Smith v. Barlow: Social Responsibility and Charitable Donations (1953)

1. Facts: Corp. formed in 1896 gave $1,500 to Princeton and SH challenged. President testified that it was sound investment and created favorable environment for the company public had reasonable expectation of such socially oriented contributions by corps. 2. Issue: Is such a gift to a university by a corporation a violation of the duty of loyalty? 3. Held: No, judges are Princeton grads. 4. Rule: Probably not an impartial judgment

Questions for Non-Profit Motivated Gifts

1. 2. 3. 4. Does the CEO get any personal benefits from such a gift? Elephant Bumping. Would a majority of SHs ratify the deal? Does the type of gift matter? Tressel bonus v. Green party presidential campaign Should SHs decide on them? a. Individually give them cash dividends and they can give to charities themselves b. Collectively Proportional allocation like Warren Buffet system of requests 5. Are executive decisions based on personal whim? Creates Conflict? a. Gifts to outside directors of favorites ties them to managers form of quid pro quo like in Seton Hall b. To bind outside directors just give their school money in their name, easiest form of bribery and elephant bumping


6. Transactional Lawyer advice: Refer to long term corporate benefits; make them small in relations to size of firm

Dividends and Stock

1. Why pay them at all? a. If earning retained, stock value appreciates. Shareholders get equal value (in increased stock not cash); b. SH needs cash: if an SH needs cash she can sell a small piece of her appreciated stock c. Use retained earnings to grow or to raise equity cushion (decrease risk of insolvency) 2. Business Reasons for Paying Dividends a. Increase investor confidence (we have cash flow competitors do not) i. New fight over best stock index (capital weighted; fundamental weighted) b. Firm s Investment Opportunities lagging (oil companies) 3. But Tax Disincentive a. Dividends taxed at 15% (Bush) if repealed or sunsets, would be 39% b. Capital Gains (sale) also 15% c. Why are sales still preferred? Timing advantages

Dodge v. Ford: Accumulation of Surplus

1. Facts: SHs of Ford, s, bring action to stop expansion and compel directors to pay more dividends company had capital stock of $2M and $12M surplus; profits were to be $60M. Testimony of said expansion would increase production and cut price for nation so they could buy cars cheaper paid large dividends year before but policy now is to only pay regular dividend. s say s idea was charitable. 2. Issue: When the directors purpose is not paying a dividend (when there is adequate surplus) is to benefit the interests of persons other than the SHs, will the court intervene to force payment? 3. Held: Yes. Can expand and cut car price BUT forces dividend; unique. Ford could have likely won if argument was that retained earnings were necessary to make the new smelting plant but instead argued they were retained for benefit of the public. 4. Rule: Corporations have reasonable discretion to act in any way they want in good faith towards profit maximizing of SHs interests but their discretion ends at a certain point. Since expansion and cutting prices was part of long-term business plan acceptable. a. Responsibility to Declare Dividends and Amounts: discretion won t be stopped unless fraud, misappropriation of bad faith (sufficient funds to do so without detriment to business) b. Here since expansion may be carried out with a large amount of surplus still available ($19M of $60M) they must still pay the dividends since withholdings would be in bad faith


Shlensky v. Wrigley: Misconduct not found

1. Facts: minority SH in corp. that owns Cubs brings derivative suit for refusal to light Wrigley Field and increase revenues. Directors motivation was result of views of Mr. Wrigley and majority SH who wanted to preserve neighborhood surrounding and who thought baseball was day sport. 2. Issue: May a SH bring a derivative suit for mismanagement where there are no allegations of fraud, illegality or conflict of interest for not installing lights? 3. Held: No, the court will not disturb the business judgment of majority of directors without above reasons. No evidence that installing lights and scheduling will increase benefits to and there appear other valid reasons for refusal to install e.g. detrimental effect on surrounding neighborhood (which Corp. Property is located in and has interest in). a. Not obligated to follow direction taken by other, similar corps. Even if these MAY be better not guaranteed.

Shareholder Primacy Rule

1. Board Members Behold only to SHs if ONLY SHs vote: SH will vote for board that maximizes SH welfare a. SH welfare without clear SH direction to contrary a DUTY to maximize SH wealth 2. Duty to Others Constituencies: Ideas a. Others may vote: Germany b. Room for duty because SH vote is a joke and board is self-perpetuating c. YES but only with a clear link of other constituencies welfare to SH welfare our system 3. Distinguish Idea: That Corp. should follow green ideals because it will do better over time (maximize profits in a long-term plan) FROM a. Following them because the expense of profits over time because society is better off (it is moral, ethical or right) b. Substitute for green sin-free like no booze, etc..

Defense of Shareholder Primacy Rule

1. Goal of Corporate Law: Serve interests of society as a whole 2. Achieved: Does this by advancing aggregate wealth good! 3. Surrogate measure of firm health best interest of SHs? SH Primacy Principle a. 95% of the time if SHs are happy everyone else is happy (litmus test even for employees); They are served last so all before them get hooked up b. Auction of board vote SHs pay the price of what they think the stock would be worse v. what they think it would be worth if they had control or if the directors had control i. If SHs control the vote then we are happy they control the interest they are the ones with the RISK and who have something to lose. 4. Who should prevail when SHs and other constituencies are in conflict? E.g. company is on edge of insolvency a. Pro-shareholder - reduce wages or dissolve because if not, I am gone


b. Pro-labor run company until broke and until all the cash is gone (like NYTIMES, GM and CHRYSLER) 5. Opponents of Rule: CEOs in OH have duty to all accountable to none; insulated board from Court Review a. Asset redistribution social engineers want say over others assets and money for greater good of society b. Opportunistic renegotiation contracts agree to terms (labor money) and ask court to change it because of circumstances (big profits, no profits) c. Promoters of idea that consensual, inclusive decision making dialogue is a universal good and will lead to peace and happiness 6. Bottom Line on Principle: one of the most What st rl i t ay significant structural assets a. Combination: Economic flexibility and  Republican r paganda : (I ish), the Republican E s do not like y views either. They do not want to accountability of those who control be held accountable in shareholder law suits; they like dividend retention and the power to ake charitable pools of investor money gifts (and political contributions to ixon).  Profits ver Environment : o, the method of b. Constant attack from politicians, protecting the environment is to pass general legislation academics, journalists, clergy, etc. and with prohibitions; do not give the board a fiduciary duty to be green. survives because competition among  Do ot Invest in (or buy Products from) only Ethical ompanies: o, recognize and accept the cost. Respect nations, states and companies; core the limits of legislating ethics. respect for individual initiative and common sense
d d


Limited Liability Company

1. Source of Law: State Codes (a Continuum: partnership to contract principles) a. ULLCA 1995; partnership principles b. OH ch. 1705 1994; corporate principles c. DE LLC Act tit. 18 Freedom of Contract 2. Characteristics: a. (1) Public Filing to Sec. of State, single-page (OH art. Of org.) b. (2) Default Rules depends on member managed or manager managed designation and most all defaults can be modified by oral or written Operating Agreement (OA) flexibility is key c. (3) Members have complete limited liability d. (4) Business Name Limited Liability Company, LLC, L.C.C., Limited, Ltd. or ltd.

Manager- or Member-Managed: Structure Options

1. Default: Member-Managed Company a. Similar to Partnership OH .24 and .25 b. OA can flesh out key details 2. Common: Manager-Managed Company a. Must make designation in filing alternate default rules apply but OA can modify defaults b. Affects member s powers to bind LLC to contracts limits member actual and apparent authority (OH .25(B) and ULLCA 301) c. Affects allocation of fiduciary duties (OH .29) clear and convincing test; damages only for intention or reckless acts; no express constituency statute (may incorporate by inference?) d. Derivative action for members (OH .49) with demand requirement (OH .51) e. Less people able to bind company and also tax purposes make popular clients want it for no double tax; f. No Double Tax: Every time they make a dollar profit ALL members must pay personal income tax (2 members, declared each) general partnership tax treatment without double tax

Fiduciary Duties of Members

1. Member-Managed: Owes Duty to Each Other (partners) 2. Manager-Managed: ONLY managers owe fiduciary duties (corporate boards) 3. Ohio: except to the extent of the OA; duty in .29(a) injunctive relief, damages compared to 1701.51 a. Corp. Style Provisions reliance on reports, conflicts and indemnification


Water, Waste and Land v. Lanham: Gap Filling and Constructive Notice
1. Facts: , manager and member of PII, . was LLC under CO LLC Act and contacted WWL, , about doing work. During discussions gave business card with PII and address of other member and president of PII, L, who had same address listed as principle office and place of business in Sec. State filing. Oral K with and asked to send written work proposal to sign and return. Never sent but authorized to begin work; when work done sent $9k bill. 2. Issue: Is a member-manager of an LLC personally liable on a K entered into by another membermanager and a 3rd party if the 3rd party lacks knowledge of the business entity and thinks the member-manager with who dealing with was acting as an agent for the other membermanager? 3. Held: Yes, even though L was agent of PII, LLC, he failed to fully disclose his principal to a 3rd party with whom his agent dealt and under agency law, failure made him liable on the K with the 3rd party. 4. Rule: Even though statute calls for filing with the Sec. of State, the member is liable when not disclosing principal is LLC. (OH has reverse .07(c)) a. To interpret the notice section of the LLC Act as making filing constructive notice even if they lack knowledge of the LLC existence would invite fraud and sharp practices; allowing agent of an LCC to mislead a 3rd party to think that the agent would make good on K. b. Constructive Notice - Better Interpretation: notice of an LLC s name puts a 3rd party who deals with someone that he knows is a member of an LLC on constructive notice f the LLC s limited liability status and that managers and members bear no liability because of status. c. Interpret Statutes in derogation of common law narrowly, particularly when broad interpretation would depart greatly from settled agency rules and create uncertainty about known rules when L got proposed K from showing thought L was principal he could have easily corrected s to avoid this.

Elf Atochem v. Jaffari: Operating Agreements and Arbitration

1. Facts: Elf and J agreed to joint venture to market J product and form M, LCC a DE LLC. says he gave 30% capital in exchange for 30% interest and J gave rights to product for 70% interest. OA said arbitration clause would govern all disputes coming from OA and forum would be in CA. files in DE claiming duty of loyalty. Because OA says forum is CA, DE Court dismissed claim. 2. Issue: May the members of an LLC, through the use of a forum selection clause in their OA, vest jurisdiction in a particular forum? 3. Held: Yes. DE LLC Act allows broad discretion in drafting LLC OA and gives defaults only when OA member s agreement is silent. a. Maximum effect to freedom to contract and to freedom of enforceability of LLC OAs. Only when inconsistent with mandatory statutory provisions will the Member s agreement be invalid. b. Omitted in OH 73

Kaycee v. Flahive: Piercing the LCC Veil

1. Facts: KC, , and FOG contracted to use s real property and Roger, , is managing member of FOG says that during use, FOG fucked up property. FOG has no assets and seeks to pierce LCC and hold ROGER individually liable for the fucking up. 2. Issue: Without fraud, may a court pierce the LLC veil in the same manner as the court would pierce a corporate veil? 3. Held: Yes. Every state that has enacted LCC piercing laws hasn t developed a different LLC standard but has chosen to follow corp. law standards; no reason to treaty LLC s differently than corps a. Some factors justifying corp. piercing like failure of formalities obviously will not apply b. OH .48 says no language on formalities

McConnel v. Hunt Sports: Member-Managed LLC with OA

1. Facts: CHL in 1996 was formed; Member managed LLC with an OA; LLC OA allowed members to compete with LLC; restricted liability of members of willful misconduct; required majority to file suit. Member of LLC formed new LP to take sports franchise in competition with LLC 2. Issue: Can an OA of an LLC limit of define the scope of fiduciary duties imposed on its members? 3. Held: Yes, 3.3 of the OA said that members may compete and shall not in any way be stopped from engaging or owning any competing interest. Language is clear and unambiguous o By very clear terms OA allowed competition and voided duty of loyalty for the LLC members involved; no duty not to compete o OA obligations only apply to conduct in carrying out their duties of the OA: Breach of LLC OA was by member for filing an unauthorized suit against LP 4. Waiver of fiduciary duties: in partnerships harder to do this because of common law duty; cannot be engaging in any other business in joint venture industry (so preserve the right to pursue other businesses) o Members may waive: all duty of care claims other than willful acts and some types of duty of loyalty claims (duty not to compete) o Court Refusals to Respect Waiver: basic contract theory strict construction of language mistake, fraud, contract of adhesion, non-waivable fiduciary rights? o Homer Opinion: in this case, OA doesn t specifically say that cannot TAKE THIS BUSINESS only says cannot take others (ridiculous) 5. Cannot waive in RUPA 103: generally any unless manifestly unreasonable

Formalities of LLCs
1. Many Without Formalities: Operate with one-page Articles of Associations a. Many oral implied agreements custom, course of practice evidence b. Usually member-managed but can be manager-managed in mutual unwritten understanding that only B runs business, not A. 2. Effect on Integrity of Entity: Court interprets implied agreement and other applies default rules


Ohio: Summary of ch. 1705

1. Keys: No constructive notice on filing; no freedom of contract language 2. Default Rules: a. Create LLC capital contributions create division of profits b. No automatic capital calls c. New members on unanimous vote d. Lock-in: members may not withdraw but may assign interest in membership to others for consideration (ceases to be a member on death or insolvency); partnerships withdraw at your own will e. Withdrawal: 1705.16 (go from no lock-in in A and B from absolute lock-in in C) f. Authority depends on member- or manager-managed distinction g. Duties of managers comes from Corp. Model 3. Lock-In: Member of LLC with no OA and want to unilaterally leave a. Cannot withdraw b. Can sell; purchaser not a new member c. Sue to dissolve not practicable to carry on business in harmony, etc. d. Die estate has powers of members, can assign, not membership e. Lesson: Use an OA and DO NOT use the default rules.

Transaction Lawyers: Operating Agreements

1. Why is lock-in important? Automatic lock-in with LLC defaults, which is why they are so popular 2. Why not law firms? Because of the vanity of the word partnership a. Inherent lock-in, too 3. Minimal info in articles because updating 4. Money into business not personal 5. Critical membership issues allow what? Deny what? 6. Review to see if change procedures if so, amend 7. Know about tax issues 8. Oesterle: a. (1) Put Minimal Information In Articles: Updating Obligations Are Easy to Forget and Remember Annual Fees; also Check Name (Make Sure No-one Else Has It) b. (2) Take Extra Care on Instructing Client on Proper Use of Business Name: LLC in Title and on Signs and Instruct Client, in Writing, on How to Sign Documents c. (3) Take Extra Care on Instructing Client to Keep Separate Business/Personal Accounts d. (4) Always, Always Use a Written OA (Start with a Good Form; Modify It) i. Include Critical Client Understandings on: Membership Issues (Admission; Withdrawal and Expulsion; Assignments) Division of Profits; Capital Calls; Management Structure (Decision Making and Voting Procedures) and always Prefer Simplicity ii. Handy Road Map: Client Can Read and Follow the Directions - Include Tailored Rules and Default Rules into a Single Package of Instructions 75

iii. Review the OA Periodically to Make Sure that Client Has Not Changed Procedures. If so, Amend OA or Amend Client Procedures. Do not let it go. a. (5) Know a Few Essential Details About Partnership Tax and A Good, Reliable Tax Expert for Clients and Yourself.

Fiduciary Duties on the Corporate Side

1. Control of judges: in corporate context much more refined 2. Duty of Loyalty of Good Faith: Bound by rules of fairness, loyalty, honesty and good faith in their relationships, dealings and managements 3. Duty of Reasonable Care: Exercise reasonable care, prudence and diligence in the management of the corp. 4. Duty of Candor: growing in corporate context and reduced in partnership and LLC context (duty to reveal or disclose info)

Duty of Care and Common Factual Issues

5. Takeovers: Board sold for too little or refused to make a good offer (Van Gorkom and Cede) a. Buyer just pays too much, buy a company that isn t worth that much; OR target company sells for too little by not holding out for more cash 6. SH Dividend Cases: Board should NOT have paid a dividend (AmEx case) a. Board decides or doesn t decide to pay an extraordinary dividend (dumping cash on shareholders) should we do this? 7. Duty of Monitor: (1) Inattention (Francis and Allis-Chalmers) and (2) lack of legal compliance programs (Caremark) a. New stuff board is just not paying any attention, stuff is happening with the company and they are just not informed and don t care enough to create legal compliance programs to structure information sharing 8. Illegal Act Cases: AT&T Case a. bribe foreign officials, statute act to stop wholesale bribery of foreign officials; campaign contribution violations

The Business Judgment Rule

1. Along with Care and Loyalty, Third Standard: Confusion as to what the standard actually is thresholds? If good faith, gross negligence? Affirmative defense? Good faith as a defense to negligence? 2. Purpose: Courts are reluctant to hold directors truly responsible for the management of the corporation and truly liable for its financial errors 3. Defined: When a matter of business judgment is involved, the directors meet their responsibilities of care if they use honest, good faith, unbiased judgment. 4. Gross Negligence: When standard is applied only a director acting in good faith could be held liable if his actions were grossly negligent or worse 5. Thresholds: 76

a. (1) Financially disinterested (no conflicts of interest) b. (2) Reasonably Informed c. (3) Acting in Good Faith in the firm s interests 6. True Standard: Regardless of standard of negligence courts say they use, a. Generally just look at all the facts and determine whether the total situation is one in which the directors or officers SHOULD be held liable b. BECAUSE they knew or should have known of the situation AND they could have done anything about it. c. Applied to each individually

Kamin v. American Express: Informed Business Judgment

1. Facts: Minority SH s sue AmEx on derivative and request declaration that certain dividend in kind that is to be paid is a waste of assets. s that in 1972 bought 2M shares of DLJ at $29M and current is about $4M. 1975 board has special dividend to which DLJ were given to SHs in kind. If sell thinks would sustain capital loss of $25 and would be offset against capital gains of about $8M to . Rejected. 2. Issue: Minus of a showing of bad faith, fraud, oppression, arbitrary action, or breach of trust, are the business judgment decisions of corporate directors judicially rescindable for alleged imprudence or mistaken judgment? 3. Held: No. Once the plaintiffs had conceded that the American Express board considered the tax advantages of selling the DLJ stock before deciding to distribute that stock as a dividend, NO questioning of the board's demonstrably foolish decision would be entertained a. Neutral of tax reduction economists cannot make decision and neither can AmEx but they say that boards will spin-off and earnings number will be higher b. Key it was good faith, they acted without any impropriety.

What to do if buy business for millions and worth millions less now?
1. Could do one-time write down of -$80M; big write-down will come right out of the net profit line P/E Ratio would go down price to earnings ratio earnings per share (stock price goes down, etc. not good for shareholders) 2. Sell shares and get the cash, still have $20M in cash now (true reflection of value of the firm) but won t write-down as much a. Advantages tax deductions for capital losses 3. Which AMEX took declare a special stock dividend (not just cash): give out more cash (inkind/in-specie dividend); take shares of the sub (SH Apparent Sub) the Apparent then gives the SHs stock in the sub for free a. Tax status pay more b. Net profits looks greater but we are paying more taxes to the government in this situation EVEN THOUGH our Price/Earnings Ratio (SO therefore paying tax to the government is good for the company) SHs say NO, take the deduction and cash because this is retarded c. AMEX won no fraud, no conflict of interest, no bad faith, just plain DUMB 77

d. EVEN THOUGH trying to cover up huge mistake in order to maintain personal reputation it is not a conflict of interest

Smith v. Van Gorkom: Informed Merger Proposals

1. Facts: sued Def who was selling train cars without much cash coming in many outstanding leases though and going broke. figures out what to do and asks R about leveraged buyout R says $50 a share but not $60 would be generated. Without consultation consults PR, takeover man, and negotiates sale for $39 above market Smith v. Van Gorkom: without study of intrinsic value or competing offers. What did the Board Hired own lawyer. Ignores board request to have own. Know? At board investor not invited and management against Stock rading in $3 - $38 Range it for low price. Sold it anyway. After, KKR made $60 per Bid was $55, a 5 Premium offer and before board saw it, cancelled not presented. Friendl e al Premiums Average Lockup 3 days to answer no other offers. Says OK. 2 2. Issue: Did the directors act in accordance with the Rail Car Business in ecline Pritzker would ot n gage in an requirements of the Business Judgment Rule? Auction 3. Held: No, breach of duty of care. NO DAMAGES.  Sell now or I m gone 4. Breach of Duty of Care: BJR inapplicable because board was not informed and the reliance on experts was not reasonable (should have done own valuation with CFO and legal counsel); ratification by SHs was also not informed a. Entire Fairness Test: Burden of Proof is on the board to prove OK b. Threshold: (1) disinterested board and (2) uninformed board 5. Court is Upset because of: a. (1) casual board procedure b. (2) no expert appraisal c. (3) no formal market vetting d. (4) CEO flippant and didn t care had to do deal in 2 hours to go to opera e. (5) Priced from an Leverage Buyout Firm study

New Standard of Adequate Information and Policy Issues

1. Better procedure leads to better decisions? No, there is really no link. 2. Is decision to act or get more info before acting a routine business decision? 3. Consequences: Shocked Biz Community couldn t get independent directors on board anymore a. Insurance D & O premiums go through the roof b. DE legislature overrules the case 102(b)(7) c. Next year DE meeting every DE companies enacted the duty of care waiver (that required recklessness with an SH vote who were compelled and waived own right to sue overwhelming) d. If on board seller shows up makes money for investment bankers


j f



e. Investment banker admits he was paid $1M; had to pay 2nd or 3rd investment banker to make deals like this (free money) 4. Effect on legal advice to board? a. Fairness opinions from investment bankers and scripted recorded board decisionmaking procedures (all a show) no short board meetings b. Makes money for lawyers for associates c. Must take at least two weeks to have board meetings on sales to sell it d. Procedure at meetings must be heavily legalized/official

Liability Waivers: Delaware

1. SHs must sue on behalf of firm: a. (1) demand requirement in duty of care cases are hard to get excused b. (2) BJR of the defense motion to dismiss; hard to overcome 2. Waiver Does not Apply: a. To injunctions only to claims for damages b. To allegations of bad faith or personal benefit 3. DOES apply to: a. Damage claims against disinterested directors b. UNLESS the Entire Fairness Test applies controlling SH transactions (Emerald Partners) 4. Duty of Care in DCL 141(a) Statutory Cases: Business and affairs of this corporation shall be managed by the board of directors, except otherwise provided in this chapter or cert. of incorporation a. Exception 102(b)(7) amending the cert. of incorporation limiting or eliminating the personal liability of the director (not the firm or an officer) for monetary damages (can always for injunctive relief) sue as a director provided that (1) cannot eliminate duty of loyalty; (2) intentional or knowing violation of the law; (3) improper personal benefit problem b. Problem what do we do for recklessness? Can we exempt or not? c. 102(a)(7) can put in a provision (voted on) to eliminate the personal liability of the director in a duty of care case unless there is a reckless or intentional conduct

Ohio: Duty to Care 1701.59 and 1701.60

1. 1701.59 duty of care; 1701.60 also has an impact 2. Tries to rip Smith v. Van Gorkom apart general statement is in 1701.59 BUT then may adopt BYLAWS in order to change 3. Bylaws in OH like rules of order use in a context where no one else would understand (regulation are the actual bylaws of a corporation in OH) 4. Codify the Exceptions to the BJR: straight negligence standard (ordinarily prudent person who would have done in the situation) a. (b) Negligence Test: b. (c) Changes everything (c) is usually most important director SHALL not be found to have violated (b) duties unless proved by clear and convincing evidence (standard of 79





9. 10.

proof like common law fraud in torts or equitable concepts); cannot sue under a duty care unless they have clear and convincing evidence i. No good faith if unwarranted c. (d) Injunctive relief to damage action d. (e) for purposes of duty of care director best interests of the corporation shall consider the SHs interests (touchstone is best interests of corporation) may consider economy, community and societal considerations, employees, debtors and creditors, continuing independence (don t sell) Default rule not amended into the cert. of incorp. but must amend out of it a. Very pro-director with lots of exceptions b. Lots of protection from the duty of care impossible to win even if get to a jury (duty to nobody) (e) constituency statute: directors can be beholden to a lot of constituencies a. Duty of care has been shat on OH is laughingstock for good corporate lawyers everywhere 1701.60(c) Redefine Duty of Loyalty a. Changes (a) conflict of interest definitions and duty of loyalty b. A director is not an interest director SOLELY because the subject of the K, action or transaction MAY involve or affect a change in control of the corp. or his continuation in office as a director of that corp. c. Damages 102(b)(7) reckless disregard; in D that excludes negligence and gross negligence for monetary damages must be intentional disregard for corp. d. Must opt-out if don t like (d) e. (e) compensation provision Irrespective of any financial or personal interests of any of them shall have the authority to establish reasonable compensation a. With conflict of interest? Goes to duty of care Duty of Care: all compensation decisions irrespective of financial interests and includes all takeover decisions as well 1701.59(a): general duty of care; a. (c) negligence definition of duty of care and also reaches out to takeovers no duty of loyalty problem b. Adds clear and convincing test in (c) standard of proof in all actions c. (d) monetary damages: more restrictions outside (c) get 102(b)(7) situation standard to get cash from a director is intent or recklessness (not gross negligence or negligence) recklessness is not express in the DE provision d. Default in OH: (c) and (d) is an opt-out limitation on director liability in OH if you don t like it, you can opt out (name the provision) with a waiver specific to this section very specific (can go back to gross negligence) e. Opt-in in DE: must have an opt-in amendment voted on by SHs



Opt In but as defaults: Will not apply to injunctions only to claims for damage and To allegations of bad faith or personal benefit

Default Rule: Opt out not opt in

DOES apply to: Damage claims against disinterested directors UNLESS the Entire Fairness Test applies controlling SH transactions (Emerald Partners)

Tighter: Clear and convincing standard of proof; best interests of Corp. included other constituencies; no improper personal benefit exclusion; no Unocal rule; reckless disregard Cons: SHs are duped.

Culpability doesn t include reckless disregard for best interests of corporation; only gross negligence

Pros of Waivers: why ratify? They know what they are doing.

Brehm v. Eisner: Informed Compensation and Severance

1. Facts: Disney hires O as Pres. In 1995 approved 5 year compensation pack of $1 with bonuses and stocks with generous compensation package. O left without fault before 5 year term. O sucked at work and 1996 Eisner allows to terminate. Vote to approve non-fault termination. Give package over $140M. 2. Issue: Was there a breach of fiduciary duty of board by failing to assess employment agreement properly or approval of termination for no fault? 3. Held: No. Had expert assess contract didn t look to package doesn t infer that board failed to look at cost of firing him. a. Standard: doesn t require that board s decision be informed on every fact only reasonably informed (even without exact cost fully informed about manner in which such payment would be calculated because of expert) b. Negotiations for severance was BJR value of contract against value of employee; court will not apply 20/20 hindsight to 2nd guess board s opinion UNLESS rare cases when a deal is so bad on its face that the board s approval cannot meet the BJ test. c. Terms of Agreement limit to gross negligence or malfeasance for at fault termination he may not have been here, so boards failure wasn t problem. 4. Duty of Care: Directors decisions respected as presumption unless a. (1) Interested b. (2) Lack independence relative to the decision c. (3) do not act in good faith d. (4) act without a rational (not reasonable) business purpose


e. (5) Use grossly negligent process (includes failure to consider all material facts reasonably available)

Business Judgment Rule: Implications

1. Design: to end cases at Summary Motion pleading matters and should use SH inspection rights at first 2. Second Guessing: Courts will not 2nd guess business judgment if they are rational or reasonable; defer to disinterested and independent directors and rely on experts (this will make judgment reasonable or rational) 3. Best Practice Standards are not liability standards: Standards evolve; process and procedure matters (keep good records, no check box drills; objective reasonable test on procedures of gross negligence) 4. BUT New Wrinkle of Good Faith: different from duties of care and loyalty? a. Violated by willfulness or recklessness (intentional misconduct or conscious disregard for duties b. Even though no recklessness in the record

Eisner v. Disney: Implications of New Wrinkle

1. Facts: Board Compensation Committee Rarely Met. Some Members (Sidney Poitier) Attended by Phone from His Yacht and Did Not Have the Foggiest Idea What Was Going On. They Relied on Eisner s Recommendations a. Changes in Severance Provisions (For Tax Purposes) At the Last Minute Were Not Understood Nor Discussed by the Board of its Committees. [The Compensation Consultant was also surprised.] b. Eisner s Severance Provisions Were Similarly Bad. 2. Issue: Breach of fiduciary duties? 3. Because of 102(b)(7) Waiver: Court must hold a. (1) Board was reckless b. (2) Board violated good faith by deliberate disregard c. (3) Wasted corporate assets 4. Loyalty Not Available because O not on board and O not family or friend of dominant SH or CEO 5. New Wrinkle Effect of BJR Rebuttal of Presumption? a. DE: shifts burden of proof to directors standard of entire fairness b. Others (Allen): s must prove(1) lack of due care (negligence), (2) proximate cause and (3) damages c. Difference: Rescission available as damages? Eliminated by Allen ruling that NO

Transaction Lawyers: Waivers

1. ALWAYS: include a 102(b)(7) waiver 2. With Waiver: board members personally liable, only for (1) willful misconduct, (2) recklessness or (3) personal pecuniary gain


3. ALWAYS: include corporate promise to employment agreement (backed with provisions in Articles) to maximize indemnification and insurance coverage 4. NOW have new rules to deal with: organizational sentencing guidelines lower fines for firms a. with compliance problems b. that turn into bad actors because scapegoats c. SOX of 2002 for publicly traded firms; they MUST have internal compliance info and disclosure programs that are audited; federal and criminal/civil penalties; CEO and CFO certifications

The Duty to Monitor: Corporations

1. Argument: directors were ignorant and things happen that should not have because they were not paying necessary attention 2. Distinguish: a breach by commission FROM one by omission (unwitting express ratification of fraud; willful blindness?) 3. Distinguish: Excusable ignorance FROM breach 4. Director must: a. (1) understand business; b. (2) stay informed in operations; c. (3) be familiar with financial status and d. (4) inquire on any red flags 5. Standards: Distinguish between objective and more subjective sophistication of director 6. Statutory Defense: reasonable reliance on experts 7. Key Question: did the board of directors establish an adequate procedural disclosure system to inform them of problems and keep them up to date on key company issues?

Francis v. United Jersey Bank: Familiarity

1. Facts: Bank was run by idiot sons who embezzled money after son died; their mother didn t care nor pay attention even though was also director. 2. Issue: Was Mother, as director, individually liable because negligent, and if so, was negligence proximate cause of losses by s? Ba ne v. And ew ( .D.N.Y. 1924) 3. Held: Yes. Causation was provable because banks are special and easier to prove causation. 4. Director must: know and understand basic and Receiver required to generally monitor affairs and policies; if illegal conduct, had duty to object and Liberty Starters Andrews (Director maybe take reasonable means to prevent such (Insolvent) and largest shareholder) conduct or resign. Liable for failure to stay informed? 5. Nonfeasance: causation issue requires Held: No, unless evidence that neglect caused losses. determining what reasonable steps a director could have taken and whether those steps 83

would have prevented the loss. The failure to act must be a substantial factor in producing the harm. Here inaction encouraged it and could infer she should have acted to object or seek counsel. a. Causation case by case analysis.

In re Caremark Intl.: Duty to Oversee Employees

1. Facts: Settling a lawsuit where Caremark employees were engaging in Medicaid fraud 2. Issue: were the directors liable for these employees who were breaking the law and losing lots of money? a. Settled the case after suit by SHs b. In the settlement (non-reviewable) directors have a duty to install internal controls (info and reporting systems) Stone v Ritter (Del. 6) 3. Settlement Creates Law new law could be installed in settlements, so they try to change The final brick in the wall against an it; now they have internal controls, could have independent good faith standard. Just a found as a judge that we established doctrine recklessness standard in disguise. based on internal control (judge) Also Affirms the Caremark duty, a duty to a. If a board doesn t have a procedure to put in internal controls. Did the company have money-laundering controls in place? stop illegal procedure and care for it, Yes. Case Dismissed. then it is a duty of care breach (by dicta)

Legal Compliance Programs: General Duty to Investigate?

1. Old Rule: No, unless there was a red flag. 2. New Rule Caremark: Must have internal legal compliance program because there is a general duty to establish it. 3. Why? 1991 Sentencing Guidelines on how to sentence Corporations 2002 SOX Requirements says they will go lenient on corporations with Legal Compliance Programs will not get sentenced harshly if illegal stuff is going on a. Sarbanes-Oxley adds to this type of thinking b. Only if you are publically traded S-O requires legal compliance and audits 4. What is a legal compliance program? Audited? Costs? a. Legal compliance program must be audited (required by Sarbanes-Oxley) b. Must hire one of the 4 big accounting firms to audit your firm Congress makes this rule 5. Problems: If the accounting firms makes a mistake? a. (1) they get delicensed SO they are hypercritical to save their own asses because of the fines and potential loss of business this happened to Arthur Anderson in Enron (out of business) b. (2) this is not their specialty they are accountants, not legal compliance officers or lawyers who should know this type of stuff (no lawyer expertise) 84

c. (3) Use checklists for CYA; use among all the officers so no problems 6. Sum total incredible added expense to our auditing of companies (antithesis of what we wanted to do in Sarbanes-Oxley to attack auditors)

Duty to Object
1. Once a director identifies a problem must the director: Object? a. Form: in a meeting? On the Record? 2. Once outvoted: a. Resign b. Attempt to prevent? Francis (unusual) c. Blow the whistle? Notify i. Government the state, the SEC (of Resignation or Of Specific Info), prosecutors ii. Shareholders (media) d. Sue offenders? Standing as a director to sue on behalf of the firm may sue the other directors 3. Compel to whistle blow? Sarbanes-Oxley whistle blow for public financials a. Rule Now: Want to protect from litigation, all you are obligated to do is resign publicly and object in the public forum (unless you have done something yourself, in the conspiracy, then resignation will not be enough) 4. Question: Should we go one step further? Problems? a. Sarbanes-Oxley: attempts to protect voluntary whistle blower you are owed lots of cash in litigation (protections voluntary whistleblowers) b. Creates incentive for voluntary whistle blowing c. Duty to Rat: creates incentive not to inform others, creates incentive to not rat, not share information or at least too much (cliques)

Illegal Acts: Exception to the Business Judgment Rule

1. Miller v. ATT&T: Allegation of illegal campaign contribution 2. Standard: good faith? In best interests of the corporation? 3. Duty to Act Lawfully: Officers and directors have a duty to act within law; if they KNOWINGLY cause their corporations to violate the law, they are in violation. Also have duty to ensure that the corporation has effective internal controls to prevent employees from engaging in illegal acts.

The Entire Fairness Test

1. Duty of Loyalty/Conflict of Interest: These are the cases you can win, have settlement value and are cases that judges actually do understand cannot judge real business decisions a. Judges are outside capacity in duty of care; here this is traditional stuff serving two masters, conflicting goals, lying to people (human condition stuff) b. E.g. Director/Officer on one firm inks a deal with a second firm that is owed by director/officer (Bayer listen to wife who is an idiot); Lewis (board members own more 85

Bayer v. Beran: Relatives

1. Facts: Wife choose advertising campaign even though she is singer. She chose herself to sing in ads and paid normal price. SHs sue who was majority owner. 2. Breach? No. Burden to show good faith of deal and inherent unfairness. No disloyalty. Just because the participation of wife may have helped her singing career is not a sole ground for subjected s to liability for breach because there wasn t excessive pay to her and directors free to chose campaign.
BOT v Benihanna

Aoki B


50.9 Common 75% Seats 2% Class A Common 25% Seats

Benihanna, US

$20M Conv Preferred oting Stock . 1 dedicat ed seat; oted as 28% of Common For 75% seats

(Abdo, Director-Exec. Comm.) BF C (Abdo, 0% w ner)

Lewis v. SL: Fairness Burdens

1. Facts: SR owns SLE and LGT and real property used by LGT owned by SLE. Transfers stock to 6 children in LGT but not SLE, who leases from LGT. Sell stock to LGT at low price and refused to sell saying rental was greater than what lease was for and so was book value. 2. Burden: Overcome by s, made no effort to determine fair rental value at any time. Must show the deal was fair and reasonable.

Safe Harbor State Statutes

1. Sources: DGCL 144; RMBCA 8.60-63; OH GCL 1701.60 86

xx tv qon nmq r ro

than lessor); BOT v. Benihanna (board member bought convertible preferred stock); has independently paid (bribed) the director/officer or CS (Agency) 2. Standard of Review: Entire Fairness Test is current version a. Test: It makes little difference whether the board is disinterested or not, the issue is whether the transaction is fair. b. Requirements: Director s interest must be fully disclosed if the board is not disinterested, the contract will be given very close scrutiny; many states have this. c. Burden: On the conflicted board with careful scrutiny met in Bayer and BOT 3. Two Types of Duty of Loyalty a. (1) Sweetheart deal: CEO who owns both corporation, one corp. is 2% and other is 100% Sweet Heart Deal - has them deal with each other with 2% share and sell goods for too little money to the 100% S (Singapore asset stripping); CEOs Mom buys .A $100 hat for $10 puts asset value out 50% b. (2) Bribery: CEO approaches CEO and wants D deal says will bribe CEO for decision-making A R f P I . in company, outside the deal (a lot of problems S A f here e.g. takeover artist with one CEO y f .A CEO C blocking it pays that guy bribe and he stops blocking it)
s t p p r x xx x q p ro o r rm p p r q p x xx x ro o z| ~ tv wvm utm o sr q p on m zy |  y ~ ~} | y | zy { ~} { z zy {

.A 100%

I .

2. Transaction not voidable if: a. Details fully disclosed AND b. Ratified by disinterested directors OR disinterested SHs c. AND Fair 3. 144 Issues: Ratification and Fairness Tests Same tests (majority)? a. If no, does ratification effect fairness; if no, use weaker test b. If yes, does ratification end inquiry? No, BJR on ratification decision c. Full disclosure required by fairness test? Majority, Yes. d. Fair procedure and pair price? Majority, yes. (Hayes Oyster, Wash.) 4. 144 Issue: Relate to suits against directors for damages or unjust enrichment like BOT? Agency law controls. BOT defines duty: a. (1) Section 144 of Delaware General Corporation Law provides a safe harbor for interested transactions if the material facts as to the director s relationship or interested and as to the contract or transaction are disclosed or are known to the Board and the Board, in food faith, authorizes the contract or transaction by the affirmative votes of a majority of the disinterested directors b. (2) Corporate action may not be taken for the sole and primary purpose of entrenchment 5. Distinguish: director deals FROM controlling SH (parent/partially controlled subsidiary) deals

144 Issues with Ratification

1. Are Shareholder Ratification and Fairness Alternative Tests?? (Is or conjunctive or disjunctive?) 2. Majority With Delaware Style Statute: No. See Fliegler v Lawrence (Del. 76)?? [But in Fliegler there was not a disinterested majority of shareholders.] a. If no, does valid ratification affect strength of fairness test? i. No, unless disinterested votes in majority. Delaware Court effectively amended the statute to look more like Ohio s. ii. If disinterested majority vote, use weaker test: BJR. iii. In parent- controlled sub deal, then shift burden of proof on majority of minority vote but use entire fairness test. In Re Wheelabrator 6. Minority: Yes (Ohio: Statute Requires a Disinterested Shareholder Vote). a. If yes, does ratification end inquiry? b. Effectively, yes (hard to second guess informed, disinterested shareholder decision when protecting disinterested shareholders). 7. Is Full Disclosure Required by the Fairness Test (as well as the Ratification Test)?? Fair Procedure and Fair Price?? Majority: Yes (Hayes Oyster)

Shareholder Ratification
1. Maybe Stronger than Board Ratification 2. BJR Applies: SH Ratification of director/officer related party transactions a. BUT if wasted assets, unanimity required (Lewis) 87

3. Fairness Test Applies: Transactions between corporation and controlling SH with burden shifted (Wheelabrator)

Transaction Lawyer: Special Committee of Independent Directors

1. 2. 3. 4. 5. Composition: independent directors Authority: full powers to decide, delegated by resolution of full board Charge: negotiate best price Powers: may hire outside lawyers, banks and accountants Effect on Standard of Review: Only shifts burden to to show unfairness in controlled SH transactions

The Duty of Loyalty

1. Distinguish from Duty of Care: a. (1) Sloth, inattention or stupidity b. (2) Disloyalty, betrayal, personal benefit at firm expense selfishness c. (3) Care: s lose; Loyalty: s win. 2. Alternative Terms: Bad faith, self-interested, self-dealing, conflicted, interested or related party transactions; conflicts of interest

Corporate Opportunities
1. Prevents: Corporate officers and directors from taking opportunities for themselves that should belong to the corporation a. Example of Property: May not use corp. property to develop own personal business 2. Distinguish: FROM related party transactions like In re Ebay (bribes not Cos) 3. Standard: interest or expectancy test; stronger line of business test (Guth) 4. Expectancies: May not assume for herself property or interests in which the corp. is interested or which the corp. could be said to have a tangible expectancy or which are important to corp. business purposes a. Corp. leases land cannot buy the land for self b. If reasonably foreseeable corp. would be interested in property necessary expectancy and if opportunities relate very closely to the business of the corp. necessary expectancy 5. Defenses: Must be in good faith a. (1) Individual Capacity: s may claim opportunities were presented to them as individuals and not through role in corp. b. (2) Corp. Unable to Take Advantage: if disclosed to corp. first, and cannot use, then officer and director may use. Need heavy justification to show no finances. c. (3) Corp. refuses: May take advantage of 6. Remedies: (1) Damages or (2) constructive trust 7. Competition with Corporation: May not use assets, property, materials, secrets to form competition BUT 88

a. A fiduciary may leave corporation and form a business in competition occasionally the conduct of the fiduciary while still with the corp. prior to leaving may be examined

Broz v. Cellular Info Systems: Financially Unable

1. Facts: hears of chance to buy company; wants to sell and tells in personal capacity because Corp. was not seen as viable to purchase. 2. Issue: did usurp corporate opportunity? 3. Held: No, they were financially incapable of exploiting the chance to buy the land and was; not clear that had a cognizable interest or expectancy in the license because their business plan didn t involve any new acquisitions. a. Emphasis that did not formally present the matter to the board of directors but these are not required under circumstances where there is no interest, expectancy or financial ability to pursue the opportunity b. Came to Broz in capacity as individual not CIS director and CIS had no expectancy or financial capacity c. Same line of business; CIS CEO says that expectancy not there failure to act on informal disclosure would be impeaching evidence

In re EBAY: Delaware
1. Facts: 1995 O and S found Ebay as sole proprietorship and in 1998 retained underwriters for IPO, GS was lead and GS recommends to rewarded clients including directors of Ebay by allocating 1000s of IPO shares at IPO price for HUGE profits. 2. Issue: Were allocations a corporate opportunity? 3. Held: Yes. Ebay was financially able to exploit the opportunity; was in the business of investing in securities and had been their cash management strategy a. Unique, Below Market Price: offered as a direct reward for their dealings with Goldman b. Agent is under a duty to account for profits obtained personally in connection with transactions related to the company; reasonable to infer that s accepted a commission or gratuity from GS that rightfully belonged to eBay

Controlling or Dominant Shareholder Transactions

1. Situations: (1) Parent-Subsidiary and (2) Dominant individual SH founder, raider 2. Can SH favor interested while running firm: Yes, but must be done within NARROW bounds a. Cannot be unfair to the minority b. Cannot be due to bribe 3. Example: if a dominant SH deals with the corp. (contract) the deal will be closely scrutinized to see that minority SHs are treaty fairly a. Corp. loans a majority SH money scrutinize b. Deals where majority had effect to make deal check to see good faith and NOT to the specific detriment of minority SHs


Sinclair Oil v. Levien: The Standard

1. Facts: owns 97% of subsidiary stock in Sinven, involved in SA Oil; appoints all board and officers and drains dividends from Sin to meet cash needs. All met limits by state law but exceeded current earnings. charged for inability to grow. 2. Issues: (1) Fails to sue on breach; (2) paid excessive dividends and(3) didn t buy fields purchased by other subsidiaries 3. Tests: Fairness to failure to sue, BJR for 2 and 3. Distinguish SELF-DEALING and failure to sue from others even though - All decisions favored controlling parent. a. Fairness applies to majority SH issue with self-dealing to show that the deal with the sub was objectively fair; failure to sue on contract from payment of healthy dividends and from allocations of business opportunities b. With dividend there was no self-dealing since parent didn t get something from the sub to the exclusion or detriment of the minority they shared pro rata in the dividend distributions c. Expansion issue didn t usurp opportunities that would normally have gone to the sub

Zahn v. Transamerica: Liquidation

1. Facts: owned class A stock two other classes B and preferred liquidation and preferred gets sset and then A gets $2:1 ratio to B class. bought both A and B then converted A into B and owned almost all of the B stock (A was controvertible). Book value of $6M and worth $20M FMV. Unknown to SHs and called A shares then liquidated assets and paid itself remained. claimed that had he been included in liquidation would have got $240 and not $80. 2. Issue: Can MSH use control over board to gain at the expense of the minority SH in a deal where each step is performed in accordance with state law? 3. Held: Majority SH has a fiduciary duty to the corp. and minority the same as directors and actions must meet good faith and fairness tests. a. Disinterested directors could have called the class A stock but here the directors were controlled by the MSH b. Directors owe fiduciary duty for the best interests of ALL of the SHs and only acted in interests of MSH.

Mutual Funds
1. Legal Structure of Mutual Funds: trustees fund is a statutory trust, not common law created in the equity court 2. Trustees: elected by the owners no default rule by elections, they can actually appoint themselves (like in NPOs) o Investors Give Cash: want return on investment o How to get cash + return: trustee hires an advisor who tells trustee what to do with the cash and sends returns back o Sponsors are also advisors and trustees hire them to give them advice they get money from fees by advisor groups (Fidelity and Vanguard) 90

3. Index Funds: mimic the movements of the major industries tell us where the markets are and we decide where they are going 4. Closed-end funds v. open-end funds no redemption value

Jones v. Harris: Advisor Fees for Mutual Funds

1. Advisor Fees In Mutual Fees: especially not in index funds the fees can get crazy big and ridiculous; consumer advocates say investors get cheated by the fees 2. Investment Company Act of 1940: one of five acts passed to regulate securities after the Great Depression (fees regulated in companies act) a. Hedge Funds: not under the act because the number of investors is small less than 30 and go to very rich guys in small groups and are not considered investment companies b. Mutual Funds: public investment funds c. Structural Protections: 40% of trustees must be independent of the sponsors, that group must be only group acting on setting fees 3. Advisors Regulated qualified, licensed, conflict free 4. Supreme Court rules against Trustees by vacating and remanding a. Vacating is odd because District Court at first did exactly what should have been and could have reinstituted that original opinion without remand 5. Gartenberg Standard: balancing test and just shill for judicial discretion a. Look to process and amount if process progress b. Less rigorous look at amount and vice versa 6. Circuit Court SHOULD have considered but threw out one of the KEY factors the factor that the advisor and sponsor were affiliated with other funds and charged different fees for those other funds they worked together with a. Other fees were much lower than the ones they charged the s who brought suit b. Evidence of fees in and out brings suit 7. Easterbrook-Posner argument based on bargaining power, if they didn t like them they could have gone to another fund because they have to disclose all the fees to the investors and they are not hidden a. Easterbrook they can leave, can drive down themselves since there is full disclosure shouldn t be allowed to sue b. Posner I used to be market-guy, market now sucks because investors are not protected; shocking to law-economics community; market is imperfect and these investors must be protected from these affiliated and non-affiliated fees 8. Supreme Court consider all factors, don t go down to the nitty gritty of Easterbrook dispute, dispute from Posner-Easterbrook is one for Congress to decide a. Punted on central issue to declare an imperfect or perfect market b. Protection in the market is up to Congress c. Preserve small procedural area for judicial review still look at a bit but defer to trustees, almost like BJR (gross negligence standard?); maybe put BJR in but didn t decide case officially


1. Statutory Definition: 33 Act 2(1); 34 Act 3(10) Ohio 1707.01 (title interests) 2. 1993 Act: Defines security very broadly as most passive instruments; if you sell the security to the public, must go through a full registration process at a federal level involving the SEC a. If didn t sell them to public find exemption to federal registration system and had procedural and merit based exemption issues b. Criminal and civil penalties criminal if sell a security which is not registered properly, you can go to jail (if selling big security, not small listen for broadness and schemes to get around it) 3. Once in broad net: (1) Register or (2) find exemption 4. Look to state laws on top of federal laws 5. Technical side of the side deal securities

Securities: Defined
1. 1933 and 1934 Acts: do not agree; a technical difference 2. Ohio title interest only state that adds to federal definition, and doesn t just take it in whole; title interests, which is real estate titles are added (split up real estate title among small amount of people may have a security) a. In Rem Property Interest: generally, outside of OH, is never a security 3. Specific Instruments: stock, notes, bonds 4. Catchalls: Evidence of indebtedness, investment contracts and any instrument commonly known as a security a. Trying to catch: passive investors (want people s manage, who are not going to manage the company who get investment back and return) b. Partnerships active investors not securities c. Surprises: worm farming, condos, strips of orange grove, oil drilling rights, pyramid sales schemes and scams

Sources of Corporate Capital

1. Retained earnings how much capital of obtained in growth a. By far the biggest way to capitalize a company b. Tax incentives to retain earnings double tax phenomenon very strong tax incentive to grow by retained earnings 2. Borrow Money: cash for promises to repay plus interest a. Bonds real estate, secured, earnings b. Debentures unsecured, middle length c. Notes unsecured, shortest term (security itself is only helpful if there is a default you don t want it, you d rather the IOU) d. Lines of credit and commercial paper house and business; 92

e. Commercial paper is alternative to line of credit but cheaper (legal notion execute a document and the document itself has value document itself is transferrable and has real value like a check) i. Rules for the endorsement; fraud, etc.; legal rules that stand behind problems with enforceable commercial paper 3. Stocks and Bonds Transferrability: 8 a. Difference with check bearer paper (check) but stock and bond has books and registration with endorsements (corp. is a player); issue bearer bonds then not a player b. Problems with Bearer Bonds/Stocks (illegal in US): money laundering since equivalent of cash 4. Commercial Paper Special IOU issued by a blue-chip, highly rated companies (highly secure) a. To issue must be qualified; AAA, very secure never been a default except for 1 (Penn Central) b. Reason so secure very short term (60-90 days must roll, pay original issuer and then get another), very secure companies issue them c. Roll: every 60 days interest rates i.e. treasury is higher, then buy a lot, then goes down, worth much less; treasury notes very secure, no money made, no interest shock d. Just as good as cash very liquid, very secure, little shock, sell for a lot; issuers of commercial paper can use it as cash e. Money market fund: no risk for individual only invests in commercial paper; no risk at all and make very little compensate for inflation and interest rates (BUY INDEX FUNDS diversified) f. Combine Money Market Fund/Mutual Funds with Index Funds invest cheaply, go for growth more in index fund and go for retirement more in index funds 5. 2008 Stock Market Crash: Lehman Brothers declared bankruptcy and had issued commercial paper a. Only One Money Market Fund Says: may have to bust the buck and lose money as money market fund shocking b. Busting The Buck: created the calamity because money markets were supposed to be so secure and this wouldn t happen c. Suggestion prop up money market funds; government does exactly the opposite with bailouts and stimulus

Hybrid of Capitals
1. Convertible option to change so if stock goes way up in value you don t just sit there with none of gains 2. Convertible preferred can convert to common a. Both for high tech companies 3. Stock options (warrants) put and call options are 3rd party bets (original derivative); company can get in the business as writer warrants with one exception if writing for CEO they are compensatory options (bonus plans) 93

4. Redeemable bonds/stock options to repurchase

Debt Covenants
1. When issue debt and IOUs to protect repayment there are many options 2. Self-help: collateral 3. Financial/Operational Commitments: limits on dividends, senior debt, veto on decisions a. Can be in indenture that is not even in the IOU itself 4. Repayment terms: periodic payments 5. Guarantees: secondary liability (homes, cars, etc.) 6. Default Conditions: broad definition, acceleration of repayment obligation a. Don t make an interest payment clearly default b. Many others: business goals, default on someone else s interest payment (then default on mine too) c. When default get principle back right now, this moment; acceleration clauses hit insolvency immediately d. When default any one of debtors can put you in bankruptcy but they don t they want to work out of a deal; bargain over Chapter 11 because no one wants it

1. Problem of dilution control: effect on existing shareholders a. Dilute percentage of ownership after you ve paid the money and you understand that is the price b. How do you protect against dilution: pre-emptive rights (whenever they issue new shares you get a piece of new shares equal to the percentage Issued of what you hold); Can put in contract rules that prohibit watered stock, stock issued for less than FMV 2. Private/Public a. Private: private offerings venture capital, etc. i. Hardly any regulations ii. Hedge funds b. Public: public offerings i. Meet 12 of Securities Act - > 300 OR IPO > belong to major market ii. Heaviest hit by regulations on securities iii. Mutual Funds

Importance of Defining Securities

1. Registration requirements: the definition indicates whether the registration requirement of the Sec. Acts apply to the transaction 2. s: generally have easier time bringing suit under federal securities laws than under state common law fraud rules because elements of federal securities are easier to prove 3. 1933 Application: offer or sale of a property interest must constitute the offer or sale of a security to apply 94

4. Three Categories: a. (1) Any interest of instrument commonly known as security: stocks, bonds debentures, warrants, etc. b. (2) Types mentioned specifically in the Act: preorganization subscriptions and fractional interests of oil, gas or minerals c. (3) Investment contracts and certificates of participation: broad and catchall (Howey Test)

Four Part Howey Test

1. Critical Test: everywhere except in OH (where we have our own test from HI) 2. Facts: orange grove, didn t want to sell securities, so sold strips of the grove and could buy the strips; problem oranges on those trees were not yours, the profits came from selling juice to the public; had option to get into the processing deal, which would take slice of the profits based on % of strips of land owned 3. Held: this is a security you don t have a % of ownership in property, you have a security 4. Ask: An investment contract is any K or scheme whereby a person invests his money in a common enterprise and expects to make a profit solely on the efforts of the promoter or a third party responsible for management. a. (1) is it a profit-making venture? b. (2) is the investor passive in management? 5. Howey Test: a. (1) Investment of value to get money back b. (2) In a common enterprise selling orange juice together, pooling requirement c. (3) With an expectative of profits - return d. (4) Solely (not largely) from the efforts of others picking, selling, marketing and profiting from the efforts of the farm 6. Glynn: is he a passive or active investor? a. Application (1) Member-managed or manager-managed? b. Member: Presumption to Member is not a security; c. Manager: Presumption to Manager it is a security and must overcome on the facts d. Glynn: overcomes presumption even though it was manager-managed; it was not a security 7. Trend Towards Expansion in Decisions: Expansion of the word security now covers situations where investors do participate in management and the form of benefit derived by the investor may be something other than cash profits a. Mentioned: (1) Is the property interest one that is specifically mentioned in the Act? b. Commonly Thought: (2) Is the type of interest commonly thought to be a security? c. Profit-Making: (3) Is it an investment contract or a participation in a profit-making venture? Benefit of substance to investor? Third party management? d. Need: (4) Is there a need for the protection of the Act? Is there an investment so that investors need the protection of full disclosure? 95

8. Examples Held as Securities: a. Interests in Land b. Pyramid sales plans

Bypass the Howey Test

1. Initially required: purchasers must perform some minor management duties like filing reports but investors don t assume the major duties normally required of a person buying a franchise 2. BUT Substantial Control: even these plans have been held to involve securities and now the test no longer requires total management passivity but only substantial control 3. Not Only Cash Benefit: may be any economic benefit as property interest

1. Registration: prior to IPO must file. 2. Purpose: to disclose all info possible to decide if sound investment 3. Prospectus: most important info is in shorter document given to a purchaser prior to buying or at some time delivered 4. Material Required: a. SEC exercises broad discretion over what is put in the statement b. Financial info about issuer is a very big part and must be disclosed

Private Placement Exemption to Registration

1. 1933 Act Allows: certain exemptions from registration in 5 (e.g. issues by banks or guaranteed by the US); certain deals are also exempt (e.g. deals without an IPO private offerings are exempted from registration under 4(2) 2. Private offerings under 4(2) 3. Fact Question: to decide if private or public offering a. (1) need for protection; b. (2) Access to investment info sophistication of offerees i. for private must show that offerees were given or had access to the same kind of info that would have been contained in a registration statement ii. Must be allied with or have CLOSE RELATIONSHIP with issuer and management c. (3) Distribution of Material info: implied that the mere access to material info is not enough may have to actually distribute to the offerees the same type of material in registration and may even have to give additional info if requested by private firm d. (4) Number of offerees: fewer in number generally not major factor but RULE OF THUMB is > 25 = IPO but now it is more like > People = > Chance of Public; e. (5) Dollar amount of offering f. (6) Marketability of securities smaller denominations greater public g. (7) Diverse group rule more unrelated to each other, the more chance of public h. (8) Manner of offering manner in which the offering is made (advertising?) 4. New Regulations: (1) Integration; (2) Info Requirements; (3) Manner; (4) Resale limits 96

Doran v. Petro Management: Public or Private?

1. Facts: PMC was LP with oil; Advised by securities broker of chance to become special participant in drilling and puts in put in $25K of $125K rest down under note by MCS and sends info periodically; overproduced in violation of allowances. Seal property. Defaults and loses money. 2. Issue: Private or public? 3. Held: No registration was filed in connection with the offering. Look to factors. Size was only 8. BUT relationship between issuer and offerees a. Information available to the offerees by virtue of special relationship clearly establishes that and were both sophisticated but had special knowledge it did not disclose to b. If the investors do not possess the info required for a registration, they cannot bring their sophisticated knowledge into play to determine if to invest c. Availably of info means either disclosure or access to the relevant info relationship may be most important

The Successful High-Tech Start-Up

1. Resales are NOT Exempt except for 504s and need second exemption to resell Rule 144 (trickle out) 2. Birth: founders, 100% equity personal savings, credit cards (but new bankruptcy laws) 3. Private Placements of Equity (1933 Act Exempt) a. Seed Money: friends, family and angels (founder 70%, equity worth $300,000, firm value $500,000) b. Venture Capital: 3 to 5 rounds of financing from VC funds (private equity markets) founder 40% equity worth $4M, firm value $10M (invest in 20 companies with hopes of 1 making it big means they must take a lot of equity in all of the companies, so when that one hits it will pay off the losses) 4. Goal: to get out of the equity market and into the debt market by establishing income stream 5. Go Public (IPO): sell 20% or more of the equity to public in a Register PO under 33 Act a. Don t go public unless worth more than $100M jackpot this market $500M b. Founder s problem: how to retain management control? Turn stock to cash? Trickle out.

Regulation D: Safe Harbors Exemption

1. Defined: Major initiative was to help small business grow with 501-506 and new definitions only apply to issue, the control persons may not use them 2. Purpose: to simply and clarify existing exemptions, expand availability of exemptions and uniformity between state and federal exemptions 3. Four Conditions to be Met: a. (1) Integration: All sales that take place at least 6 months before start of or six months after the end of the Reg. D offering as long as there are no offers and sales of same securities (aside from pensions) within either 6-month period


b. (2) Info Requirements: 505 or 506 then specific disclosure to ALL purchasers is required; Type of info depends on nature and size of offering. Must also give investors the chance to ask questions and get any info the issuer can get without unreasonable effort Only under 504 or sells under credited investor then Reg. D doesn t mandate specific disclosure. c. (3) Manner of Offering: Use of general ads or solicitation in connection with Reg. D is prohibited unless in certain 504 cases see 502(c) d. (4) Limitations on Resale: With exceptions of certain 504 offerings, have status of securities acquired in a transaction under 4(2) of the 1933 Act 502(c) issuers must use reasonable care to assure that buyers of these securities are not UWs and to make reasonable inquiry as to an investor s investment purpose; legend restricting transfer must be placed on the share certificates. 4. Form D: Uniform notice of sales form for use in 4(6) and Reg. D offerings give info on Form D with checklist within 15 days after first sale in Reg. D; then every 6 months after first sale and 30 days after last sale.

Exemptions on Lower Priced Sales

1. Rule 504 Sales Less than $1M: Section 3(b) of 1933 allows sales > $1M during any 12-month period (SA 504); not available to investment companies or to 1934 Act reporting companies commissions or similar remuneration MAY be paid to those selling the offering in a rule 504 offering a. Rule 504: Does not mandate specific disclosure BUT issuer is subject to antifraud and civil liability provisions of the fed. Sec. laws and MUST comply with any applicable STATE requirements b. If whole offering is in states with registration requirement: and the offering is in compliance then the general rule of 502(c) (manner) and (d) (restrictions) do not apply 2. Rule 505 Sales Less than $5M: Under 3(b) of 1933 Act allows any number of ACCREDITED investors and to no more than 34 NONACCREDITED investors for sale of $5M or less available to any issuer that is not an investment company

Venture Capital
1. Goal: get income flow to begin selling debt; must have some type of equity to begin selling debt and stop selling equity then final goal to sell equity into the public market 98

2. Controversial: the 20% that comes out to manager that s where the traders make the money 3. Convertible Preferred Stock: takes first cut and then residual cut from the equity pool convertible into common and also loads; unusual preferred stock usually preferred stock is not convertible, just get first cut 4. Downside Protection: voting rights, veto rights, dilution protection if sell equity to someone else, redeemable in 5 years (get out or death knell so can kill the company if don t work with them) 5. Upside Protection: Liquidation rights, registration force a portfolio company to go public if they don t want to sometimes (manager taking 20% - taxed as capital gains now; Obama tax will tax normal at 39%) a. Government would be taking cash away from the managers at the margin, make VC funding more expensive and less prevalent 6. Venture Capital in Ohio: state government in Columbus because most VC are on both coasts created VC through citizen s vote Third Frontier (add to it) 7. Alternative Investment Pools: VC, Hedge funds, etc. a. Hedge fund: only difference is duration; hedge fund wants to make money in 2-5 years, while VCs want to make money in 60 days

Private Placement Exemption

1. Graph above 2 private placements: (1) Investors investing in VC fund and (2) VC fund investing in the company 2. PP Exemption: Don t have to go through the full exemption process with the SEC, wait, etc. (very important for small business) 3. Statutory 4(2) Exemption: Ralston Purina Test 4. Reg. D: Rules 504, 505 and 506 safe harbors a. 504 - > $1M b. 505 - > S5M (35 + accredited investors), no ads c. 506: 35 sophisticated plus accredited investors, no ads 5. Disadvantage: resales are not exempt (but some 504s) need a 2nd exemption to resell rule 144 (trickle out rule) a. If Private Placement: everyone who invests and gives money, the investment contract cannot be sold unless the reseller itself has another private exemption (such as Rule 144 but only trickle it out as constrained by the rule) b. Hardest on the founders because equity they got is subject to this rule and until they do the IPO there is no market and if resell it have to take note to have another exemption 6. General Practice: Combine 4(2) and Reg. D a. Private offering memo: record recipients of memo; prefer accredited investors b. Investor meeting: info with scripting meeting; sign statements by investors c. Legends on stock certificates


Public Offerings
1. What percentage of the profits should the managers take? Shareholders v. Managers? Profit percentage issues o Historically: SH gets 75%, Manager gets 25% or so. 2. How you do a public offering? o SEC Registration Process (Sec. Act of 1933)  SEC Filings like Form S-1  Strict Offering and Sale Procedures o Role of underwriters (investment banks): participate in public offerings, buys a lot of stock from issuer and then resells the stock to the public  Buy stocks and buy bonds and sell to the public make money on a spread (dealers spread it their compensation; take risk of not being able to sell the offering) o Primary/secondary trading markets

1. Type of offering: (1) Firm commitment (like above), normal OR (2) best efforts (shakier broker: commission underwriter negotiates offering price with the issuer at price they want to sell to the public at) 2. Underwriter would be nervous of stock price UW hires many lawyers to do due diligence (gatekeeper rule) o Do not like Piggyback sales o Use contractual lockups stop insider sales for 90 days after IPO

Public Offering: 33 Act Registration

1. If don t satisfy the private placement rules you are in this system public offering 2. Firm sells a bunch of shares to underwriter (investment bank Goldman Sachs) underwriter resells the shares to the public; founder wants to get into it, he can kick shares into the underwriter offering (piggyback offering), if found doesn t do it have to find another exemption; o Primary and secondary offering secondary is hated, have to convince money not going to the firm is still OK; o Primary is underwriter to public, secondary from founder to the UW to the public as piggyback

Public Offering Process

1. No sales or offers after decision to go public pre-filing period there are no offers or sales if so, it is a felony o Negotiate with UW and prep filings 100

2. File registration statement with SEC: waiting period of limited offers and no sales felony if do it o Go on the road (road shows) 3. SEC: effective distribution period (offers and sales with delivery of prospectus) o Declaration declared to be effective o Everyone who buy stock during primary distribution period must have this prospectus o When distribution period is over start the secondary trading on the NYSE, etc. 4. Key to process: protect the exclusivity of the prospectus during and until the distribution period cannot buy and sell without a prospectus 5. Goals to Regulation: o All buyers in distribution receive prospectus on sale or confirmation of sale o Distribution over: secondary market trading like NYSE without prospectus delivery requirement 6. Liability of Participants Offering Firm, UWs and Individuals o Defective Public Offers 12, 33 Act no registration, not exempt (invalid private placement) and defective offering process C/L \ 10(b) \ 11 \ 12(a)(1) \ 12(a)(2) o Fraud (material misrepresentatio Mi sstat. or yes yes no yes yes O m issi on ns or omissions): 11, 12 and 17 of M ateri ality yes yes no yes yes 33 Act and Rule strict 10b-5 of the 34 State o f strict scienter scienter (negligence) M ind liability liability Act

Section 12(a)(2) Misstatements

Securities: Liability

Reli ance

yes yes

transaction causation loss causation

tracing requirement (loss causation)


no (loss causation)

C ausati on


choi pritchard securities regulation &


1. Common Law: a offering Dam ages unlimited unlimited rescission rescission p rice defrauded purchaser had to prove same thing to recover for any other good; now can recover for material misstatements and omissions in an effective prospectus unless the s can show they had reasonable grounds to believe and actually did believe that the statements were accurate 2. Materiality: must prove that it was actually material fact 3. Persons Subject to Liability: 11 says that a. (1) anyone who signs the registration statement (including people who MUST issuer, CEOs, CFO, accounting officer and majority of board of issuer); b. (2) Director of the issuer; c. (3) Named with his consent as about to become director;

d. (4) Any expert who gives certification that part of the registration statement was prepped by him (accountants, etc.); e. (5) Every UW involved f. (6) Controlled persons people who control any other person listed above SA 15 4. Key Practical Issue: Law firm should be very interested in what partners are doing because the law firm itself and board of directors may be liable for it; can get malpractice insurance but there are often rider for securities to not insure you for it a. Why don t insure it? Can t assess the premium, cannot assess the liability so often exclude environmental and securities liability because cannot predict what judges will do

Private Securities Litigation Reform Act

1. 1994 Contract of America Legislation put in to reign in Clinton 2. Key: to try to reign in strike suits 3. How: if you are on the private side and bring 10(b)5 lawsuit, you must plead scienter (particularity) with particularity, must show in the pleadings why there was scienter so that means that you can throw a lot of these out for Rule 12(b)(6) 4. Key Provisions apply to Section 11 but not Rule 10(b)5 on slide

Elements in Section 11 Action

1. Privity of Contract not Required: Anyone buying a security that was subject of a defective registration may sue under 11 but there is a tracing requirement so that the must be able to trace the securities bought back to the defective registration statement 2. Reliance: need not prove relied on misstatement or omission in order to recover BUT if the issuer sends out an earnings statement covering period of 1 year after the effective date of the registration statement then a person buying it after that must prove reliance to recover

Section 11: Defenses

1. Issue Defenses: a. (1) Show were true b. (2) Show immateriality c. (3) Show knew of them and bought the securities anyway 2. Distinctions: Non-issuers can get due diligence excuse but issuers cannot

Non-experts in Section 11
1. Standard of Diligence: Must meet test and (1) actually believe statements were true and that belief must be reasonable


a. With reasonable investigation; look at each based on position, skill, background, responsibilities, training and access to info to determine if a reasonable investigation was made b. Goes Beyond just trusting: and respecting the responses and opinions of the issuer s officers as to material facts c. Includes: original written records, verifying facts and statements in the statement and would probably examine facility, ops, material contracts, minutes and other documents and items material to financial status 3. Portions of Registration: Attorneys a. Nonexperts For attorney-director of issuer who drafted registration statement for the issuer to be nonexpert as to registration statement b. Expert: May be conceivable that attorney may be requested to examine, certify, as an expert, some portion of the registration statement in that case, he would be held to due diligence test of expert c. Inside Directors and Principal Executive Officers: Must meet standard of due diligence required by nonexperts 4. Reviewing Statements of Experts: lower standard of care and non-experts are entitled to rely to a greater extent on the ste statemens made by experts (outsider director relying on accountant s financial statements, e.g.) a. Nonexpert MUST: (1) did not think they were untrue and had no reasonable ground to think they were false no need for investigation b. (2) s usually meet burden: BarChris

General Civil Liability under the Act 12

1. Fraud: Prohibits fraud generally if sale or offer and anyone who offers or sells a security by the use of any means of interstate commerce and makes an untrue statement of material fact or omissions in connection with and who cannot sustain the burden of proof that he didn t know and in the exercise of reasonable care could not have known of such untruth is liable to the buyer. 2. Privity Requirement: Must be arms length may only sue the seller from whom she purchased the security 3. Persons Liable: Only people offering or selling security can be liable a. Issuers, dealers and maybe control people can be liable but others in registration process like directors, accountants would not be)


4. Liability Standard: is held for intentional of negligent violations has burden to prove nonnegligence a. (1) Privity with b. (2) has violated one of the privisions of Section 5 and she can recover c. (3) No need for reliance, causation and scienter 5. Damages: Consideration paid with interest MINUS the amount of any income received on the securities OR for damages if the purchaser no longer owns the security

Experts and Section 11

1. Statement Test: a. (1) Must ACTUALLY believe that they were true b. (2) Belief must be reasonable c. (3) Reasonable belief comes from investigations perform at least standards of his professor (accountants in certifiying that financial statements of the issuer are prepared according to generally accepted principles of accounting, e.g.)

Rule 10b-b Fraud

1. Rule: Unlawful in connection with the purchase or sale of any security for any person, directly or indirectly by the use of any means to: a. (1) employ any scheme or device to defraud b. (2) make any untrue statement of material fact OR to omit a material fact necessary in order to make the statements made (circumstantially) not misleading c. (3) engage in any act, practice, or course of business conduct which operates or would operate as fraud or deceit upon any person 2. Transactions Covered: a. (1) Purchases and Sales can be either buy or sell b. (2) Remedies: security must be involved c. (3) Securities: a security must be involved in some way broad application d. (4) Jurisdiction: interstate commerce must be involved or MEANS e. (5) Statute of limitations: not applicable f. (6) Liable parties: broad to application ANY person CONNECTED WITH a securities transaction so accountants and lawyers and others involved in some way with a securities deal may be liable

Elements of 10b-5 Fraud

1. (1) Fraud, Deception, Misrepresentation, etc.: Must be fraudulent act that has ACTUALLY occurred a. Insider Concept: Two elements to an insider (1) must have a relationship that grants them access to info intended to only be for a business purpose and not for personal benefit of anyone and (2) must be inherently unfair where party takes advantage of such information knowing it is unavailable to those he is dealing with 2. (2) Materiality: Material fact 104


4. 5.


a. Reasonable person standard: whether a reasonable person would attach importance to the misrepresented fact in determining his choice of action in the deal in question b. Probability balanced against magnitude: high probability likely will occur or high magnitude of occurrence will be clearly material c. Totality of Facts: under whatever test use all facts to see if info might reasonably influence conduct d. Examples: intention of a company management to pay a dividend or a significant drop in the profit level of the company (3) Reliance: relied on fact to make decision; actual with effect on market; act different if know facts; Trend towards abolishment may allege that s statements a. Two Cases: (1) Actually relied OR (2) Effect on market affects the market price at which the sold his stock; would need not argue reliance (4) Causation: s action must have caused the s injury. E.g. misrepresentation caused the drop in the price of the stock; necessity is also trending to disappear (5) Scienter: A material misstatement or material omission of a fact necessary to make revealed facts not misleading runs afoul of 10b-5 if defendant intended to defraud, knew he was defrauding, or was reckless with regard to the possibility that he could be defrauding a. Mental state embracing the intent to deceive, manipulate or defraud BUT b. Other courts have held recklessness to apply c. Supreme Court must be shown in injunctive actions brought by the SEC d. Private damage and SEC injunctions reckless couduct may also qualify under 10b-5 e. IF SEC is there is no Scienter Remedies: a. (1) Rescission: take deal back and restart in place came from b. (2) Damages provide restitution e.g. restore what lost (reasonable period of time?) c. (3) Unlimited Liability unsettled if can be held for unlimited amount d. (4) Punitive none


Escott v. Barchris Construction

1. Garden variety financial fraud like Enron in small case 2. Facts: Barchris sells bowling alleys to athletes, then take back a note under Art. 9 if real estate note, it s a mortgage (goods v. real estate); then Barchris has cash problems and sells the IOUs from the bowling alleys to Talcott (factor) and he gave back cash 3. Misrepresentations: a. (1) Amount of sales backlog b. (2) Contingent liability to Factor guarantee to repay c. (3) Loans repaid d. (4) Use of proceeds lied about what they would use for bailing out bowling alleys they d already sold stuff too 4. Problem: bowling alleys start to default on the loans then Barchris needs money from debenture investors to pay of the notes a. Defaults owe to people then take over and register sales to self (which you cannot do) so revenue statement looked acceptable 5. Fraud: selling debentures to the public and were making a public offering of debentures (fairly unsecured debt instruments on short-term) 6. Young Lawyer: hit by red flag test and lost reasonable investigation test even though he was a non-expert in a non-expertise situation; two key problems: a. (1) two contracts should have been read the factor contract more closely at the guarantee that if money was lost had to pay guarantee (cannot pay off guarantees because he does not take the full risk definition of ownership off-balancing financing) hiding debt with independent guarantees to factors b. (2) Sales same types of guarantees to sell a bunch of stuff; have trouble paying, we will pick up payments and buy the bowling alleys from them off-balance sheet financing their our sales

Securities and Fraud

1. Factor someone you sell obligations to 2. Channel stuffing inventory channeled down to buyers you control and setup to look like sales to outside buyers on balance sheet even though they aren t getting money back from it o Dealing with self and lying about it OR dealing with 3rd party and lying about risk

Fraud in the Markets

1. Common Law (State Law): Shareholder to Shareholder traditional fraud o Reason why works complexity and misunderstanding; superseded by federal now 106

2. Federal Securities Flaw Special Rules for: o Publicly-traded firms (mandatory disclosure): must disclose lots of things publicly-traded if gone through IPO, traded through national exchange, or of a certain size (> 500 Shareholders and worth more than $$10M, employees, etc.) o Insiders as traders:  firm itself IP; buy-backs, self-tender offers, etc.;  individual insiders (controlling SH or officer/director face-to-face and open market transactions) 3. Number One Indicator of Fraud: who accountants are o Red flagged if not involved with a big four accounting firm o Try to get one? Big enough? Rejected? Or chose not to?

Disclosure and Fairness: Securities Acts

1. 1933 Securities Act: Primarily regulates raising capital rather than trading in securities and creates a scheme of mandatory disclosure for IPOs by issuers, UWs and dealers in the primary market a. Registration Statement: Prospectus bar any effort to sell before filed to SEC and makes it effective; only written materials an offeror may use are registration and prospectus b. Strictly Liable: Issuing corps. Are strictly liable for their misrepresentations or omissions in their registration statements and subject others unless can show DUE DILIGENCE 2. 1934 Securities Exchange Act: Regulates securities trading among investors in the secondary markets and creates mandatory continuous disclosure for corps that: a. (1) list on national exchange b. (2) own at least $5M in assets and have at least 500 SHs of any class OR c. (3) file a 1933 Act registration statement that becomes effective d. Must file: annual, quarterly and event-prompted reports that investors may obtain

Blue Sky Laws

1. Simultaneous Application: State laws and securities statutes that may subject brokers, dealers and investment advisors to licensing regulations; 2. Fraud: Most prohibit fraud and most require securities registration with a state agency 3. Some also allow state to bar sales on substantive grounds 4. NSMIA of 1996: exempts all covered securities from state registration and other blue sky requirements 5. Covered Securities: those trade on any SEC approved exchanged SLUSA of 1998 preempted class actions and other consolidated or multiple party actions like them brought under state law for securities fraud

Duty of Company to Inform Market: Mandatory Disclosure Rules

1. Some state disclosure rules applied to companies sometimes in Ohio 107

o Duty to inform at annual meeting? Ohio .38 is very broad o None unless SH vote needed (Malone) o State Blue Sky Law exemptions 2. Federal Law: Very heavy Mandatory Disclosure Rules Publicly-traded, wherever Incorporated; o Periodic filings of financials: quarterly earnings reports audited forms of 10-K (cannot lie) o Episodic filings Events: 8-K (mergers, lose accounting forms); S-1 (IPO Filing); and 14d-1 (tender offer) 3. Voluntary Disclosures (CEO Statements): Duty to be accurate

Policy Debate
1. Mandatory Disclosure o Cons: (1) firms would disclosure voluntarily anyway and that stuff would be more tailored to what market really wants and then (2) enforce anti-fraud rules we have  Incentive to disclosure negative information? Accurate for fraud rules? o Pros: More info 2. Contours of Private Actions for Disclosure Violations o Con: Strike suits legal extortion o Pro: Private attorney-generals can supplement government where no time

Basis Elements of Fraud: Rule 10b-5

1. Misstatements or omissions of a: o (1) Material fact with (TSC Industries, Basic) o (2) Scienter (Intent to Deceive Hochfelder) plead with specificity now o (3) In connection with the purchase or sale of securities (Blue Chip Stamps) includes stock options like Deutchman (must be buyer or seller cut out people who would have bought or would have sold); does it Rule 0b-5 include derivatives and swaps? Big new question SEC says YES now. A swap is a  Face-to-Face Fraud in Securities ransactions security completely neutral third party (brother buys sidlings stock in a family corporation) bet on anything (interest rates, life of CEO,  Fraud in the Primary rading Market: Fir m/Sh ar e ho ld er ra n sactio n s (P ri mar y Ma rke t Sa le s life of company, etc.) (P la ceme n ts o r istr ib utio n s); Se cur ity R ep ur cha se s o (4) Upon which relies but see ( e g otia te d; S el f- e nd er f fe rs)  Fraud in the Secondary rading Markets presumption of reliance in Basic if firm s Ma rke t Ma ni pu la tio n (i.e ., o sho rt, sta rt ba d ru mo rs, clo se securities publicly-traded) po siti on ; o lo ng , fa lse ly to ut, clo se po sitio n ) Insi de r ra di ng /Misa p pr op ria tion o (5) Reliance was proximate cause of injury (lost causation)

Types of Actions
1. Criminal DOJ 108

2. SEC can prosecute can be in Fed. Ct. or in Agency Actions 3. Private Actions by Investors implied under 10b-5 and express in 16 (34Act)

Elements of Rule 10b-5

1. When is failure to disclose actionable must be under a duty to speak: SEC Filings, mandatory duty to disclosure; voluntary statements, duty to be accurate; insider trading o (1)Materiality probability X magnitude test to determine if material o (2) Scienter Ernst and Ernst o (3) Reliance or Causation o (4) Standing 2. Rule 10b-5 Elements Change if SEC is o No scienter o No standing problems o Enhanced remedies

Puffery: vague statements of optimism by company officials are immaterial Bespeaks Caution: read in context Zero Price Change: price of security doesn t drop when truth revealed Trivial: only effect small % of total firm sales/revenues (exceptions for lies of the CEO presumed to effect and not be trivial) 5. Truth in the market: if market already knows truth, then new lie isn t material 1. 2. 3. 4.

Materiality Problems
1. Internal Forecasts: Do I have to tell everyone internal ideas of what business will be like? 2. Sensitive Business Info: like merger don t want to tell the world you are negotiating, what to do.

1. Ernst & Ernst: intention to deceive a. Only Private Actions b. Inference from Recklessness?? 2. Pleading: Private Securities Litigation Reform Act of 1995. State with particularity facts giving rise to a strong inference of scienter. a. Is pleading motive and opportunity enough?? 3. Possession (Trading while in possession of) Versus Use (Trading on the Basis of) See Rule 10b5-1 (possession test with exceptions) 109

1. Blue Chip Stamps: Plaintiff must have been a buyer or a seller. Those who, e.g., relied on false statements by not buyer or not selling (forgoing opportunities to trade) cannot sue. 2. Pledge a Sale?? 3. Apply to Requests for Injunctions??

1. Basic: Fraud-on-the-Market Theory for Liquid Stock a. Presumption of Reliance on the Integrity of the Market Price; Plaintiff Does Not Need to Know of Specific Fraudulent Statement b. Rebuttable: Plaintiff Knew Truth 2. West v Prudential Securities: a. Public Fraudulent Statements Will Affect Market Price for Some Period b. Non Public Statements?? Market Price Increase Alone Not Enough; Must Be Explained (Class Certification Reversed)

Stoneridge v. Scientific Atlanta

1. After Central Bank of Denver in 1993: A private plaintiff may not maintain an aiding and abetting suit under Section 10(b) of Securities Exchange Act. Court of Appeals reversed. 2. 2007 SC Kennedy opinion 5-3 (dissent Ginsburg) securities fraud claims not permitted against third parties that did not directly mislead investors but were business partners with those who did; limited primary violator definition, rejected scheme liability public did not know of vendors o Must have someone who makes the mistake 3. Limited Enron scandal lawsuits 4. Cable Co. overpaid cable box venders who then used extra cash to buy ads on cable TV outlets (cable revenue inflated $17M) o Overpaid vendors in return for ads on cable TV ad revenue was inflated since they were quid pro quo (self-dealing taking own cash and putting it in revenue stream) o Cable company was not the liars so they are not liable

Inside Information and Duty to Disclose

1. Insider Trading: typical problem is situation where someone related to the corp. like an officer is in a position to have inside info about how corp. is doing and thus what the stock is or will be worth. Insider then buys stock with an advantage and sells it. 2. Issue: What duty does the corporate insider owe to the other party selling to? 3. Common Law Majority Rule: Held that directors and officers owed no special duty to present or future SH and could deal with them at arm s length with no duty of disclosure of inside info required. a. Minority Rule: Held that directors of officers had a fiduciary duty to disclose facts to an outsider (Hotchkiss)


b. Example- Widow SH asks director before a board if company would pay dividend and he showed her financials and said didn t know; he then bought her stock for $1.25 and declared $1 per share dividend three days later director was liable 4. Special Circumstances Rule: Number of courts took position that a duty of disclosure is owed only if there are special facts or circumstances making nondisclosure unfair a. Example Strong v. Repide director and pres. And 75% SH use strawman to buy minority interest knowing that government would buy company property had duty of disclosure 5. State Law No Duty to Disclose unless special facts in Goodwin v. Agassiz

SEC v. Texas Gulf: Materiality and Probability

1. Facts: TGS conducted exploratory activities in eastern Canada. These operations resulted in the detection of a significant amount of commercially mineable ore. Rumors of the ore strike began circulating throughout Canada. TGS issued a press release denying having struck ore and stating that the rumors were only speculation. Between the time of the press release (April 12) and the dissemination of the TGS official announcement (April 16), two of the defendants purchased TGS stock as the mining industry journal article was published, statement to Ont. Min of Mines and US Finance Media released. . April 13 press release drilling inconclusive but stock goes to 30 because info was seeping out that they pulled some good stuff out a. April 16 Release to media they found largest copper mine in all of North America timeframe from 9:40-10:54 am. 2. Questions: a. Coates: left TGS Presser and buys shares at 10:20 liable? Yes, because market must have time to disseminate info which was done at 10:54 am when ran on ticket b. Call Options: if client buys call options who usually doesn t buy them at all, he is doing insider trading use them for leverage because for $1 in stock but if option on 10,000 shares is $1 because for each share I buy I can get leverage on stock price 3. Held: Basic test of materiality is whether a reasonable person would attach importance to the information in making decisions about the deal. a. Need not be conservative one in sense of facts solely by measuring effect knowledge would have upon prudent and conservative investors (may be risky) b. Test encompasses any fact that in reasonable and objective contemplation may affect the value of the securities

Insider Trading: Duty to Disclosure and Questions to Ask

1. What was the injury to the people who sold their shares: 2. Who are the insiders? directors, Sr. employees and in some cases (like man who pulled out sample of copper) can be an insider ONLY if there was a confidentiality agreement with employer and anyone these people tells 3. Information is material? Must be was discovery of hole material YES. 4. Trades? Purchased stock and calls on stock. 5. Latent Issue: is possession alone enough or must it motivate the trade possession is enough. 111

Critical Question in TX Gulf Sulphur

1. Assume that after find copper TGS had to buy land for mine what do they have to tell the farmer who owns the land? NOTHING, just cannot misrepresent, however: 2. Why is what TGS has to tell farmer different from what insiders must tell SHs when insiders purchase shares? He owns the land, could have found it himself. o Fruits of his labor not the farmers; but why not fraud by omission? o Essence of capitalist system: the incentive to discover something, do something for yourself so you can benefit for yourself o Law: no need to tell farmer but cannot tell farmer there is nothing on your land, don t worry; if farmer asks why are you buying borderline? o Difference between SHs and telling farmer? Fiduciary duty to you, if there is not a fiduciary duty (like farmer) then it is ok

Dirks v. SEC: Tippers and Tippees

1. Facts: was officer in firm to give investments to insurance company securities to investors info on EF due to fraud were grossly overstated and investigated many regulatory fail to act and EF says he is right. No one published the articles, etc. talked with clients about it and they sold shares. EF plummeted as fraud shows up and is investigated. 2. Issue: Is a tippee always under an obligation to disclose inside info before trading or to refrain from trading? 3. Held: No, tippees inherent the insider s duty to SHs to disclose material, nonpublic info before trading to not trade ONLY when the info has been IMPROPERLY disclosed to them by the insider. a. Cannot impose duty just because someone knows something b. Test: will the insider receive a direct or indirect personal benefit from the disclosure, if the insider doesn t stand to personally gain he has not breached his duty to the SH and there can be no derivative breach by the tippee

Insider Trading: Potential s

1. Insiders: Senior Executives, Directors, Controlling SHs 2. Quasi-Insiders: Temporary Insiders Professionals (UWs, Investment bankers), accountants, lawyers, consultants who get info with an obligation of confidentiality 3. Tippees of Insiders or Quasi-Insiders: or other tippees

Tipper/Tippee Liability (Dirks)

1. Why was Dirks not liable as a Tippee of Secrist (insider officer of equity funding)? o Dirks liability is derivative of Secrist s liability problem with tippor and tippee because he gave him information without any motivation for PERSONAL GAIN o In tippee and tippor relationship must know that Secrist is breaching (1) fiduciary duty AND (2) doing it for personal gain directly or indirectly with a (3) personal gain 2. Personal Benefit: o Secrist was just a whistleblower not doing it for personal gain doing it out of good faith and that was difference 112

Must usually be: Pecuniary gain, reputation benefit that will generate future earnings, gift to fried or relative 3. From 1934-1967 insider trading was illegal in US Japanese are forced to adopt but does so without tippor/tippee liability: not universally illegal except with US pressures countries to do it o

Aftermath of Chiarella/Dirks
1. Chiarella: Employee of printer handling corporate takeover bids who deduced target companies' identities and dealt in their stock without disclosing knowledge of impending takeovers, held not to have violated 10(b) of 1934 Securities Act (15 USCS 78j(b)) and SEC Rule 10b-5. 2. Misappropriation Theory: A person commits fraud in connection with a securities transaction and violates 10(b) and 10b-5, when he misappropriates confidential info for securities trading purposes, in breach of a duty owed to the source of the information. a. Liability: premised on trader s deception of those who entrusted him with access to confidential information not fiduciary duty; duty is owed not to other trader BUT to the source of the information b. Requirement: Deceptive conduct in connection with securities transactions MUST involve deceptive device (fake identity while secretly getting info from confidential source for personal gain) i. If had disclosed to source that he planned to trade on this nonpublic info, there would be no deceptive device and no violation 3. SEC Rule 143-4 Tender Offers: Prohibits fraud in connection with a tender offer given authority to prescribe means reasonably designed to prevent, such acts and practices as are fraud. a. Rule 10b-5 covers all misappropriation cases 4. No More Selective Disclosure: open to all market professionals 5. Secondary liability: catches professionals in aiding and abetting and conspiracy a. Answered in Central Bank of Denver (1994) no aiding and abetting in private civil actions 6. Strike Suits: Hurdles erected in PSLRA of 1995

Duty of trust or Confidence: Rule 10b5-2

1. Person Agrees Explicitly to Maintain Confidence 2. Recipient Knows or Reasonably Should Know that Confidence is Expected by Tipper 3. Info from spouse, parent, child or sibling, not confidential unless knows or reasonably should know of expectation of confidentiality


4. Questions from O Hagan: If Burglar Breaks into Dorsey, steals information and trades, breach of Rule 10b-5? a. Deception required; none from burglar; Would breach Rule 14e-3, however. 5. If O Hagan tells Dorsey he wants to trade and Dorsey does not object, breach of Rule 10b-5?? a. No, Breaches Rule 14e-3, however. [Odd language from the ACLU Justice.] 6. What s left for eavesdroppers? a. Shadow Traders: Can broker shadow trade on Warren Buffett s purchases? b. Assume he is a client: No. c. Assume broker is an eavesdropper: No. d. Assume a janitor, eavesdropper: Yes, if not explicit duty to remain confidential and information is given in trust.

Congr : Enfor A t A, A &


nt t t t )


In ider Tr ding S n ti n Act f 1 4 SEC can impo e treble damage fine , plu disgorgement (4x). Insider Trading And Securities Fraud Enf rcement Act f 1

ounty Hunter Pr visi ns (10%) Contemporaneous Trading, Private Plaintiff Class (also covers Rule 14e 3) 20A Controlling Person Liability ($1 M or treble damages)(brokerage firms) Lead Plaintiff Substitution (largest financial interest) Specific Pleading Requirements Settlement Notice & Damage Allocation

Private Securities Litigation Reform Act of 1

SEC Safe Harbor: Rule 10b5-1 Plans

1. On the Basis: Not trading on the basis of inside info IF a. Insider has adopted a written plan before becoming aware of information b. Written plan should specify mechanics for period deals c. No subsequent influence d. Good faith and not scheme to evade liability


Shareholder Derivative Suits and Indemnification

1. Derivative Suits: State statutes govern extent to which the corp. may properly indemnify its officers for expenses incurred in of suits for conduct in official capacity; apply to both derivative and direct exclusive basis for indemnification o Demand on SHs? o Right to jury trial? 2. Court approval of settlement (or voluntary dismissal): Ellison settlement in CA derivative litigation 3. Recovery of attorney s fees: Benefit to Corporation standard o Non-monetary awards consent decrees with injunctions against future violations and/or structural relief

1. Mandatory v. Options: Discretionary o Statutory: mostly discretionary with Indemnification and Insurance: the board but under some statutes Terms the corp. must indemnify the Ds and Os when he is successful on the  Indemni ication: Firm ays Jud ments and merits in of derivatives. ama es evied ainst embers o the o Ex Post DE: right is subject to a oard judicial finding that his conduct fairly  & Insurance: Firm ays remiums to and equitably merits such indemnity Insurance ompany; Insurance ompany o Ex Post (optional board of directors ays Jud ments and ama es evied ainst hires attorney and pays advances embers o the oard that is unsecured) 2. Mandatory: Successful defense 145(c) 3. Contractual Option ex ante becomes owed in ex post o optional ex ante firm will indemnify to the full extent allowed ex post; 145(f) BUT requires board to indemnify if able to o Good Faith: good faith finding required to extend

Ex Post Indemnification
1. Ex post good faith (DE); as long as the D or O wins on the merits, there is usually no problem; o DSCC 145(c) required indemnification expenses in connection with the of any action as to which the indemnification is successful on the merits or otherwise o When loses: varying statutes when lose distinguish 3rd party suits and derivative suits o Amounts paid DGCL 145(a) and (b); o Advances in (e) unsecured promised to repay reasonableness requirement 2. Procedure: Decision By o independent board (not been sued); 115

o independent legal counsel (only area where lawyers may speak for firm) o OR Shareholders 3. Ohio Distinguish Direct/Derivative Modeled on Del. 144 o has weird one again and adds Court of Common Pleas Procedure adds Court review to Decision by board or independent counsel o Advance for expenses is mandatory and not optional in Ohio (opt out) unless you go to court and they find under clear and convincing test that the CEO intended to hurt the corporation o MUST extend CEO cash to defend themselves with a lawyer

D & O Insurance: Practically

1. Power to insure broader than power indemnify? o Yes, insurance companies will limit coverage based on their ability to price and profit 2. Maximize money two clauses o (1) agree to indemnify to max and o (2) insure for what additional protection they can (D & O insurance) 3. Employment Agreement: o MAX Obligation to advance o MAX obligation to reimburse o MAX obligation to buy D & O Insurance 4. In litigation: claim advance, if derivative settle and claim indemnification; o Otherwise claim insurance 5. New wrinkle Thompson memo

Duty of Care: Summary

1. Very hard to win: AND If lose don t pay damages o Exception: Francis Total Dereliction of Duty 2. If Win: Directors Don t Pay Damages: o Indemnification for settlement amounts o Insurance for judgments 3. Cases, even if success very embarrassing to the s because Court o Court moral arbiters; scolding the CEOs

Dutyof Loyalty:

s Gold Mine

1. Key Hurdle: Only hurdle is effective ratification (vote of independent board or SHs) 2. Preponderance of evidence, burden on s no deference to business decisions (de novo review entire fairness test) 116

o Can argue good faith test cannot be met on indemnification 3. Indemnification is harder best interest of the firm? on settlement; insurance coverage offend not available 4. Insurance Companies will not insure CEO on OWN duty of care

Basics of SH Voting Proxy

1. Combination of State and Federal Law 2. State Law: defines what a proxy is because an area of agency 3. Federal law: defining disclosure obligations for publicly traded company o Not publicly traded no federal law at all with exception of anti-fraud statute 4. Record owner writer grants proxy to proxy holder to vote shares at a physical meeting o Guy s name on record books of a corporation o Right to vote when shows up at SH meeting then vote your shares of which you are a record owner o If do not go may grant an agency power to someone else (proxy) who shows up at the meeting and votes your shares o Proxy delegation of agency to vote on your behalf 5. Proxy is an AGENCY created by state law OH .48 and DE 212 6. NOT a written or absentee ballot: o distinguish written consent procedure 7. Terms: revocable at will unless coupled with an interest (e.g. sale of stock after record date but before meeting) o Coupled problem with SH meetings is that you must close the record 30 days prior to the meeting; what if buy stock in that period record holder does not change, so there may be a guy who sold his stock and still has right to vote as record holder; SO when you buy stock from a record holder, you get stock PLUS proxy (that would be coupled with an interest) exrecord stock o Supplemented by federal law if IPO

Federal Proxy Rules

1. Defined: required that you solicit proxies from all your SHs; if have annual meeting, must send out firm proxy solicitation to all the record SHs and then firm will nominate proxy for SHs who do not show up and votes all the shares in whichever way the firm wants 2. Why are they needed? 3. What law controls? o State o Federal: 34 14(a)-(c) AND has rules 14a to 14a- 15 and Schedule 14A

Overview: Regulation 14A

1. Mandatory Disclosure Requirements: Full disclosure all material information to the SHs


2. Solicitation Regulation can only solicit them in certain way, regulation form no discretionary voting; general anti-fraud prohibition; must be true(form and process) 3. SH Resolutions (Rule 14a-8): regulates when ordinary SHs can get access to the firm held property normally board of directors controls what is on the firm 4. Fraud Prohibition (Rule 14a-9)

Proxy Voting: Terms

1. Must be publicly traded company 2. Must be a proxy someone authorized to act on someone s behalf 3. Solicitation is carefully defined o Doesn t include: efforts at persuasion as opposed to requests for proxies Rule 14a-2 o 10 Person exception Rule 14a-2(c) o Cannot just try to convince people to vote one way or another must try to get them to give proxy votes to you before going in

Basic Requirements
1. Proxy statements form 14A, items 2. Proxy Card: format requirements o Limited discretionary grants o Slates of directors yes and abstain (no NO or other) 3. Filing requirements: general rule for plain vanilla proxy statement and form file with the SEC on first use

How is a Ballot Slate Selected?

4. Only one candidate per seat decided by the board of directors with ONE choice (YES or abstain) 5. Opponents do not have access to Management s Proxy 6. Voting Oddities: All you need is plurality so when there is no vote it is very hard for anyone to win 7. Must send out NEW FORM to get someone else on the form in there is a quorum requirement but SOME do not have it in states that don t require it (usually 25% vote abstentions count toward it) 8. New Rage: majority vote buy-ups, we will not seek a director unless he or she gets a majority of all those voting (which means more yeses than abstentions) o Stricter: majority of outstanding shares to vote YES o If do not get: seated because you win but you offer letter to resign but Board has decision to take it or not if there is an empty seat and they accept, Board fills empty seat

Proxy Contest
1. Insurgents: to defeat management slate MUST o Create own proxy statement and card with an alternate slate o File with the SEC AND o Pay to have firm mail the material to all SH or if firm elects, mail material themselves 118

2. Who Pays: Incumbents firm pays all expenses and no SH ratification is necessary o Insurgents pay own way, firm pays back only on victory if ratified by SH vote and if on policy dispute 3. If want to contest board must get own group of candidates together o File own form o File own statement o Send to all SHs 4. Costs - $500,000 to $1M and chance to win is very small o Very rare 5. Even with happen rarely win; only makes sense if you have a huge block of shares or are coupling the proxy contest with a takeover control of board then buy the stock 6. If win firm pays all the expenses of the incumbents, no SH ratification necessary o Insurgents firm pays ONLY on victory if ratified by SH vote and if on policy dispute

Options for Thrifty Challenge

1. Ask SH to abstain on Management s proxy: Disney in 2004 o CEO running for board had 45% abstention vote stripped of Chairman title and resigned in 2006 because 2. SEC Rule Change now languishing major SHs can nominate a candidate IF nominee gets 35% abstention vote 3. SH Resolutions on Management Proxy Rule 14a-8: Bylaw Amendment that allows large SHs to nominate candidate for board AIG case o Cannot run a contested election through a 14a-8: problem is whether you can force a bylaw through that allows this type of stuff 4. Who nominates candidates for the firm? o Nominating committee creates a slate but independent nominating committee usually just takes advice of the CEO and doesn t give much thought to anything else

Litigation Over Proxy Materials: Supreme Court

1. J.I. Case v. Borak (1964): first private cause of action for violations of Rule 14a-9 (up to now private lawyers couldn t bring these types of suits, could bring 16b suits, though) o Affirmative vote on merger false statements in proxy statement o After this case lid was blown on 14a and 10b-5 for all securities actions to open up to litigation in lower courts o Began argument of what materiality is because false statements must be material o Material: maybe same as reliance, show that if new would have been negative vote on merger (changed vote of merger), if not just leave it alone 2. Mills v. Electric Auto-Lite Co (1970): Causation doesn t require proof that vote would have been different o Facts that s controlled 54% needed 66% to control o Virginia Bankshares 66% control does break causation o Awards of attorney s fees to proper 119

o Substantial benefit test does not have to be pecuniary 3. TSC Industries v. Northway: Defined materiality o Materiality: doesn t require proof that the vote would have been different but for false statement o Defined as Reasonable Investor-Total Mix Test If a reasonable investor would have found it to be an important fact in the questioning of the deal o Define causation, materiality, reliance 4. Take these doctrines and apply them to 10b because these proxy fights were big deal: open license to sue as private litigants under 10b-5 with the diminished causation, reliance and materiality requirements o Borak now limited to its facts o Congressional Intent Test Now: if you have an open-ended prohibition in a federal statute the presumption is NO and rebutted only if you have very strong evidence that Congress intended to have a private cause of action available; generally not implied by the courts would write it in

Seinfeld v. Bartz Application

1. Importance: compensation of CEOs and stock options 2. Qualified 16b-3 Plan: must have a plan distributed to your SHs 3. Facts: everyone knew all the details of dates and what not but there was no present valuation of the options in the statement released; o CEO would get $2m salary and then $1m in stock options but they didn t say they were paying the CEOs the salary plus the options because firm didn t value the options correctly and were under by $320,000 4. Held: No, not material. If you wanted to value the shares, then you do it. We have no obligation to do it ourselves when you have enough information that was released o Call Options: Note on p. 555 on options; compensatory call option that give CEOs, can buy stock from company that is well in the black o No back dating controversy

Proxy Rights and Shareholder Proposals (14a-8)

1. Compare incentives for takeover and proxy fights 2. Compare Methods of Takeovers to Proxy Fights 3. Capitalism (1) private property ownership and (2) are able to aggregate, buy and sell, property (widows and orphans owning one share of GM permissibility of aggregation creates our largest corporations) o Example assume only own 10% (very much) of firm with capital value of $8m (worth $800,000) and believes that firing CEO will raise value by 20% to another $1.6m o Question: how do you execute upon that belief when willing to take the risk 4. Option 1 Proxy Fights: win majority of the seats and throw him out but cost lots of money $250,000 and you wouldn t gain enough back to gain costs (odds of failing are extremely high, risk not worth rewards) 120

Effect of Staggered Board: two 2 successful contests gain control of board elect 1/3 first year and another 1/3 the next year double expense o Usually not done proxies unless gains would be monstrous with low risk 5. Option 2 Takeovers: Have 10% and want to buy 40% but key is you want to buy it at the lower rate get interest rates to cover the difference so it makes up for the losses while also getting 20% - must get another from firing CEO to repay the 20% and carry the interest payment o Purchase 90% you don t own costs $7.2m and gain $1.6m assume premium is required; can pay SHs up to 20% (less than $8.2) and still show gain o Assume premium required and must borrow money can pay SHs up to 20% minus interest (e.g. 6%) and still show gain o States and politicians hate on these now stop it at the buying majority ownership in OH Board must accept takeover (meaning there are ZERO takeovers here UNLESS there are special consulting contracts OR confidential information agreements that are basically bribery); OH empowers boards to take bribes so they don t have to allow the takeover o Bad Managers Blocking Takeovers: stay in power effect OR can pay SHs up to 20% minus interest and minus bribes to managers and still show gain (severance, golden chutes, etc.) o Worries: companies are liquid in the past you could not raise that type of money so quickly but now you can easily  So with the OH legislation all the shares are worth 97% less than they are in other states without this type of legislation  Instead front-end tax incentives like property tax relief (non-contingent on anything government planning) o

New Option Three

1. New Rules for Proxy Contests: AIG Case stands o SH proposes and wins 14a-8 resolution 2. Let 10% SH nominate slates of candidates for the boards and the firm has to pay o Option one would suddenly make sense o If force firm to put opposing slates that are real on ballots then there is whole different issue o Easiest way to pick opposition slate SH amounts of largest opposition SH gets the right to select candidate to oppose 3. Problem: more collusion CEO pays much more attention to that SH in opposition and may give him other perks and information that may dissuade him from putting quality candidate on the ballot

Rule 14a-8: Shareholder Proposals

1. Town Meeting Rule: Qualifying SHs may include some kinds of proposals for a SH vote in the company s proxy solicitation material o Allows ordinary people to get on the SH Voting proxy list; 500 words or less o Something for nothing 2. 14 in SEC Act (a) delegates power to the SEC and regulating proxies 121

o 14a means it was 1934 Act rule, later Acts are larger numbers 3. Policy: o Pros: Low cost SH access to SH vote process  No SEC filing, no cost of mailing  Even failed proposals make the point o Con: Costly annoyance overwhelming number of proposals fail; infringed on management prerogatives 4. Procedure: Submit to request (resolution and supporting statement) to corp. within deadlines of 14a-8 o Firm requests a no-action letter from the SEC on whether firm can exclude o SEC issues no-action letter (will you sue us? Not at this time, but may sue you later but not today doesn t bind SEC); only if clear precedent that the SEC will not allow this to keep out then they will try to get it out of there o Review of staff latter by 5 SEC Commissioners o Loser Petitioners Federal Circuit Court to overturn SEC decision or firm excludes it despite advice and forces SEC to sue in FDC 5. Types of Proposals: 13 Most Improper o Personal Grievance or Personal interest o Ordinary business operations (Dole proposal, study on health care, Con Ed proposal on retirement age) o Election for a board seat (AIG case) o Materiality (relevance): less than 5% of  Total assets or net earnings and gross sales  Exception for otherwise significantly related to business (Iroquois Brands proposal on pate) o Resubmission in 5 years: any do-gooder that gets 3% vote once, less than 6% twice this is the definition of victory 6. Shareholder Power? o Are these Rule 14a-8 Resolutions Binding on the board:  NO Corp. Code State that Board has power to manage because resolution must be proper under State Corp. Codes (which gives power to the directors)  Possible exception: SH power to amend bylaws o Solution: make resolutions precatory recommend or request the board act (see Con Ed proposal)  Board may or may not comply boards often fail to comply;  If they do not? Option is to vote them out. 7. Special Case: Bylaw Amendments o Not Resolved o Common Practice: To allow SHs to make bylawys by charter election in MBCA; boards have exclusive power to amend bylaws (DE and OH) some states can take this right out in the charter


o o

But DE 109(b) and OH 11(regulations): SHs have inherent right to amend bylaws can SHs amend bylaws with a Rule 14a-8 resolution, making it binding? When do SHs recommend bylaw changes?  In DE issue is scope of SH management power SHs do not have power to manage board; directors do some argue that this invalidates Poison Pill bylaws

AIG Case: Amending Bylaws

1. Proposal: Amend bylaws to allow major SHs (3%) to nominate candidates for board elections; put a bylaw amendment on AIG proxy solicitation to allow a major SH to nominate candidates o Access Bylaw can SH amend proxy machinery that is in place? 2. SEC: Deals with election, may be excluded 3. 2nd Circuit: SEC is not following text of rule AN ELECTION allows bylaws that change election procedure ( all elections) 4. SEC Could rewrite rule: DE could change SH power to amend bylaws (would not stop precatory resolutions, however) o SEC has new rule out to change decision of 2nd Circuit and o DE has new rule to blunt effect 2nd Circuit decision

Voting Results
1. Social Responsibility Resolutions Fail (Dole vote, 5.4% in favor; 83.6% against, 11% abstained unusually high) goal is to beat resubmission 3% bar; Vietnam victory for proponents (advice to Nixon declare victory and pull out) 2. Governance resolutions may succeed: these may be ones that matter o Example drop the staggered board because it makes it too hard o Drop the poison pill plan o Sponsored by the institutional investors in your company who are worried about the stop price o Resolutions by the big players, on economic issues to maximize the stock price

Corporate Responsibility Proposals

1. Types abortion funding, gay rights, affirmative action, environmental impact rarely succeed 2. Cracker Barrel controversy (not in book): o 1992 SEC allows company to exclude SH proposal to prohibit employment discrimination based on sexual preference  Ordinary business matter or not material (5% rule) o 1998 Under political pressure SEC withdraws Cracker Barrel letter says it will rely on a case by case analysis

Governance Resolutions
1. Examples: Repeal stagger boards; repeal poison pill plans; majority vote bylaws; SH nomination bylaws (AIG case) 2. Success? Because institutional investors involved and public pension plans 123

o o

Supported by Proxy Advisory Firms (ISS) hated by all corporations ISS is proxy advisory firm every year Institutional SHs get a letter from ISS evaluating whether or not you should vote YES or NO on the proxy resolutions; they will tell you whether or not you can make money on these proxy resolutions CEOs hate them because sometimes they say CEO has really messed up and you should vote this resolution up