Business Associations Outline

Basics of Business Law:

Internal Rules: how the parties (shareholders, directors, managers) of a corporation act with each other; i.e.- their rights and responsibilities to each other. With respect to power and duties within the business entity itself. External Rules: relative to how the business entity interacts with the public: investors, creditors, consumers, etc. Mostly statutory. There are 6 basic business entities. Agency: (The Foundation for this Course!) The fiduciary relation which results from the manifestation of consent by one person to another that the other shall act on his behalf and subject to his control, and consent by the other so to act. This relationship is one of trust and openness: the agent owes a special duty to the principal. The agent has to act in the best interest of the principal, whose interest also must be protected before the agent can think of himself. The agent is accountable to the principal for any profits arising out of the transactions he is to conduct on the principals behalf. The agent breaches his duty to the principal if he acts either to benefit himself or someone else other than the principal. This fiduciary obligation exists even though the contract is silent as to the duties of the agent or purports to abolish this duty (b/c cant contract out good faith obligation) Relationship is based on conduct; may be contractual, but need not be. Ergo, no necessity to reduce it to writing. An artificial entity can only act through its agent. The scope of an agents actual authority is determined/limited by the principals purpose for commissioning the agent. Actual authority arises from the manifestation of a principal to an agent that the agent has power to deal with others as a representative of the principal. The scope of apparent authority (of an agent) arises from the manifestation of the principal to a third party (directly or indirectly) that another person is authorized to act as an agent for the principal. That person has apparent authority and an act by him within the scope of that authority binds the principal to a third party who is aware of the manifestation by the principal and believes the person is authorized to act on behalf of the principal...even though the act was not in fact authorized by the principal. Apparent authority: commonly occurs when one person creates or permits the impression that broad authority exists when it in fact does not, or when one person represents to a third party that someone else is his agent when that is not the case. Either party has the right to terminate the agency relationship at any time; however, in order to protect himself, the principal should notify third parties of the termination so as to destroy all manifestations of apparent authority. A partner is an agent of the partnership (which is the principal). Incidental authority arises from the agency itself and without regard to actual or apparent authority. May be viewed as arising by implication from the authority actually or apparently granted. *Simply the authority to do incidental acts that relate to an authorized transaction.

 An independent contractor is a person who contracts with another to do something for him but who is not controlled by the other nor subject to the others right to control with respect to his physical conduct in the performance of the undertaking. A principal is disclosed if the third party knows the identity of the principal at the time of entering into the transaction. The principal is bound here. A partially disclosed principal is one whose identity is unknown but the third person is on notice that the agent is in fact acting on behalf of some principal. Agent and principal are both liable to the contract here. A principal is undisclosed if the third party is not aware that the agent is acting on behalf of anyone when in fact the agent is acting on behalf of a principal. Here the agent is personally liable to the third person on any contracts negotiated by him. The undisclosed principal is also liable on the contract to a third party if the agent was acting within the scope of his actual authority. The principal has only the rights an assignee to the contract would have, but the agent can enforce the contract directly against the third party on behalf of the undisclosed principal. There can be co-agents: i.e.- 3 partners are all co-agents of the partnership/principal. Business Forms: There are many different types of business: restaurants, clothing stores, office supply stores, etc. The form is the vehicle for doing business. There are 6 general categories of a vehicle to operate a business. What is the appropriate vehicle for the business? The lawyer should analyze each form in how it is managed, and what the tax consequences of each form are, and what liability for the operation rests with the owners/operators (personal liability), and what kind of formality is needed to operate the business. Six Forms: Sole Proprietorship: a business operated by one person. General Partnership Limited Partnership (LTD) Limited Liability Partnership (LLP) Limited Liability Company (LLC): can also be organized by professionals. Corporation (INC): owners are all licensed to provide some service within the state. (i.e.professionals such as doctors, lawyers, accountants can form a corporation). Typically, a corporation (a C-corporation) pays a tax on the earning of the entity (entity itself is taxed, and then the profits paid out to the shareholders is also taxed--the TP shareholders have return these dividends as G.I.). S-Corp is another type of corporation (these letters represent letter designations in the IRC). *A one-member corporation or LLC can exist (ex.- a lawyer can have a sole proprietorship in essence, but wont want to because of personal liability consequences--he will be personally liable for all business debts, etc.--instead, he can form a one-person LLC or INC). *The problem on page 7 represents a ubiquitous instance of the formation of partnerships in our American capitalist society. A represents the venture capitalists, and are more seldom. B represents the managerial expertise conducive to that particular business (and B usually has the business plan/model too); the Bs are much more common. Formation of a Partnership: Governed by sect. 202 of the 1997 UPA (Uniform Partnership Act)

 Anything said or agreed to in the partnership agreement (which may be oral) is binding on the partners. There are, however, certain things in the agreement which cannot be waived (sect. 103); e.g.- cannot waive the duty of loyalty or the duty of good faith and fair dealing (these are fiduciary duties that the partners owe to each other and to the partnership). Sect. 404 sets out these duties: General Standards of Partners Conduct. The partnership is the principal to whom the duty is owed, and the partner is an agent to the partnership. (sect. 301). Bane v. Ferguson: Negligence represents a violation of the duty of care. Because he was no longer a partner (he retired), the remaining partners owed him no duty. Rule: Once a partner leaves or retires, the remaining partners duties to him are extinguished. Business Judgment Rule: a court is not going to second guess an action or decision made in good faith by the directors, partners, etc. The courts dont want to employ hindsight to overrule the decisions made by the professionals, even if the decision results in disaster. **Note: The early cases are historical in terms of showing how partnership principles came into form. The key case is Meinhard v. Salmon. Apparent and actual authority extends only to the scope of the business involved. Nabisco v. Stroud: Business form? General partnership (Stroud and Freeman). Stroud makes a written representation to Nabisco stating that he would not be responsible for any additional bread sold by Nabisco to Strouds (essentially, dont give us any more credit; I wont be responsible for any purchases incurred because of credit). Stroud puts them on notice that he wouldnt be responsible, but he is still on the hook. Freeman is a partner and has actual authority. A majority of partners is needed to cut off his actual authority, and that is not possible here (except by dissolution). Stroud had no authority to override Freeman. Rule: All partners are jointly and severally liable for the acts and obligations of the partnership. (unless outside the scope of the business, which was not the case here) There is a distinction here between apparent authority and actual authority. Smith v. Dixon: The business form is a general partnership Rule: A partnership is bound by the acts of a partner when he acts within the scope or apparent scope of his authority. The scope of the partnership: they were involved in the sale and lease of property the partnership owned. The managing partner agreed to sell a parcel of land for $200K, but the other partners authorized him to sell it for no less than $225 (this is his actual authority), and therefore he went outside the scope of (exceeded) his actual authority. He would therefore be liable to the partnership (in reality, though, he probably wouldnt be sued). He used his apparent authority to sell it for $200K, though. Other firms/people in the town knew he was the managing partner and that he had done deals like this before; hence: his apparent authority.

 The partnership is still bound! W.R. Smith was acting within the apparent scope of his authority as a partner when he signed the contract...[and] it is binding and enforceable upon the partnership. Rouse v. Pollard: Shows the limitation on apparent authority: the action must be within the scope of the business. This is a law firm. Plaintiff had legal work done by the partnership. One of the partners (Fitzsimmons)suggests to her that she give him the securities and he would invest them into mortgages and give her the income derived therefrom. The law firm worked somewhat in investments, corporate law, etc., but what F. asked her to do was a little different; typically, the firm did not invest in arbitrary mortgages. Mortgage: a loan secured by the property. They have always been a good investment, until now. Instead of investing the money, Fitzsimmons embezzled it by putting it into his own account. He gave her interest from the money over the following years. Later he leaves the firm and is arrested. She brings suit against the partnership, which is liable for the actions of its partners, acting within the scope of the business. Fitzsimmons did not have actual authority to take her money; but did he have apparent authority? (She knew he worked at the firm, and that the firm worked with banks and investments; but would she really know the intricacies of the firms business dealings, such as mortgages, etc.?) The court said no because he acted outside the scope of the firm (although she had no reason to know this). *Note: Dont give advice in an area in which you are not licensed or proficient (but most lay people dont know that) Roach v. Mead: Law partner borrows some money from a client, saying that he would pay the client back, with 15% interest; the client did not secure the loan. Borrowing money from a client is definitely outside the scope of the business of a law firm. This case turned on a malpractice claim: the lawyer took money from the client without advising him: the lawyer had a duty to inform his client that he should seek independent legal counsel for advice on the consequences of the loan; he didnt. Bad legal advice also exists here because the lawyer did not inform the client that he should get the loan secured, and this was detrimental to his client. (A lawyer should always advise his client on the consequences of loaning money to someone: get it secured, check the third partys credit report, financials, etc.) The second loan was given at the clients home and therefore the partnership was not liable: it was outside the scope, was not in the legal office, and the lawyer offered no legal advice. Rule: The partnerships assets have to be exhausted before the assets of the partners are taken. If a partner enters into a transaction outside the scope of the business, and the other partners acquiesce in the decision, they are also liable and on the hook. If a third party reasonably believes the partner is acting within his scope, then the partnership is bound. (apparent authority) Meinhard v. Salmon:

 Salmon was an up-and-coming real estate developer, approached by the Gerry family over what to do with the Bristol Hotel, whose value was under-utilized. They came to an agreement, under which they would lease the property to Salmon for a period of 20 yrs. There were conditions: he had an obligation to convert the hotel into office space and retail shops, the cost of this being about $200K. Salmons father covered the lease. But Salmon couldnt raise the $200K, although the Gerrys gave him $100K on loan. Meinhard was also a young upstart, a factor: he would loan money to companies in exchange for monies out of their accounts receivable. Therefore, he knew the ins and outs of money. There was controversy as to whether these two knew each other (Meinhard wrote later in his memoirs that they were good friends, even had opera tickets). So the two entered into a deal: Meinhards obligation under the partnership was to provide the money. He would get 40% of the profits for the first 5 years, and then 50% each year thereafter. Salmons obligation was to manage the property. They called the deal a joint venture (the difference between this and a general partnership is that a joint venture is a partnership for a specific purpose, usually with a fixed time-period; e.g.- a joint venture to construct a hospital. It doesnt mean that they are partners for other reasons. For all purposes, partnership rules apply to the extent of the joint venture. Meinhard became annoyed with the bills Salmon was presenting, and the relationship soured. They agreed that Salmon would take a 6% management fee and provide information about the deal to Meinhard whenever he asked (but M went to FL and no communication occurred between them for the next 7 years). It later ends up in court. It turns out that this piece of real estate was the most valuable piece of real estate in the world, in terms of values of the property. The Gerry family knew this; they looked to acquire more property and did, to the north and west of the Bristol, so that it could be all one parcel. The Gerry family wanted to tear down the Bristol and erect a skyscraper. We are now four months away from the end of the 20 year lease. The deal was that Gerry would charge Salmon for the property ($475K/year) on a 20 year lease. But Salmon didnt want to build a skyscraper and in 20 years give it to the Gerrys when the new lease ended (if one constructs a building during a lease, when the lease ends the lessor keeps it). So instead they made an 80 year lease, with many options. Salmon personally agreed to secure the lease, and had a bunch of money saved up. The deal was made. Meinhard knew the lease was going to end in four months, and then he heard about the new deal between the Gerrys and Salmon. So he sued. There are factors here that weigh in favor of Salmon: No precedent for this kind of situation. It was a joint-venture, short-termed. Meinhards name never appeared anywhere: he wasnt the manager of any project. When a bill became due Salmon paid it, sent the bill to Meinhard, and Meinhard reimbursed him for half of it. For purposes of authority, people knew of Salmon, not Meinhard. Had they bargained, Salmon probably wouldnt have given Meinhard anything, and he would be out anyways. All Meinhard brought to the first venture, and all he could bring to the current one, was money; Salmon didnt need money anymore. Meinhard never contacted Salmon, or anyone, regarding what would happen when the lease ended in 4 months (even though they had an agreement to this effect). Meinhard had no experience. AND the Bristol Hotel was not part of the new deal because they were going to tear it down.

 AND Meinhard was hugely compensated from the earlier venture (he gave $52K and received $550K). KEY: The fiduciary duty discussed in this case is one of loyalty. A partner cannot take for himself an opportunity that comes to him on behalf of the partnership. If youre a partner, while that partnership exists, both partners have a fiduciary duty to the partnership. Under that, each party must refrain from seizing any benefit intended for the partnership for his own gain, and to the detriment of the partnership. But if Salmon and Gerry entered into a deal for another parcel of property, it probably would have been okay. The court asserts a high sense of honor between the two that will not be lowered. Accordingly, Salmon should have permitted Meinhard to compete or get in the deal, or at least make him aware of the deal so he could find someone else with whom to compete. What Salmon owed Meinhard a higher duty than vice-versa because Salmon was the managing partner (co-adventurer, Cardozo says); i.e.- because he took responsibility for the management (fiscal responsibilities, etc.) of the partnership he owed a higher duty to Meinhard. Cardozo labelled Salmons conduct as not living up to that standard. The problem here is that Salmon did not wait for the expiration of the lease to enter into the new deal; but Salmon did pay Meinhard everything he was owed under the lease, up to the date of expiration of the lease. Note on Duty of Loyalty: If the offer is made for something outside the scope of the business of the partnership/corporation, you can take it without violating the fiduciary duty of loyalty. But in reality, just to cover ones 6 he should disclose to the company. Partnership Dissolution: Collins v. Lewis: Business form? General partnership (Money guy and operational guy just like the AB scenario). Lewis had an idea to construct a cafeteria, but he needed Collinss money to fund it. Lewis assured Collins, based on Lewiss estimates, that he would not have to expend more $300K for this purpose, because this was Lewiss estimated cost for getting the cafeteria up and running. This didnt happen, though. Collins would be repaid $30K plus interest the first year and then $60K plus interest every year following. Also, Lewis guaranteed Collins against loss to the extent of $100K (he pledged his ownership interest in the partnership as the security if he failed to pay). Lewis was to take an agreed-upon salary. He was going to run/control the project. The profits would be split 50/50. Collins actually had to expend $636K in order for the cafeteria to get up and running. Lewis got it opened, but could not make the first payment so he asked Collins; Collins sued to dissolve the partnership and enforce his guarantee (essentially, Lewis would have to forfeit his interest). The jury found Lewis competent to run the business, but that no profit was expected under his continued management; they also found that Lewis could have made profits but for the behavior of Collins (in delaying the payments and initiating a suit). The actions of Collins deteriorated the

businesss expectations of profit, and the continuing success of the business was impeded by Collins actions. The actual cost of everything was $697K. The difference between this and the $636K ($61K) was pulled out of the operation (by Lewis) to fund payments Collins should have made. This money came out of operations and Collins should have covered it, and because he didnt, he received a credit for it (ergo, he doesnt get Lewiss shares). Collins was not granted relief because of the doctrine of unclean hands; his bad behavior caused the loss of profits, so the court refused to grant him the remedy requested. (This doctrine applies in courts of equity.) Sect. 601: Events Causing Partners Dissociation: A partner is dissociated from a partnership upon the occurrence of any of the following events: The partnerships having notice of the partners express will to withdraw as partner... An event agreed to in the partnership agreement as causing the dissociation The partners expulsion pursuant to the partnership agreement. The partners expulsion by unanimous vote if: (more follows) Section 602: Partners Power to Dissociate; Wrongful Dissociation: A partner has the power to dissociate at any time... A partners dissociation is wrongful only if: It is in breach of an express provision of the partnership agreement, OR In the case of a partnership for a definite term or particular undertaking, before the expiration of the term or the completion of the undertaking: (i)... Section 603: Effect of Partners Dissociation: Upon partners dissociation: Right to participate terminates... Duty of loyalty terminates... Duty of loyalty...and duty of care... continue ONLY with matters that arose before the partners dissociation, UNLESS the partner participates in winding up of the partnership... Section 701: Purchase of Dissociated Partners Interest: When you get out rightfully, the partnership has to compensate you for the value of your interest. Damages for wrongful dissociation MUST be offset against buyout price. Interest from date amount owed to payment date. If no agreement for purchase...within 120 days after written demand for payment...partnership shall pay...amount partnership estimates to be the buyout price and accrued interest. Section 801: Events Causing Dissolution and Winding Up of Partnership Business: A partnership is dissolved, and its business MUST be wound up, only upon the occurrence of any of the following events... Inadvertent Partnerships: Martin v. Peyton: (Year) Same court that decided Meinhard v. Salmon.

 Rule at this time was that statements saying this isnt a partnership were irrelevant; any arrangement of two or more people as co-owners would constitute a partnership. The default was a general partnership. Rules: Statements that no partnership is intended are not conclusive. If as a whole a contract contemplates an association of two or more persons to carry on as co-owners a business for profits, a partnership there is. An arrangement for sharing profits is to be considered...[but] it is not decisive. A partnership may be so created where there was none before[;]...that the original statement has been so modified may be proved by circumstantial evidence--by showing conduct of the parties. Here the question was: were they partners or lenders? The Court ruled that they were lenders because they did all the same things a bank would in giving a loan: obtained security, set standards of how much employees could make, etc., even though they were to get a share of the profits (these profits were compensation for the loan). Smith v. Kelley: They list the employee as a partner, introduce him to others as a partner. When he leaves, he sues for a 20% interest in the partnership. He loses because a partnership is contractual relationship and the intention to create it is necessary. They never intended to make him a partner. He never had actual authority as a partner, so he never had an interest. (They never made him a partner, nor did they intend to.) Even though he (probably) had apparent authority, he had no actual authority; therefore, he was not an actual partner.

Principles of Accounting:
Accounting: method of communicating economic information to various decision makers: managers, investors, creditors, the IRS (although they have their own system of accounting) and the government. One of the big components is conservatism: do not overstate the financial statements, etc. Be conservative in your estimates! Also defined as: Process of recording, classifying, and communicating financial information Internal (managerial) information: management can keep whatever format it wants for internal record-keeping. It better be correct, though, for purposes of external and taxation information. Managerial formats are those that suit the managers needs. Managers decide the nature of the information that is needed to make appropriate decisions. (Managerial Accounting) External information: investors, creditors; there is a standardized format. External financial information which is delivered to outsiders (non-management and non-governmental) must follow a format that is understood and allows for comparison between entities. A standardized format has been developed for such use. The format is known as Generally Accepted Accounting Principles (GAAP). GAAP involves 6 concepts: Must deal with an economic entity The entity must be considered a Going concern: If an outside auditor audits your books and gives a qualified opinion, what they are saying is that they are not certain that the company will survive the next year; they cannot attest to the company being a going concern. For purposes of GAAP, the economic entity must be a going concern: it is a

company that will survive the next year and continue to make money; an auditor is assured that the company will continue operations, meaning the auditor will give it a clean opinion. Monetary valuations: everything in a financial statement is converted to dollars. (e.g. if Company A has 10 Corvettes, it must convert the value to dollars.) Accounting period: cannot have a financial statement without stating the period for which it applies. So you must have a definite period of accounting. Matching--revenue/expense: We have to match the revenue (money-generated) of an accounting period with the expenses that are connected to the making of that revenue. (e.g.- 3 month period: list all the revenue generated, as well as listing all the expenses associated with generating that income; so $300K worth of business [selling shoes] is done in the quarter. You have to include the cost of all the shoes sold. Have to deduct from revenue how much it cost to furnish the inventory. This will get you to your net instead of gross revenues. Generally the expense is treated as the cost of the item. *Be aware, though, that companies often cheat to make themselves look better; e.g. a company makes $100M of revenue in a year, but doesnt include the expenses of $60M. Here the company looks like it made a $100M revenue, but in actuality it was only $40M. This is colloquially referred to as cooking the books.) Conservatism: take a conservative approach to determine the amount that is given out; dont speculate. (e.g. if something can be considered a bad debt, where the company has not received payment for more than 6 months, i.e., then that amount should not be included in revenue.) Taxes: governmental (referred to below as Tax Accounting) Tax Accounting: standards are established by the appropriate governmental entities to which the information is delivered (Fill in the blanks and follow instructions). Financial Statements: Balance Sheet: a financial picture of the economic entity as of a given day (snapshot). Key terms: Assets: resources of the firm Liabilities: claims/debts against the enterprise (can include litigation, if it looks like a losing case) Equity: value of the ownership (net worth) The balance sheet is essentially the restatement of the fundamental equation of accounting: Equity= Assets - Liabilities Standard balance sheet Format: Assets= Liabilities + Equity (These MUST balance! Equity can be negative) Current Asset: assets that are cash or can be easily converted to cash within 30 days. Non-current assets: assets that take more time to convert to cash (e.g. equipment, buildings) Inventory: amount of goods, at whatever they cost, that are available for sale. Not the equipment used in operation, but rather the goods that are sold to the public. Includable in current assets as the value (cost) of those items. (e.g. an inventory of 10 cars that cost the dealer $1K/car would equal $10K; price of inventory has nothing to do with how much the goods are sold for; rather, it reflects how much the goods cost.) Income Statement: demonstrates the operating results of the economic entity over a fixed period of time, usually a year. (motion picture) The format lists all revenues earned and the expenses incurred to generate those revenues.

 Statement of Cash Flow: measures the amount of actual cash entering into or leaving the economic entity over a fixed period of time; indicates all cash coming into or going out of the entity over a fixed period of time. This is very important for managers. The statement shows the net change in actual cash for the period: Net cash from operating activities: Sales and profits Net cash from investing activities: sold stocks Net cash from financing activities: borrowed money **Notes on Taxation of Income: There are 2 systems people use to maintain economic activity: Cash basis: if A sells a computer for $500, A would not enter that sale into his books until he received the actual $500. Dont record a bill on the expense side until it has been paid. Cigar box mentality. Has some flaws, though; cant be relied on. Accrual basis: Same scenario, but here when the sale is made for $500, A records the sale as revenue even before collecting the money. But since it has not been paid, it goes to the accounts receivable category because it is owed to A. This is a generally-accepted accounting principle, and is the best way to do it. Tax laws have changed over time to abnegate various loopholes found by lawyers; consequently, taxation is not an underlying principle regarding which entity to use when forming a business (i.e.-choosing a business entity depends less and less on taxation because of the changes to the laws). Things to Consider when Forming a Business: Management Personal liability (does the owner/operator/manager of the enterprise have any liability for the obligations of the enterprise?) Tax treatment Formality Application of the Above Considerations (chart on portal): Drawbacks to a sole proprietorship: only one person to manage the operation; limited to the funds of that person too. A general partnership is taxed (passed through) as such: The company files a return, saying that the partners are responsible for their respective allocated shares (of the income) on their personal incomes. (e.g. Partners A and B each have $30K of the partnerships income, and they will include this in their G.I. for that year, effectively making them pay the taxes of the partnership: the income of the partnership is passed through to the partners to be taxed as part of their incomes.) Pass through includes losses and gains. Also, a partnerships assets will first be extinguished to satisfy any debts; any remaining debts must be satisfied by the partners, giving rise to their possible personal liability. Limited Partnership (general partner, limited partner): a limited partner does not manage; the general partner is the manager. Limited partners expend money and their liability is only to the extent to which they provide that money (Contribute $50K, only liable for that much). But the general partner is liable. The formality here is that the a certificate (regarding the formation of this business) must be filed. A trick to combat/eradicate the general partners liability is to form the general partner as a corporation. A limited partner may then be a director, manager, etc. of that

corporation, and can therefore manage the limited partnership without fear of liability. This entity also employs the pass through of taxes. Limited Liability Partnership: Management by all partners; there is, by statute, no liability for any of the partners. Also employs the pass through tax practice. There must exist some form of insurance or proof of such, regarding the formality of the entity, which must be filed with the state. What if you want to grow your business, though, and have a multitude of investors willing to invest in your companys growth? The appropriate form here is an Incorporation (C Corp): Management by 3 classes: owners (shareholders, who generally appoint the directors; shareholders can wear many hats: can be a director and a manager as well), board of directors (who are responsible for the operation of the corporation, set strategy, etc.), and managers/officers (president, secretary, treasurer). None of them have any personal liability for obligations of the corporation; do something wrong (e.g. commit fraud), and you will be personally liable for it. For many years professionals were not allowed to form an INC. Now they may form a professional corporation. Here the corporation has to pay its own income tax on its property, whether money or otherwise (INC is taxed as an entity). The shareholders are also taxed on the distribution of profits (dividend); this leads to a double-tax. This leads to a real problem of operating a small business under a corporate umbrella. Formality: Have to file the articles of incorporation with the state (should also have the bylaws--internal rules of how the business will operate--and the record of activities). The Code combated the double-tax of small corporations with the implementation of an election to become an S corporation. Here, the S corporation is not taxed as an entity, but rather as a partnership: any profit or loss is passed through to the shareholders. The S Corporation is limited to 75 shareholders, who must be U.S. citizens. Limited Liability Company: Unlimited number of participants, known as members (not shareholders). The members manage, if nothing else is expressed. Another option is for a small contingency of members to manage, or they could bring in outside managers. In any case, members have a right to manage (designated as manager-member/MGRM). There is also no personal liability. The tax treatment: check the box (if you want to be taxed as a partnership, tax that box; if you want to be taxed as a corporation, check that box, etc.). The LLC has emerged as the most preferred entity among small businesses. Formality: Articles of organization; internal rules are called the operating agreement. **Notes: There is no way that a professional could choose any of these entities and be free of all personal liable; there is always a possibility of malpractice. You can have a single-shareholder or single-member entity thats not a sole proprietorship. So there is really no reason to form a sole proprietorship (unless youre operating a lemonade stand). Likewise, why would anyone choose a general partnership if you can choose an LLC? In reality, there are really no reasons to choose anything except an LLC or INC (C or S).

Organization of a Corporation or LLC:

Efficient to view corporations through paper and people:

 People making up a corporation, and First group of people (or person) that initiates a corporation is called an incorporator. Usually a lawyer, someone not a director/manager; responsible for signing the paper that starts the whole process. Once the articles of incorporation are filed, there is no longer a need for the incorporator, so the owners come in. The owners of a corporation are called shareholders; can have an incorporation with just one shareholder. They are responsible for organizing the whole operation. At their first meeting they must appoint/elect the people responsible for the operation of the corporation: the directors. Directors: responsible, by law, for the management of the company; doesnt mean they are there every day, though. They delegate their responsibility to officers. Officers are the day-to-day managers of a corporation: president, VP, etc. (Shareholders, directors, and officers are very important to a corporation; internal rules with govern the interaction among these three groups; external rules will govern how the corporation interacts with the public.) What paper is used to start that . The articles or incorporation: this is the official notice to the world about a particular entity; is filed with the Secretary of State in the state in which this corporation wants to be organized. One these are filed, there is no longer a need for an incorporator. The paper for the shareholder meeting is usually labeled as the minutes of the first meeting of shareholders. Will name the shareholders, and who they have appointed as directors. Those directors are responsible for operation of the corporation, but will delegate this authority to officers. Paper associated with the directors meeting is the minutes of the first meeting of the directors. They will generally sign/adopt the internal rules (bylaws) of the corporation. Corporation can adopt any rules they want, except certain things (like waiving a duty of loyalty, or a duty of good faith and fair dealing). If it is silent on a subject, the default provision is whatever is in the statute (most bylaws mimic the statutes of the respective state in which the corporation is formed; these bylaws are all forms now, so the lawyer doesnt have to start them from scratch). In most states, either shareholders or directors can adopt bylaws (if the shareholders adopt, then the directors ratify). Also in this first meeting, the directors will appoint officers (president, vice president, treasurer, secretary-usually a lawyer) and delegate eachs authority (actual authority). The only requirement is that there be one officer, whose responsibility is to maintain the books, etc. Usually the directors also authorize the opening of a bank account (a form needs to be filled out so the bank knows the corporation is real). If directors want the officers to act outside their scope of actual authority (e.g. sign a lease or buy some new equipment), they will have to write/pass a resolution (another piece of paper). Wording might resemble this: The board of directors on the 10th day of May 2010 met to determine to hire ABC as their accountant. It is hereby resolved that the president of the corporation is authorized to sign the letter for ABC. A resolution is just a piece of paper stating that the president (or other officer) has the actual authority therein. All these papers comprise the foundation/formation of the corporation. (With an LLC, the shareholders are called members, and the directors are called managers. Sometimes the managers can take titles that are similar to president, but its really just the two classifications. Also the articles of incorporation are called the articles of organization.)

 Sunbiz.org (Florida Department of State Division of Corporations): can form a corporation ($78.75 filing fee) or LLC ($125 filing fee) online. Miscellaneous Notes on Corporations/LLCs: There must exist at least one shareholder for a corporation to exist, and at least one share. A corporation has the right to issue a number of shares: the corporation will authorize the issue of 10K shares, but that doesnt mean they have to issue them. Authorizing the shares merely means that it can issue said shares. The principal appoints the agent, and gives him the authority. The principal will define the scope of the agents authority. A registered agent is the person that will accept service of process on behalf of a business entity. The registered office is the address where the registered agent is located during normal business hours. (Businesses--especially law firms--can serve as registered agents, but will usually form a corporation for this purpose.) The address must be in the state in which the corporation is formed. The agent must also accept the principals offer; there is a block on the webpage where the agent will sign his acceptance. Incorporator is usually not the same person as the agent. Corporate purpose (years back, corporations had to list these, and anything outside the scope of the enumerated purposes might not be held up; now that has changed and what follows is all that is needed): Any and all lawful business. Unless it is a professional corporation, in which every practicing member must be licensed to practice in that state; for a P.A., you must list specific purposes. For LLCs, MGMR is a manager-member; LLCs dont have incorporators. They can have members all over the world, and corporations can have shareholders all over the world (unless its an S corporation, which can have a maximum of 75 shareholders, who must not be resident aliens or foreign citizens). The trend seems that the organization/operation of corporations/LLCs is becoming more userfriendly. The Minute Book and Notes on Formality: Bylaws generally follow the statutes of the corresponding state. In the past, if a corporation failed to follow the formalities, the court would disregard its existence as a corporation, and would instead deem it as a general partnership or sole proprietorship. Now its different because a corporation can have only one shareholder, officer, and there is no real need for meetings with one person. But there should be some kind of formality followed: No real need for internal rules (e.g. bylaws) in this context. But external rules regarding the entitys relations with the public does need to be established. Also, a separate, corporate bank account should be employed. Pay any bills in the corporate name too. (The bank account will be made in the name of the corporation.) Any money received by the corporation should be deposited into this account. A corporate tax return should be filed. Any agreement entered into with a third party should be entered into on behalf of the corporation, not the individual, and signed for on behalf of the corporation (accomplish this by signing the corporate name: ABC, Inc. by J. Smith, President; sign it in your official capacity). You have to have a written document

Formation of a Closely-Held Corporation: Closely-held is held by a small number of owners; generally regarded as a small group that can make decisions sitting together at a table. If the corporation is closely-held and its business is to be conducted largely or entirely within a single state, local incorporation is almost always to be preferred (instead of DE). Delaware had some rules that were favorable to the operators of a corporation; i.e. favorable to directors and officers: gave them more power. Other good reasons: If a CEO violates his duty and the directors refuse to file suit against him, the shareholders can bring a derivative suit, on behalf of the corporation, against the CEO. Its harder for them to do this in Delaware, leading many people to incorporate there. Other states wised up to this, and now the laws are all pretty much uniform. There is also a huge body of law in Delaware regarding shareholders and directors, so a person wanting to incorporate can determine with some degree of certainty the outcome of litigation, should it arise (there is not much case law regarding LLCs, throughout the U.S., because they are so new). Delaware also has a very astute bar and judiciary, concerning business cases. This also leads to faster disposition of cases there (which again makes DE more favorable). How to Incorporate: Pretty much taken over by the online process. But you still must have: A paper naming the directors, officers. Stock certificates (saying that the shareholders have been issued these shares; the shareholders will maintain their certificates, but the INC has to issue them). Bylaws Up until 20-30 years ago, if you had a stated purpose in the articles of incorporation, and you acted outside the scope of that written purpose, you could be subject to a lawsuit brought by your shareholders; also, the non-authorized act is voidable (doctrine of ultra vires). But that is not so anymore. The registered agent is the only person who has to have an address in the state of incorporation. There must also be at least one share of stock to be distributed. 4.01(b): A corporate name must be distinguishable upon the records of the secretary of state from other corporate names. 3.02 automatically grants every corporation perpetual duration and succession in its corporate name unless the articles of incorporation provide otherwise.

Piercing the Corporate Veil, or Disregarding the Corporate Entity:

Generally, this is a hard case to make. It is illogical in many ways, particularly given the fact that corporations have gotten very informal (see above). A corporation doesnt want to put itself at risk for a particular activity; they would then set up a subsidiary corporation (the justification for this is that if a corporation could not set up a subsidiary and thus shield itself from liability, then it would be very unwilling to take risks (because of possible exposure of liability to the parent), which are crucial for the enhancement/development of business and the market). The doctrine of piercing the corporate veil is invoked to prevent fraud or to achieve equity.

 This doctrine is entirely a phenomenon of closely-held corporations, and predominantly oneperson corporations. The corporate form is simply never pierced so as to impose liability on publicly-traded corporations. If the veil is pierced, it may only apply to one shareholder, not all. This doctrine is unclear, so its hard to advise a client. No corporate veil has been pierced for a corporation with more than 9 shareholders, and it has never been pierced in a publicly-held company. Arises in two types of cases: Contract situation where a creditor loans money or does business with the entity, and the entity doesnt live up to its end of the contract. Tort cases: where the conduct of a corporation, through its employees, causes a person to be injured. Dewitt Factors: *Failure to follow corporate formalities Undercapitalized (this is really insolvency at the beginning/foundation) In a contractual relationship, the creditor should do some research into the finances of the corporation with whom he is entering. For torts cases, there is no such opportunity for research, investigation into the companys financial fitness: i.e. a customer drinking in a bar has no idea of the finances of that company, typically (so this factor is probably stronger in a torts case). This could be a strong factor, as it could suggest that the purpose was to commit fraud, or something else illegal, from the companys beginning. *Failure to pay dividends Companys insolvency (if this is after the fact then its irrelevant; no court will second guess the business decisions of the officers/directors, as long as they made their decisions in good faith: business-judgment rule) Siphoning of funds (the company can become insolvent because of the directors/officers siphoning off the funds) *Non-functioning of officers/directors *Absence of record Is the corporation a facade (i.e. is it a front to do something else)? (This seems to resemble fraud or illegality, for which the corporate veil does not need to be punctured, because the wrongdoer is personally liable anyways. So this is relevant if the company was established as a facade from the beginning.) All the *s demonstrate that the corporation is not acting as such, and the court will not treat it like a corporation if it doesnt treat itself like one. Bartle v. Home Owners Co-Op: Defendant set up a subsidiary, WesterleaBldgs, Inc. A co-op has shareholders. All the shares of the subsidiary are owned by the co-op (its parent company). If the subsidiary screws up, then Home Owners could not be held liable. General Rule: The shareholders of a corporation are not liable for the corporations debts. The only person liable is the corporation (here the subsidiary) itself. Suppose an officer of a company commits fraud; there is no need to pierce the corporate veil here. The lawsuit can be filed directly against the person committing the fraud. But if the

company knows it has potential liabilities, and then disposes of its assets (making it essentially judgment proof), then they could be sued for fraud, probably. (but there is no hard and fast rule) Undercapitalization (not putting enough money into a corporation) is a factor in deciding whether to pierce the veil (but who is to say how much money is needed to start a corporation?) Lack of formality is another factor. Dewitt Truck Brokers v. Flemming: In an appropriate case and in furtherance of the ends of justice, the corporate veil will be pierced and its shareholders will be treated as identical to the corporation. Proof of plain fraud is not a necessary element in a finding to disregard the corporate entity. The mere fact that all or almost all of the corporate stock is owned by one individual or a few individuals, will not afford sufficient grounds for disregarding the corporation. But when substantial ownership of all the stock of a corporation in a single individual is combined with other factors clearly supporting disregard of the corporate fiction on grounds of fundamental equity and fairness, courts have experienced little difficulty and have shown no hesitancy in applying what is described as the alter ego or instrumentality theory in order to cast aside the corporate shield and to fasten liability on the individual stockholder. Other factors emphasized in the application of the doctrine are: Failure to observe corporate formalities Non-payment of dividends The insolvency of the debtor corporation at the time Siphoning of funds of the corporation by the dominant shareholder Non-functioning of other officers or directors Absence of corporate records, and The fact that the corporation is merely a facade for the operations of the dominant shareholder(s). The decision to disregard the corporate entity may not, however, rest on a single factor...but must involve a number of such factors; in addition, it must present an element of injustice or fundamental unfairness. When one, who is the sole beneficiary of a corporations operations and who dominates it, induces a creditor to extend credit to the corporation on such an assurance as given here, that fact has been considered by many authorities [as a]sufficient basis for piercing the corporate veil. Here, Flemming is the single owner/shareholder of the company. He commingles funds, says there is a 10% partner but cant name him. The reasons for piercing here are: Failure to observe corporate formalities No one received a salary or dividends because there were no other officers or directors Insolvency of the corporation He siphoned funds (This case presents a blending of the very factors which courts have regarded as justifying a disregard of the corporate entity in furtherance of basic and fundamental fairness.) Baatz v. Arrow Bar: Here Plaintiffs were badly injured in a car accident caused by an uninsured drunk driver.

 Plaintiffs sue the bar that served the alcohol to the already-intoxicated driver (under most state law, the bar would be liable for injuries caused by the drunk driver under a dram shop claim.) The Arrow Bar has no dram shop insurance, though. Plaintiffs then try to take a shot at the individual owners of the corporation by piercing the corporate veil. The issue was whether the corporate veil should be pierced. The bar started with $150K put into the company: $5K from the individuals, and $145K borrowed from the bank. The $145K was personally guaranteed by the individuals, but it was still in the company. (This doesnt seem undercapitalized) Courts are very reluctant to disregard the corporate entity because it essentially undermines many laws upholding/establishing the validity of a corporate entity. Radaszewski v. Telecom Corp.: Plaintiff was injured by a driver of Contrux, Inc., a subsidiary of Telecom. General Rule: Anyone injured by an act of an employee (negligence for example) can recover from the employee and/or his employer (exceptions exist). What if Telecom put no money in Contrux, but bought $10M of liability insurance; would this be considered undercapitalization? Under the contracts realm there might be a problem with undercapitalization, but with a tort situation it would be okay because there exists $10M in insurance. The problem here was jurisdiction over Telecom; the claim arose out of Missouri law, where Contrux was considered a resident. The only way to bring Telecom in (hale them into court) was to pierce the corporate veil. Three Part Test for Piercing the Corporate Veil: (one must show these to pierce) Control, not mere majority or complete stock control, but complete domination, not only of finances, but of policy and business practice in respect to the transaction attacked so that the corporate entity as to this transaction had at the time no separate mind, will, existence of its own, and Such control must have been used by the defendant to commit fraud or wrong, to perpetrate the violation of a statutory or other positive legal duty, or dishonest and unjust act in contravention of plaintiffs legal rights (the creation of an undercapitalized subsidiary justifies the inference that the parent is either deliberately or recklessly creating a business that will not be able to pay its bills or satisfy judgments against it; i.e.- undercapitalization supports an inference that the purpose was to commit fraud or something else illegal or inconsistent with sound business practices), and The aforesaid control and breach of duty must proximately cause the injury or unjust loss complained of. United States v. Bestfoods: Whether acquisition of a company that had previously polluted an area makes the parent company liable for the cost to clean up the pollution. The only way they could be liable is if the parent company is directly involved in whats going on, because then it could be deemed an operator. If the parent company is disregarding the corporate entity, and controlling everything itself, then it could be labeled as an operator. Rules: The corporate veil may be pierced and the shareholder held liable for the corporations conduct when, inter alia, the corporate form would otherwise be misused to accomplish certain wrongful purposes, most notably fraud, on the shareholders behalf.

 If a subsidiary that operates, but does not own a facility is so pervasively controlled by its parent for a sufficiently improper purpose to warrant veil piercing, the parent may be held derivatively liable for the subsidiarys acts as an operator. Directors and officers holding positions with a parent and its subsidiary can and do change hats to represent the two corporations separately, despite their common ownership...courts generally presume that the directors are wearing their subsidiary hats and not their parent hats when acting for the subsidiary.

Financial Matters and the Corporation:

The financing firms use to fund their business activities is called capital. Two kinds of financial capital: Debt, AND Equity Debt and Equity Capital: Debt is associated with the idea of borrowing; at some point, it must be repaid, and repayment is not contingent on the success of the business. It also contains the cost (really a fee) associated with the use of the money (i.e., interest). Debt claims are sometimes referred to as fixed claims, meaning that claimants are entitled to be repaid the principal and interest owed to them on the loans they have made (no matter what the financial status of the company). The loan agreement lays out the terms of the loan. Specifies where payments are to be made, how made, including financial promises (e.g., the company has to maintain certain ratio with respect to debt and assets, or they have to maintain a certain cash flow). A promissory note says that the borrower owes the lender the money, at a specified interest; if the borrower defaults the lender can present this note directly to a court and get a judgment against the borrower (sometimes the very same day). A security agreement says that all the particular items (i.e., collateral) are given to the bank to guarantee that the loan will be paid; if not, the lender has the right to take the collateral. The primary motive for lending is to make money (get a return on the investment). Quickest way to make as much money as possible? Make a wager, place bets. However, much more risk is involved here. Putting money into a business, in terms of a risk-reward analysis, is much the same. Corporations can issue a corporate bond in order to borrow money from the public. It will be protected by the assets of the company; the risk is minimal, but, consequently, so is the reward. Interest is earned on the bond (4-5%), however, as a fee for the corporations ability to use the money (b/c this is essentially a loan). If you want to make the most money, but take the highest risk, you would purchase common stock. This is not a loan; rather, it is equity in the company. Equity, however, is synonymous with ownership (rather than being paid back, they take a piece of the ownership, and are subjected to the same fate as the other owners; if the company fails, so do they and their investment is lost). The value of an owners equity in a piece of property equals the market value of that property minus the market value of the debts that are liens against that property (i.e. equity= FMV of assets - debts).

 Equity claims are referred to as residual claims to connote the idea residual claimants (equity owners) have a claim on everything that is left over after the fixed claimants have been paid. The Securities Act of 1933 imposes substantial disclosure requirements on the public sale of securities using the mail or the facilities of interstate commerce. Types of Equity Shares: MBCA 1.40(22) defines shares as units into which the proprietary interests in a corporation are divided. A corporation may create and issue different classes of shares with different preferences, limitations, and relative rights. MBCA 6.01(b) sets forth 2 fundamental rights of holders of common shares: They are entitled to vote for the election of directors and on other matter coming before the shareholders, AND They are entitled to the net assets of the corporation (after making allowance for debts), when distributions are made in the form of dividends or liquidating distributions. Common and Preferred Shares: If a corporation has more than one class of shares, a customary distinction is between common shares and preferred shares (the MBCA uses neither of these terms, but they are ubiquitous throughout the business context). Common Shareholders: Have the fundamental right of voting for directors and receiving net assets, as outlined above. Have a right to inspect the books and records (MBCA 16.02) Have a right to sue on behalf of the corporation to right a wrong committed against it (MBCA 7.40-7.47) Have a right to financial information (MBCA 16.20) Are part-owners of the residual value of the company. Are the last party that gets a piece of the company; if the company fails, they will be the last ones paid (the bond-holders will be the first paid, then the creditors, etc.), so there might not be anything left. The Supreme Court identified the characteristics usually associated with common stocks as: The right to receive dividends contingent upon an apportionment of profits Negotiability (capable of being transferred by delivery or endorsement when the transferee takes the instrument for value, in good faith, and without notice of conflicting title claims or defenses) The ability to be pledged or hypothecated (ability to be pledged as security or collateral for a debt, without delivery of title or possession) The conferring of voting rights in proportion to the number of shares owned, AND The capacity to increase in value Whatever the niceties of definition, because common shares represent the residual interest in the corporation, their financial interest is open-ended in the sense that they benefit as the business prospers and the corporate assets increase. Preferred Shares: Have rights that are preferential to those assigned to the common shares, but are limited in some way. Usually, but not always, non-voting.

 Entitle the holders to a priority or preference in payment as against the holders of common shares. i.e. the holders of preferred shares are entitled to specified distribution before anything can be paid on the common shares. The precise scope of the preferred shareholder is traditionally established by detailed provisions in the articles of corporation. Generally, with a preferred stock the reward is higher, but the risk is also higher (because it comes after a debenture in priority). There are no rules on preferred stock; they can be designed however the corporation elects (same with junk bonds). Other Instruments for Investing in a Company: Debenture: really another debt instrument: it must be paid back. It differs from a bond in that a debenture is unsecured (there is no mortgage on the property of the company), and because of this the risk factor is higher than a typical bond. But concomitant with that higher risk is also a higher reward (the interest rate is typically higher for these than for bonds, usually about 6-9%). Junk Bond: an investment device purporting to be a bond (in that it has to be repaid), but it is not secured, and carries more risk than a debenture; but it also pays a pretty good return (1315%). Also contains a convertible provision to convert to common stock (also referred to as high-yield bonds). These were used in the mid-80s to take over companies. Dividends and Distributions: A dividend is a distribution from current or retained earnings. Distributions are payments to shareholders out of the corporations capital. Typically, common shareholders have no legal basis for complaint if distributions or dividends on common shares are omitted over extended periods of time. The MBCA currently does not have a minimum capital requirement. Special Rights of Publicly-Traded Preferred Shares: A cumulative dividend means that if a preferred dividend is not paid in any year, it accumulates and must be paid (along with the following years unpaid cumulative dividends) before any dividend is paid on the common shares in a later year. A non-cumulative dividend is not carried over from one year to the next; if no dividend is declared during the year, the preferred shareholder loses the right to receive the dividend for that year. A partially-cumulative dividend typically is cumulative to the extent there are earnings in the year, and non-cumulative with respect to any excess dividend preference. Unpaid cumulative dividends are not debts of the corporation, but a right of priority in future distributions. Typically, publicly-traded preferred shares have cumulative dividend rights. Preferred shares also have a liquidation preference, which is often fixed at a specified price per share, payable upon the dissolution of the corporation before anything paid out to the common shares. Preferred shares may be redeemable at the option of the corporation, usually at a price fixed by the articles of incorporation. The corporation has the power to buy back the redeemable shares at any time at the fixed price, and the shareholder has no choice but to accept that price. Typically, the power to redeem (call) shares may only be exercised after a specified period of time.

The redemption price is usually set somewhat in excess of the amount of the shares liquidation preference. Preferred shares may be made convertible at the option of the holder into common shares at a fixed ratio specified in the articles of incorporation. Typically the conversion ratio is established so that the common shares must appreciate substantially in price before it is profitable to convert the preferred shares. Convertible shares are also usually redeemable, but typically the power to convert continues for a limited period of time after the call for redemption. A conversion is forced when shares are called for redemption at a time when the market value of the shares obtainable on conversion exceeds the redemption price. Sometimes, the corporation will write the conversion provision such that the right to convert may expire after a specified period of time. The corporation and the holder will engage in negotiations regarding the terms/provisions of the stocks, before they are purchased/issued. Preferred shares may also have certain financial protections. Example: sinking fund provisions require the corporation to set aside a certain amount each year to redeem a specified portion of the preferred stock issue. The preferred shares described above are non-participating, which are entitled to the specified dividend payment and the specified liquidation preference, and nothing more no matter how profitable the corporation. Participating preferred shares are entitled to the specified dividend and, after the common shares receive a specified amount, they share with the common in additional distributions on some predetermined basis. They also usually have liquidation preferences that are tied in some way to the amounts receivable by the common shares on liquidation. A corporation may issue different classes of preferred shares. Because of the difficulties inherent in raising substantial amounts of capital, some states authorized the creation of a class of preferred shares that contained no financial terms at all but authorized the board of directors to carve out different series of shares from within the class, and designate the financial terms of each series when it was issued. Preferred shares for which the board of directors is authorized to establish terms are often called blank shares.

Evaluating a Company Before Investing (in order to Minimize Risk): Concept + Capital + Plan= Money Concept is essentially what the business does; a potential investor would want to know about the products, services, target market (who the products are pitched to; an investor wants an expanding, rather than a stagnant or shrinking, target market), supplies, competition, delivery mechanism of the products, regulation of the particular industry. Capital: Human, and An investor would want to know about the owners/managers, their reputations, their dispositions, before giving them money. Financial An investor would want to know what kind of money/funds the company has on hands. An investor would also want to know how the company is going to use its money to turn the concept into a money-maker. Plan: financial projections will be provided by the company to the investor to indicate (assume) where the company is going (or plans to go); essentially this is what the company plans to do

with the money. Companies usually promulgate five-year plans. This projection is an estimate, and gives the investor a clearer picture of the company. The investor would also examine the historical financial status of the company. After considering all these factors, a potential investor will decide whether to expend money (and take the risk) to join the venture, or not. (This is also a good mechanism for deciding whether to join a law firm, or other prospective business.) **Note for the Final: Know the instruments (corporate bonds, debentures, preferred stock, common stock) used to raise corporate capital, ranking them in terms of risk and reward, and the rights inherent to each. LLCs dont sell stock; they can sell memberships, but this creates a potential for cumbersome problems. In FL, a corporation with 100 or less shareholders can elect to be a small company, eschewing the restrictions and, more importantly, the formalities incumbent on a large corporation. Public Offerings: The principal benefit of going public is to raise additional capital for expansion. Going public has the advantage of reducing a corporations debt to rely on bank debt. How to Define a Public Company: Stock is held by a wide number of people or institutions in the public. The securities are registered with the SEC. Those holding stock generally are not involved in the day-to-day operation. Subject to public disclosure (shareholders have a right to inspect the books) Its shares are regularly traded on a stock-exchange (NYSE is the biggest) Shares traded by the public are called the public float. It is illegal for companies to sell stocks to the public for the first time without registering them. The Securities Act was passed in 1933 as a response to (the ambivalence--indolence?--by the federal government regarding stock fraud leading--somewhat--to) the Great Depression. (Over the past 20 years, the most significant legislation promulgated by the federal government regards the regulation of these agencies; i.e. SEC laws, regulations.) The SA of 1933 required disclosure: if a company gives everyone information (concept + capital + plan), then it can sell stocks to the general public. If the company screws up, then the company, the lawyers, and the accountants will be liable (ergo, lawyers practicing in securities must carry significant amounts of malpractice insurance). The government passed Regulation A to help big businesses. Regulation D is an exemption for the registration process, promulgated by the government in an effort to promote small businesses, if certain mandates are met. Rule 147 exempts a company from the federal scheme if they can confine their sales of stock only to residents of that state (every state has a securities law). (These regulations apply to bonds and debentures too). Why take a company public? Advantages: Opportunity to acquire much more capital (probably have to raise $10M or more to make it worth it). Get better employees (stock-options can be offered as incentives to prospective employees, especially those in senior or high positions, and because the company will be better known)

Funds acquired by a corporation in an IPO sometimes are employed to acquire other companies (e.g., AOL and Time Warner merger with stock-swapping and no trading of actual money; Terex bought company for $25M and offered $15M in stocks, the value of which would go up upon announcement of Terexs takeover). Provides liquidity; its rather easy to sell stock of a publicly-traded company: call the broker. Even if the company is doing really well, a shareholder can, if he or she so desires, sell the stock. Two Bites at the Apple: can make money by selling the companys product and by selling the companys stock. Negatives: Disclosure (once a company goes public, every quarter it must send the SEC a report of the financial activities for the prior quarter.) Potential for insider trading violations, or allegations. Pressure on the company to perform (everyone is on managements case; long-term is considered 90 days: the quarter.) Dow Jones: the number is the aggregate of the cost of the top-30 companies shares. Market cap: take the share price today and multiply that by all the shares that are in the public; this will give you the market value of the company. Prior to an IPO, management will have to clean up its balance sheet. The company is strictly liable under Section 11 of the Securities Act of 1933 for material misstatements and omissions in the Registration Statement (which contains the prospectus and other documents that must be filed with the SEC before the company may make an IPO). Even after a company goes public, it must file quarterly and annual financial reports under the Securities Exchange Act and comply with strict internal accounting control measures and recordkeeping requirements. Congress decided to forgo the states blue sky law system of a merit approach, opting instead for full disclosure (the theory is that investors are adequately protected if all aspects of the securities being marketed are fully and fairly disclosed and thus there is no need for the more time-consuming merit analysis of the securities...) The Securities Act of 1933 contains a number of private remedies for investors who are injured due to violations of the Act. The most important remedy follows: Section 11 permits purchasers of securities in a registered offering to bring suits for losses incurred if the prospectus contains misleading statements of material facts. Reliance by the purchaser on the false statements is not required, but a purchaser cannot recover if he or she knew of the misstatement when making the purchase. The issuer is strictly liable under Section 11.

Dow Jones Industrial Average: Made up of 30 of the nations top companies. The number is the weighted average of the combined prices of all the stocks. Combined value of all 30 is the average. Each company is weighted based on its market capitalization. Stock Characteristics: EPS means earnings per share. Divide the price of the share by the EPS to get the price to earning ratio (P/E).

Federal Government: Generally assumes a protective role, implemented through disclosure mechanisms. A full disclosure allows the purchaser to make an educated, informed decision in buying the stock. Concept + Capital +Plan (there are 27 items, but basically they represent this formula). This is extremely expensive, so the government made it easier for small businesses. The Securities Act did create some exemptions, though: Purely local transactions between a local company and the residents of the state. (a FL company sells stocks only to FL residents, it would be governed by FL law, which stipulates--like the federal statute--that full disclosure is required). Regulation D: sets up certain criteria for an exemption from full disclosure. If we are going to sell to an accredited investor (esp. under (5) & (6)) we dont have to fully disclose. If selling to others, you have to give the information to the purchaser (a prospectus, although some lawyers call it a private placement memorandum), but dont have to file it. There can only be 35 purchasers (not including accredited investors; (e) below calculates the number of purchasers) The federal government stepped in to regulate the trading of stocks after the crash in 1929. Contracts are typically regulated/governed by the state and state law. Securities Act of 1933: Accredited investor under 230.501: Accredited investor. Accredited investor shall mean any person who comes within any of the following categories, or who the issuer reasonably believes comes within any of the following categories, at the time of the sale of the securities to that person: (1) Any bank as defined in section 3(a)(2) of the Act, or any savings and loan association or other institution as defined in section 3(a)(5)(A) of the Act whether acting in its individual or fi- duciary capacity; any broker or dealer registered pursuant to section 15 of the Securities Exchange Act of 1934; any insurance company as defined in section 2(13) of the Act; any investment company registered under the Investment Company Act of 1940 or a business development company as defined in section 2(a)(48) of that Act; any Small Business Investment Company licensed by the U.S. Small Business Administration under section 301(c) or (d) of the Small Business Investment Act of 1958; any plan established and maintained by a state, its political subdivisions, or any agency or instrumentality of a state or its political subdivisions, for the benefit of its employees, if such plan has total assets in excess of $5,000,000; any employee benefit plan within the meaning of the Employee Retirement Income Security Act of 1974 if the investment decision is made by a plan fiduciary, as defined in section 3(21) of such act, which is either a bank, savings and loan association, insurance company, or registered investment adviser, or if the employee benefit plan has total assets in excess of $5,000,000 or, if a self-directed plan, with investment decisions made solely by persons that are accredited investors; (2) Any private business development company as defined in section 202(a)(22) of the Investment Advisers Act of 1940; (3) Any organization described in section 501(c)(3) of the Internal Revenue Code, corporation, Massachusetts or similar business trust, or partnership, not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5,000,000;

(4) Any director, executive officer, or general partner of the issuer of the securities being offered or sold, or any director, executive officer, or general partner of a general partner of that issuer; (5) Any natural person whose individual net worth, or joint net worth with that persons spouse, at the time of his purchase exceeds $1,000,000; (6) Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that persons spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year; (7) Any trust, with total assets in excess of $5,000,000, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a sophisticated person as de- scribed in 230.506(b)(2)(ii); and (8) Any entity in which all of the equity owners are accredited investors. (The key to this concept is that they dont really need the protection of full disclosure. Ostensibly, an accredited investor will know what to look/ask for. Some of these are quite vulnerable, though. They also dont count as part of the 35 purchasers allowed under the regulation. Look to (e): (e) Calculation of number of purchasers. For purposes of calculating the number of purchasers under 230.505(b) and 230.506(b) only, the following shall apply: (1) The following purchasers shall be excluded: (i) Any relative, spouse or relative of the spouse of a purchaser who has the same principal residence as the purchaser; (ii) Any trust or estate in which a purchaser and any of the persons related to him as specified in paragraph (e)(1)(i) or (e)(1)(iii) of this section collectively have more than 50 percent of the beneficial interest (excluding contingent interests); (iii) Any corporation or other organization of which a purchaser and any of the persons related to him as specified in paragraph (e)(1)(i) or (e)(1)(ii) of this section collectively are beneficial owners of more than 50 percent of the equity securities (excluding directors qualifying shares) or equity interests; and (iv) Any accredited investor. Conditions to be Met: 230.502: (d) Limitations on resale. Securities acquired in a transaction under Reg. D...cannot be resold without registration under the Act or an exemption therefrom: There is a period of time in which the purchaser cannot resell it (Rule 144). This restriction goes away after a period of time (usually 2 years) if the purchaser is not involved in operating the company. There is a stamp on the stock stating that it is restricted. Generally the price is set in reference to the market (probably around half). 230.504: Exemption for Limited Offerings and Sales of Securities Not Exceeding $1M: (b) Conditions to be Met: 230.505: Exemption for Limited Offers and Sales of Securities Not Exceeding $5M: (b) Conditions to be Met: Aggregate offering price shall not exceed $5M No more than 35 purchasers 230.506: Exemption for Limited Offers and Sales Without Regard to Dollar Amount of Offering (i.e., no price cap):

 No more than 35 purchasers Nature of purchasers. Each purchaser who is not an accredited investor either alone or with his purchaser representative(s) has such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment, or the issuer reasonably believes immediately prior to making any sale that such purchaser comes within this description. 230.508: Insignificant Deviations from a Term, Condition, or Requirement of Reg. D: Failure to comply with a term, condition, or requirement of 230.504, -505, or -506 will not result in the loss of the exemption...if the person relying on the exemption shows: The failure to comply did not pertain to a term, condition, or requirement directly intended to protect that particular individual or entity, AND The failure to comply was insignificant with respect to the offering as a whole..., AND A good faith and reasonable attempt was made to comply with all applicable terms, conditions, and requirements. **Notes: Reg. D is an exemption from full disclosure. It is much easier to do this if the company is already up and running, but this does not have to be the case. Should give the private placement memorandum to purchasers to cover your 6, but you dont have to register/file it. Blue Sky Laws: When the states first saw unscrupulous promoters trying to sell stock in corporations, 1900-1910 or so, the states passed laws to control/regulate these practices. Essentially, the promoters were selling air: hence, blue sky. People were selling stock in gold mines, asserting that infinite gold was within, when there was nothing. The states can regulate on-going relationships. The rights of shareholders with respect to a company, or the rights of directors of a company. States can regulate beyond who can sell. The federal government, pursuant to the Constitution, cannot and has never regulated this. States also have the power to license corporations, settle disputes among shareholders, and to enforce/recognize contracts. Distributions by a Closely-Held Corporation: How can the company distribute its profits? A dividend: giving the surplus back to the stockholders. We generally consider dividends as a share of the profits, given to the shareholders in proportion to the amount of stock owned. Dividends are taxed as gross income (remember the concept of double taxation). Might give some of it as bonuses. A way of avoiding double tax is to have no profit on the corporate level, and bonuses (usually for the shareholders who are also directors) provide a way to utilize this: the process of doing this is called zeroing out. What if there is no profit, but there is still money in the bank account? What if the company gives the money to its shareholders, but still has corporate debts? The officers and directors cannot be sued, and neither can the corporation, nor its shareholders. This prompted the government to pass laws regarding how a corporation may distribute its profits.

Gottfried v. Gottfried: Closely-held corporation owned by a family, operating two businesses: Gottfried Baking Corporation, and Hanscom, a subsidiary of Gottfried Baking Corp. The plaintiffs are minority shareholders who have not been given a dividend, and want their share of the profits. Rules: If an adequate corporate surplus is available for the purpose, corporate directors may not without the declaration of dividends in bad faith. But the mere existence of an adequate corporate surplus is not sufficient to invoke court action to compel such a dividend. There must also be bad faith on the part of the directors. The following factors are relevant to the issue of bad faith and are admissible in evidence: Intense hostility of the controlling faction against the minority Exclusion of the minority from employment by the corporation High salaries, or bonuses or corporate loans made to the officers in control The fact that the majority group may be subject to high personal income taxes if substantial dividends are paid The existence of a desire by the controlling directors to acquire the minority stock interests as cheaply as possible But if they [these factors] are not motivating causes [for withholding a dividend] they do not constitute bad faith as a matter of law. The essential test of bad faith is to determine whether the policy of the directors is dictated by their personal interests rather than the corporate welfare. i.e., Bad Faith: a director/officer acting for personal reasons rather than what is in the best interest of the corporation. This is the bedrock of determining bad faith. The Business Judgment Rule: The court will not substitute its judgment for that of the board of directors if made in good faith, even if the decision turns out bad or detrimental for the corporation. So the only way to get a court to examine/question the judgment of the directors/officers is to prove they acted in bad faith. The excess of assets over liabilities in the corporate context is called owners equity; in the personal realm it is called net worth. The problem in this case is that the majority shareholders (owning 62%) were also the directors and officers, and were essentially zeroing out the minority shareholders (owning 38%), because the majority wanted to force/squeeze them out. The court found that the majority shareholders did not act in bad faith. Expenditures were for the retirement of preferred stock, meaning they cashed them out (e.g., say there was $150K of preferred stock; cashing them out means the company used its own funds to procure that $150K worth of stock). Here, the plaintiffs were the beneficiaries, because they held the preferred stock which the company purchased back from them. So if the majority wanted to screw them, they could have, and ostensibly would have, done it then. A dividend was paid out in the year following the commencement of the lawsuit (while it was still going). Dodge v. Ford Motor Co.: The Dodge brothers were given stock (10%) during the inception of Ford Motor Company because Henry did not have enough capital to pay them for making engines for him. They wanted their dividends because they wanted to start their own car corporation; once they were to receive their

dividend, they would resign from the board (thus, not violating the duty of loyalty) and form their own company. Ford Motor Company has assets of $132M, liabilities of $20M, with equity then being $112M. They also made profits in the year of 1916 in the amount of $60M. Henry thought the company made too much money. He thought the company was becoming embarrassingly large. He wanted to reduce the price of the cars, but how would this hurt profits? Because you still have to manufacture it at the same cost, so if he drops the price, the profit will be reduced accordingly. He wanted to reduce the costs so many Americans can buy it, as well as his employees. But if he reduces the price, he is really increasing profits because he is doubling his sales: many more people will buy a Model T because it is cheaper. He also wanted to make more cars (and therefore employ more people, who worked in shifts). He increased the wages of the factory workers and reduced their hours, in order to stop/stall high turnover rates. After this, people flocked to Detroit to work in his factories. He also wanted to make a smelting plant so the company could manufacture/mine its own steel. He also wanted to expand the car plant so they could make the increased inventory of cars he desired. Rules: A business corporation is organized and carried on primarily for the profit of the stockholders. The powers of the directors are to be employed for that end. The discretion of directors is to be exercised in the choice of means to attain that end, and does not extend to a change in the end itself, to the reduction of profits, or to the non-distribution of profits among stockholders in order to devote them to other purposes. It is not within the lawful powers of a board of directors to shape and conduct the affairs of a corporation for the merely incidental benefit of shareholders and for the primary purpose of benefitting others. The Court ruled that sufficient money for the dividend existed, but they found that Henry had good intentions and put the public in front of his shareholders, but that it wasnt bad faith. How can we reconcile this? The public doesnt come first is what the court says; the corporation comes first. The best interests of the corporation (i.e., really the best interests of the shareholders) come first. Henry wasnt acting in bad faith, per se, but his rationale was erroneous. So a dividend had to be paid to the Dodge brothers. Other Constituency Statues have emerged from this case (even though the court did not imply or insinuate this concept). These statutes state: A director, when making a corporate decision, can take into consideration the effect on certain other constituencies (such as the community where the plant/corporation is located, its employees, its suppliers, its creditors). If they took these into consideration, along with whats in the best interest of the corporation, how would this effect the decision to move a plant from PA to AL, because AL will provide a lot of money for the plant, and doesnt have unions? If this is decision a director makes, it probably is in the best interest of the corporation, but probably not in the best interest of the community, the employees, the suppliers, etc.: the other constituents. The states passed these laws in response to takeover movements in the 1980s. A group of venture capitalists would offer to buy out the shareholders of the company. The directors want to fight the takeover attempt. If they dont have any excuse for making the decision to fight the takeover, they are essentially acting in bad faith. But these laws give them leverage to combat a takeover attempt. (These laws have not really been utilized, though.) *You cant use a company for your own personal reasons!

Regulation D Offerings
Under the Securities Act of 1933, any offer to sell securities must either be registered with the SEC or meet an exemption. Regulation D (or Reg D) contains three rules providing exemptions from the registration requirements, allowing some companies to offer and sell their securities without having to register the securities with the SEC. For more information about these exemptions, read our publications on Rules 504, 505, and 506 of Regulation D. While companies using a Reg D (17 CFR 230.501 et seq.) exemption do not have to register their securities and usually do not have to file reports with the SEC, they must file whats known as a "Form D" after they first sell their securities. Form D is a brief notice that includes the names and addresses of the companys executive officers and stock promoters, but contains little other information about the company. Rule 504 of Regulation D Rule 504 of Regulation D provides an exemption from the registration requirements of the federal securities laws for some companies when they offer and sell up to $1,000,000 of their securities in any 12-month period. A company can use this exemption so long as it is not a blank check company and does not have to file reports under the Securities Exchange Act of 1934. Also, the exemption generally does not allow companies to solicit or advertise their securities to the public, and purchasers receive "restricted" securities, meaning that they may not sell the securities without registration or an applicable exemption. Rule 505 of Regulation D Rule 505 of Regulation D allows some companies offering their securities to have those securities exempted from the registration requirements of the federal securities laws. To qualify for this exemption, a company:
y y

y y

Can only offer and sell up to $5 million of its securities in any 12-month period; May sell to an unlimited number of "accredited investors" and up to 35 other persons who do not need to satisfy the sophistication or wealth standards associated with other exemptions; Must inform purchasers that they receive "restricted" securities, meaning that the securities cannot be sold for six months or longer without registering them; and Cannot use general solicitation or advertising to sell the securities.

Management and Control of a Corporation:

Traditional Roles of Shareholders and Directors: Three groups of people key to the internal operation of a corporation: Shareholders (in an LLC: members): owners; have specific rights; one of the primary rights is to elect directors. Rights to view the books. Rights to the residual value of the entity. Right to vote. Directors: act as a board; they dont have any authority individually; they are charged with managing the business of the corporation (statutorily), and making the major decisions, such as policy, etc.; they arent involved in the day-to-day operations; they elect officers to deal with day-to-day operations; they dont have to tell officers every day what the officers should do, but when they appoint an officer, they give him a job description describing his authority: i.e., his actual authority is given in his job description. Officers: they carry out the instructions and orders of the board of directors; they usually have the day-to-day function; the officers actual authority is usually included in the job description given by the directors; if the officer goes beyond his job description (i.e., exceeds his actual authority), this would be outside the authority vested to him. A third party might reasonably believe that the officer has this authority though (apparent authority); in this case, the action will bind the corporation. Shareholders vote according to their interests: if a shareholder has 45% of the shares, he has 45% of the votes (usually one vote per share). A board of directors will vote per capita: one vote per person. Same in a partnership; if voting differently, have written agreement evidencing it. McQuade v. Stoneham: (1934, C.O.A. NY) Directors are the exclusive representatives of the corporation, charged with administration of its internal affairs and the management and use of its assets. They manage the business of the corporation. An agreement to continue a man as president is dependent upon his continued loyalty to the interests of the corporation. (quotingFells v. Katz) An agreement among stockholders where by it is attempted to divest the directors of their power to discharge an unfaithful employee of the corporation[,] is illegal as against public policy...stockholders may not, by agreement among themselves, control the directors in the exercise of the judgment vested in them by virtue of their office to elect officers and fix salaries. Directors may not by agreements entered into as stockholders abrogate their independent judgment. Stockholders may combine to elect directors. The power to unite is limited to the election of directors; it does not extend to contracts or other agreements whereby limitations are placed on the power of directors to manage the business of the corporation by the stockholders selection of agents at defined salaries. Public policy is a dangerous guide in determining the validity of a contract and courts should not interfere lightly with the freedom of competent parties to make their own contracts. The public policy invoked here is charged with protecting the directors ability to choose officers and set their salaries. The contract at issue here, with respect to who would be officers and how much

they would be paid, effectively negated the duties/roles of the directors. The action by the shareholders of enacting the agreement is outside their scope, which is traditionally limited to the election of directors. Everything back then was very formal. Any agreement limiting the directors ability to choose officers and provide for their salaries was held void. Shareholders, however, can agree to do what they have the legal right to do: elect directors. So shareholders can make any agreement they want regarding the election of directors, because it is their legal right. They can also fix the salaries of directors, usually a stipend these days. A trustee is held to something stricter than the morals of the market place. (quotingMeinhard v. Salmon) *Holding: A contract is illegal and void so far as it precludes the board of directors, at the risk of incurring legal liability, from changing officers, salaries, or policies, or retaining individuals in office, except by consent of the contracting parties. Notes: Shareholders vote by interest, not per capita. Traditionally the board of directors has been charged with the duty and responsibility of managing the business and affairs of the corporation, determining corporate policies, and selecting the officers and agents who carry on the detailed administration of the business. In large, publicly-held corporations, the role of directors has been increasingly seen as involving oversight and review rather than actual management. Most shareholder agreements are held valid. Arguments arise when the agreements infringe on the power of the directors, or which are related to matters like election which are reserved to the shareholders. Clark v. Dodge: Where the directors are the sole stockholders, there seems to be no objection to enforcing an agreement among them to vote for certain people as officers. Long Park v. Trenton: Where the powers of the directors over the management of [its theaters,] the principal business of the corporation are completely sterilized...such restrictions and limitations upon the powers of the directors are clearly in violation.... Galler v. Galler: (1964, S.C. Illinois) When dealing with a closely-held corporation, the law should afford different treatment and not treat them as harshly as the archaic laws mandate. We should give effect to shareholder agreements that dont hurt anyone. The power to invalidate the agreements on the grounds of public policy is so far reaching and so easily abused that it should be called into action to set aside or annul the solemn engagement of parties dealing on equal terms only in cases where the corrupt or dangerous tendency clearly and unequivocally appears upon the face of the agreement itself or is the necessary inference from the matters which are expressed, and the only apparent exception...is...in those cases where the agreement, though fair and unobjectionable on its face, is a part of a corrupt scheme and is made to disguise the real nature of the transaction. If the enforcement of a particular contract damages nobody--not even, in any perceptible degree, the public--one sees no reason for holding it illegal, even though it infringes on the general statute charging the boarding of directors with managing the business of a corporation.

 As the parties to the action are the complete owners of the corporation, there is no reason why the exercise of the power and discretion of the directors cannot be controlled by valid agreements between themselves, provided that the interests of creditors are not affected. (quotingClark v. Dodge) ...This court upheld an agreement entered into by all stockholders providing that certain parties would be elected to the offices of the corporation for a fixed period. Holding: ...The agreement, under the circumstances here present, is not vulnerable to the attacks made on it. Notes: Following Galler, statutes have developed in most states allowing closely held corporations to depart dramatically from the traditional statutory scheme of shareholders/directors/officers in specified circumstances: Modification of the Statutory Scheme by Provision in the Articles of Incorporation: About 30 states. The statute permits the authority normally placed in the board of directors to be vested in other persons or organizations by an appropriate provision in the articles of incorporation. Those persons or organizations then have the duties, responsibilities, and liabilities of directors. Integrated Close Corporation Statutes: About 17 states. Usually involves a numerical limit on the number of shareholders. The election to take advantage of the integrated close corporation statute is usually evidenced by a provision in the articles of incorporation stating this Corporation is a statutory close corporation. Some close corporation statutes permit a corporation to dispense with bylaws, annual meetings, and other formal requirements generally imposed on corporations. Shareholders can even agree to do away with a board of directors. MBCA 7.32 governs. In FL, if a corporation has 100 or less shareholders, and wants to limit the discretion of the board of directors, or eradicate them wholly, it can do this by an agreement of the shareholders; all the shareholders must agree. Once they all agree, they have the power to do whatever they lay out in the agreement. There must be a stamp on the front and/or back of the stock certificate stating that the corporation is subject to a shareholder agreement; this affords protection for a potential shareholder who wants to invest: if he sees the stock certificate, he has record notice of the shareholder agreement because it is stamped. This can be voided if the shareholder threshold is exceeded, or if the corporation went public. If the shares went public on an exchange, it would be impossible to give notice to the potential buyer: shares trading on a stock exchange have to be essentially clean shares. Zion v. Kurtz: Dealing with a situation in which the parties acted like they invoked this small corporation statute, but didnt sign the registration document they should have. The Court acknowledged that they committed a mere clerical error, and that the shareholder agreement should be upheld, especially because they intended it to be.

Shareholder Voting and Agreements: Shareholders can enter into any agreements they want with respect to their inherent rights, such as voting for directors; they cannot infringe on the rights of the directors. If an agreement exists, the stock certificate must state as such. The closely-held corporation also has rules for this: less than 100 shareholders, e.g. Salgo v. Matthews stands for the proposition that, for voting purposes, the parties entitled to vote for the shares are the ones of record on a particular date. Cumulative Voting: Some states used to mandate this; now its voluntary. A minority interest in a corporation may be able to get represented on a board by virtue of this concept of cumulative voting. Examples: In a corporation, A has 18 shares and gets 18 votes. B has 82 shares and thus 82 votes. There are 5 director positions available. They each cast their nominations for directors (5 each). If this is straight voting (one vote/share), we would vote this way for each vacancy, and B would be able to outvote A for every vacancy. This seems inequitable to a minority shareholder. How can a minority shareholder protect himself, then? Before paying for the shares, the minority shareholder should have a written agreement with the majority shareholders (which, e.g., perhaps provides that the majority will vote all its shares in favor of the minority having a seat as a director, or electing another director for a seat). For cumulative voting, you will tally up all the votes each person has: A has 18 votes for 5 directors, which equals 90 votes; B has 82 votes for 5 directors, which equals 410 cumulative votes. Now A can cast all 90 votes for himself; he is guaranteed that he can elect at least one director. A problem can arise when one party votes straight, and another party knows this and instead votes cumulatively, trying to usurp seats on the board. When this happens, a majority shareholder in the company might not be able to get a majority interest on the board. Formula for Determining the Number of Shares Needed to Elect 1 Director: (S/(D+1)) +1, where S equals the total number of shares voting, and D equals the number of directors to be elected. In the above example, the formula determines that A would need to vote at least 84 shares in order to elect one director: (500/(5+1)) +1= (500/6) +1= 84.3. Salgo v. Matthews: Who has the legal right to vote for the shares of a stock? Here, one of the holders of the stock went bankrupt. The stock is voted by whomever has the authority of the listed name; i.e., whoever has the name on the record stock of the company. It doesnt matter if he gives the stock away, as long as he remains the record holder (shareholder of record). Eligibility to vote at corporate elections is determined by the corporate records rather than by the ultimate judicial decision of beneficial title of disputed shares.... All that matters is who is the record shareholder on the date of the vote, or on the date the corporation gives notice that a vote is forthcoming. Deadlocks, Dissension, and Oppression:

Gearing v. Kelly: The clause as justice may require does not enlarge the courts power nor authorize it to grant different relief from that specified in the statute. The board in 1955 consisted of Meachem, Margaret Lee, and Kelly, Sr. There was a vacancy at this point, to which Kelly, Jr. was appointed. The majority says that Meachem really gave up control when Kelly, Jr. was appointed to the board in 1955, because the balance of power tips in favor of the Kellys. In 1961, Lee resigned and created a vacancy for the board. So now the Kellys can outvote her 2-1, and she can do nothing to stop it, except not showing up at the board meeting (because under the bylaws of the corporation at least 3 directors was needed for a quorum: which is needed to conduct the business of the corporation). The argument is made by Gearing that the election of Hemphill was void because a quorum was not present. This is an equitable remedy. For equity to apply, one must have clean hands. (To receive equity, one must do equity) But here the whole problem was created by Meachem not attending the meeting, and she therefore didnt come to the court with clean hands. Therefore Meachem cannot get the relief she wants. Quorum was set in the bylaws that at least 3 of the directors must be present and able to vote. No legitimate action could take place unless the Quorum was met. This was the only action Meachum could take to make the action invalid. The failure of Mrs. Meachem to attend the directors meeting, under the present circumstances, bars appellants from invoking an exercise of the equitable powers lodged in the courts under the statute. But if she would have gone to the meeting she would have been outvoted, and would have perpetually been outvoted, and it would have been legitimate. The dissent is closer to the modern rule: Its a 50/50 split, so the courts should refrain from helping either side. The court could have either confirm the election or order a new election. In re Radom v. Neidorff, Inc.: Brother and sister (who received her shares in the company following her husbands death) deadlocked in the corporations activities. They each own 50%. She said he was extorting funds and mismanaging the company, and she was suing him, and therefore she said she would not sign his paychecks. The business is doing well and making profits. He sues for dissolution. Dissolution means the company shuts down; this will not be good politically and, accordingly, judges refrained from doing this. The order [for dissolution] is granted only when the competing interests are so discordant as to prevent efficient management and the object of its corporate existence cannot be attained. The prime inquiry...for dissolution is whether judicially-imposed death will be beneficial to the stockholders or members and not injurious to the public. Here the judges say the company is doing well and making profits, so the grounds here do not justify dissolution. Once again, the dissenting judge probably has the right idea; in any event, it more accurately reflects the modern position. This lays the groundwork for modern impression in Davis v. Sheerin. Davis v. Sheerin: (Modern Law)

 Sheerin, who holds 45%, wants to see the books (which is allowed to any shareholder of a public corporation), but is denied by Davis, who owns 55%. Davis says Sheerin must show him the stock certificate to prove youre a shareholder, stating that Sheerin allegedly gave the stock to him as a gift. Sheerin cant find the stock certificate, so his only remedy is to litigate. Davis is appealing an order for him to buy out Sheerins stock for $550K, arguing that a buy out is not the appropriate remedy. The court says that Oppressive conduct is the most common violation for which a buy-out was found to be an appropriate remedy in other jurisdictions. Other conduct for which a buy out is appropriate are: Fraud: if the majority (or party managing) perpetrates fraud. Illegality: doing something illegal Mismanagement (harder case to make) Waste of Assets: majority either gives away or steals assets. Deadlock: 50/50 impasse The court finds oppression here: the majoritys conduct substantially defeats the expectations of the other party. They look at the expectation of the minority owner, which is (at the least) a right to examine the books and share any profit. But here the majority is going to the very core of oppression by saying that Sheerin has no ownership interest at all: We find that conspiring to deprive one of his ownership of stock in a corporation, especially when the corporate records clearly indicate such ownership, is more oppressive than either of the other techniques of oppression (not letting him look at the books or share in the profits). Also, in this case the corporation was a private company, so the minority shareholder did not have the ability to sell his shares on the open market, so buy out is really the only appropriate remedy (short of dissolution). Notes: A buy out, assuming FMV is received for the shares, gives the plaintiff a cash-out right that he would not otherwise have...Getting rid of a dissatisfied shareholder permanently is also advantageous to the corporation and remaining shareholders. Buy-outs were not common (as evidenced from earlier, common law cases), but now are, and are codified in many states. Most judges have the power now to force a buy-out.; these solutions do not apply to publicly held corporations; mainly only closed corporations/small corporations. Actions by Directors and Officers: In the Matter of Drive-In Development Corp.: The principal question in this appeal relates to the circumstances which may bind a corporation to a guaranty of the obligations of a related corporation when it is contended that the corporate officer who executed the guaranty had no authority to do so. Rule: Statements made by an office or agent within the course of a transaction in which the corporation is engaged and which are within the scope of his authority are binding upon the corporation. Notes: The court refused to grant the third persons the benefit of the estoppel principle set forth [above] where the 3rd person must have been aware that the transaction had not been authorized by the board of directors.

 If a document is appropriately executed and sealed by the corporate secretary, third parties without specific knowledge about the actions taken may rely with confidence on the document. Essentially, you dont have to go beyond the written document. Lee v. Jenkins Bros.: What authority does an officer (specifically here, a president) have within a corporation? Here the president promised Lee a pension to entice him to come work for the company, which would be paid even if the company was no longer in existence at the time of Lees retirement. The issue is whether this promise was within the scope of the presidents power? The rule most widely cited is that the president only has authority or bind his company by acts arising in the usual and regular course of business but not for contracts of an extraordinary nature. It is generally settled that the president as part of the regular course of business has authority to hire and discharge employees and fix their compensation... But employment contracts for life or on a permanent basis are generally regarded as extraordinary and beyond the authority of any corporate executive if the only consideration for the promise is the employees promise to work for that period. Apparent authority is essentially a question of fact. Relevant factors include, but are not limited to: The nature of the contract involved The officer negotiating it The corporations usual manner of conducting business The size of the corporation and the number of its stockholders The circumstances giving rise to the contract The reasonableness of the contract The amounts involved, AND Who the contracting third party is. Chapter 9 Management and Control of a Publicly Held Corporation: Shareholders The right to elect directors, share in residuals if sold, right to dividends Directors elect officers, set salaries, have the right to manage the affairs of the corporation, hire and fire the CEO, make sure operating structure in place (does the company have a mechanism where info can go from bottom to top and vice versa), make sure the company is operating legally, make sure they are operating ethically Officers Day to day operations under actual authority under the by laws, because of the title they may have apparent authority above and beyond what they have actually been given. A publicly-held corporation is one: Whose shares are traded on the market or some exchange Which is usually a large company (usually required to have a threshold number of stockholders and market cap (total worth)). The notion of a board of directors controlling a large, publicly-held corporation is really a fiction; e.g., Heinz Co., is essentially run by four members of a board (the President of Heinz USA, President of Heinz Canada, CFO, and Chairman/former-CEO), although the board of directors probably has about 25 members (but they dont really know the goings-on of the business on a

day-to-day basis). Shareholders elect the directors, who elect the officers, who in reality run the corporation. If officers run the company, though, then what is the role of the board of directors? (they cant do anything on a day-to-day basis, and they really dont know what goes on in all the divisions). A board is only going to take action based on whatever the management (i.e., officers) want them to; this effectively negates/undermines the traditional role of the board of directors. A board, simply by virtue of forcing management to report every quarter, has some semblance of control over the officers/management. The other component within the realm of a board is to appoint/retain/control the CEO, who really is the only officer who would report directly to the board of directors; if some terrible situation occurs, the board has the power to fire the CEO. Boards also work on strategic plans: where will the company be in 5, 10 years; here, the board directs the management to compile the plan. When a directors term comes up, the company sends out a proxy statement of who is up for election. Here, management really controls the election of directors, because it is too costprohibitive for outsiders to set up proxies or to get on the ballot. Here, the directors are usually more loyal to the CEOs than the shareholders, rendering the company rather shaky, because the directors usually have quid-pro-quo agreements with the CEOs regarding election to the board. The potential parties asserting a takeover would send out a proxy stating how they would better and more efficiently run the company, how it would improve under their watch, etc. In the days of junk bonds, the cost-prohibition of proxies was cast aside, as the potential investors possessed ubiquitous amounts of money. One of the major concerns of public companies in the 1980s was the (hostile) takeover movement. A decline in stock value usually reflected (or the theory was that it typically reflected) poor management of the company; when the stock depreciated, the possibility of a hostile takeover ensued, striking fear in the directors (because they would all be replaced). They would try to fight off a takeover by convincing shareholders not to sell, although this hardly seems laudable or plausible. Other constituency/alternative constituency statutes were enacted in many states providing that a board should look not only to its shareholders and the maximization of profit, but also to the community, suppliers, creditors, etc. These statutes were passed in response to the hostile takeover movement, and assuaged the fear imbued into directors. The Committee on Corporate Laws provides: Directors may take into account the interests of other constituencies but only as and to the extent that the directors are acting in the best interests, long as well as short term, of the shareholders and the corporation. Management of a Public Company: In a public company, one of the primary questions is: To whom is the public company accountable? (How would Henry Ford answer this question: probably to the employees, customers, community and the public at large; this can be labeled social responsibility. The court in Dodge v. Ford said that the corporation was accountable to itself and the shareholders basically profits were more important than social responsibility.) Would anyone invest in a company in which he thought that the company would give away its profits to a charity instead of the shareholder? Probably not. The objective of every corporation should be whats in the best interest of the corporation from a financial standpoint. The obligation of a public company is to make money, build wealth, and generate profits. If they didnt have this obligation, then they wouldnt have access to capital (ostensibly because shareholders invest with the hope of generating returns). Individual

shareholders have the benefit of the street option: if they are dissatisfied, they can sell it on the market (street) Now, the majority of shares in public companies is held by institutions: insurance companies, mutual funds, pension funds (e.g., CALPers). They take big positions in shares, making it harder for individuals to challenge corporate decisions. Do these institutions have the benefit of the street option? Probably not as much, because they have large blocks of shares (and if one institution dumps its block of shares, no other institution will probably buy it, and no individuals will be able to purchase that much). So their only recourse is to put pressure on the management, urging them to perform better. They can do this by threatening to elect a new board of directors. These institutions are usually big enough to pull it off, too. Perhaps they want outside directors: those directors who are not executives in the company. What can this new board do to effectively keep management in check? They always have the power to fire the CEO. They could also, to take power from a CEO, have the (independent, outside) Chairman of the Board set the corporations agenda. A problem can arise here regarding the potential liability a director will have depending on his or her conduct. The first place to look to determine what kind of conduct can get a director in trouble is the applicable state statute. For Florida, its 607.0830 (mirroring the MBCA 8.30), and it mandates each director execute the duties of good faith, care, and loyalty. The duty of good faith is tied to the duty of loyalty: a director is not acting in good faith if he is acting for his own interests instead of those interests of the company, which violates the duty of loyalty. *An argument (probably a strong one) can be made that looking to the other constituencies (factors listed in 607.0830(3)) is actually in the best interest of the company. The Business Judgment Rule only applies to the duty of care (i.e., that the director is acting with the care an ordinarily prudent person in a like position would exercise under similar circumstances). Keep in mind that no director can know everything. A director must 1) Became Informed and 2) Deliberated then you can apply the business judgment rule and prevent them from being liable. Duty of Care and the Business Judgment Rule: Two functions of the duty of care: Decision making when an issue arises a duty to do something, become informed, deliberate, Oversight obligation to have a functioning hierarchy, mechanisms in place to discover fraud and illegality, training on employment discrimination etc. Business Judgment Rule: If you make your decision on good faith, and are informed, you will be protected from liability; no court will second-guess it. The modern view does not focus on the decision; rather, they focus on the process and procedure of making the decision: how did the director inform himself (because a director can be informed and still make a bad decision), and was the decision made in good faith? Exercised the duty of care? Litwin v. Allen: Shareholders (Plaintiffs) sued the directors (individually)(Defendants) of certain companies (JP Morgan, Guaranty Trust) in a derivative suit.

A derivative suit usually starts with shareholders sending notice to a designated person in the company that they want the company to bring a lawsuit against the directors, based on the grounds that fiduciary duties have been breached; very often the request is denied, ostensibly because the suit would be against the officer receiving the request; if it is denied, the shareholders can bring a suit on behalf of the corporation. Some corporations stipulate that only shareholders possessing a specified percentage of stocks can bring these suits; here the plaintiffs owned 36 of the 900K outstanding shares. The Allegheny Corporation could not borrow any more money, so it went to JP Morgan, asking for $10M to close a deal on some railroad stations it had purchased and for help to make it happen. The Allegheny Corporation is precluded from its bylaws that it cannot borrow anymore money over the $10M so they needed a transaction other than a loan with all the elements of a loan. The plan was to sell debentures (owned by Allegheny) issued by Missouri Pacific Railroad; they couldnt borrow on these anymore, so they decided to sell $10M of them to JP Morgan and its group (other investor banks were involved; the money was spread around). The debentures contained a provision stipulating that Allegheny could buy the debentures back in 6 months for the same price (meaning no appreciation in value could be realized by JP Morgan). The debentures were also convertible into common shares. The debentures included 5.5% interest accruable to JP Morgan. Allegheny has no risk, whereas JP Morgan has lots of risks (if the value declines, and Allegheny doesnt buy them back, they lose their shirts; if the value increases, then Allegheny can buy them at the original purchase price, meaning the appreciation in value goes to them, not JP) The suit was brought for the directors breaching their duty of care. Duty of care requires some degree of skill and prudence and diligence. Directors are liable for negligence in the performance of their duties. A director owes loyalty and allegiance to the company (Duty of Loyalty)--a loyalty that is undivided and an allegiance that is influenced in action by no consideration other than the welfare of the corporation. Any adverse interest of a director will be subjected to a scrutiny rigid and uncompromising. He may not profit at the expense of his corporation and in conflict with its rights; he may not for personal gain divert unto himself the opportunities which in equity and fairness belong to the corporation. In the discharge of his duties a director must, of course, act honestly and in good faith, but that is not enough. He must also exercise some degree of skill and prudence and diligence. Directors are liable for negligence in the performance of their duties. Directors are not liable for errors of judgment or for mistakes while acting with reasonable skill and prudence. If a director uses the degree of care ordinarily exercised by prudent bankers (those in a like situation under similar circumstances) he will be absolved from liability although his opinion may turn out to have been mistaken and his judgment faulty. Whether or not a director has discharged his duty, whether or not he has been negligent, depends upon: The facts and circumstances of a particular case, The magnitude of the transaction, and The immediacy of the problem presented. A director is not liable for loss or damage other than what was proximately caused by his own acts or omissions in breach of his duty. So the directors are only liable here for the loss attributable to the improper repurchase option itself, and no decline in value occurring thereafter.

 The Court holds that no fraud occurred here, nor did evidence of bad faith exist. Still, the directors were liable: The directors plainly failed in this instance to bestow the care which the situation demanded... liability should be imposed in connection with this transaction because the arrangement involved here was so improvident, so risky, so unusual and unnecessary as to be contrary to fundamental conceptions of prudent banking practice. This case has been overturned by the business judgment rule; in this case, the court looked at the decision itself; that doesnt happen anymore. Terms used to describe the standards a director must embody/espouse/maintain: Conscientious fairness Honesty and purpose Unselfishness Allegiance to the company Loyalty to the company Good faith Morality Duty of care mandates the director use skill, prudence, reasonableness (i.e., he must maintain a standard). Shlensky v. Wrigley: (DUTY OF CARE) Plaintiff alleged that Wrigley (chairman and CEO) did not want baseball at night for personal reasons, and that the directors were going along with him without question. Because they are following Wrigley, the no lights decision is being made because Wrigley personally believes baseball is a daytime sport. The directors are following blindly, plaintiff alleges. What duty is implicated here? The duty of loyalty: the directors have to do whats in the best interest of the company; and the plaintiff argues that the best interest of the company would be to install lights so baseball could be played at night. The plaintiff assets that directors are acting in the best interest of Wrigley, and not the company. Plaintiff alleges that they are not making informed decisions incumbent to the duty of care (but no evidence existed for this supposition). The B.O.F. is on the plaintiff to show this (he doesnt). It is fundamental in the law of corporations, that the majority of its stockholders shall control the policy of the corporation, and regulate and govern the lawful exercise of its franchise and business. The judgment of the directors of corporations enjoys the benefit of a presumption that it was formed in good faith and was designed to promote the best interests of the corporations they serve, unless shown to be tainted with fraud. There must be fraud or a breach of that good faith which directors are bound to exercise toward the stockholders in order to justify the courts entering into the internal affairs of the corporation. Be able to distinguish among the duties of: care, loyalty, and good faith. Smith v. Van Gorkom: (DUTY OF CARE) Good faith is irrelevant in determining whether the Board made an informed business judgment.

 Bad Decisions is not something the court wants to get involved with; business judgment rule, 20/20 hindsight. What the court does look at is the process culminating into making that decision. Process required for directors to make decisions (Case by Case basis)(Using reasonable expectations) Be informed Deliberate Leveraged Buy Out: Determine how much the company is worth, and then divide that by the number of outstanding shares, to determine the stock value needed to by the company. Then this offer would be made to the shareholders by the Board/Management (who are trying to buy it). Inside directors are in a conflict of interest in an LBO, and must therefore seek an independent outside appraiser to show that the companys value is fair. Van Gorkom approached Pritzker, offering him $55/share (they were selling for $37/share; the company was undervalued, leading to the decision for an LBO) if he would buy the company in an LBO; Pritzker also was promised that, if the sale didnt go through, he could buy 1.75M shares at $37/share. V.G. didnt inform the rest of the Board, but told upper management about it before the meeting. The shareholders brought a derivative suit. Rule: Once an issue has come before the Board, the directors must: Become informed (so really they should get an outside appraisal, determine the status of the market, etc.) Deliberate The court held that the Board had not done these and therefore they failed in process, and were held liable (however, the court says that if they would have done these requirements, even if the result would have been the same, they would not be held liable). A corporation can indemnify a breach of loyalty, but not a breach of good faith, says the court. Self-Dealing: (DUTY OF LOYALTY AND CONFLICT OF INTEREST) Common Law Self dealing conflicts of interest were automatically deemed voidable New Rule Not automatically voidable if ratified by 1) Majority of disinterested directors or 2) Majority vote of disinterested shareholders or 3) Judicial determination that the act complained of is intrinsically fair to the corporation. Marciano v. Nakash: - Loan being made by 3 shareholders that hold 50 percent of company stock entering into a transaction to loan there own company 1 million at a 5 year 8% interest collateral. The other50 percent is held by the brothers Marciano. Classic self dealing enterprise. - Section 144 Delaware General Corporation Law. Allows for a validation of interested director transactions. Where a shareholder deadlock prevents ratification but also where shareholder control by interested directors precludes independent review. - The sole forum for demonstrating intrinsic fairness may be judicial when deadlocks that prevent shareholder ratification occur. Hellar v. Boylan:

Derivative action of 7 out of 62,000 shareholders. Alleged improper payments to companies officers. Minority share holders maintained large bonuses created waste and spoliation thus giving away company property against the protest of minority shareholders.

Brehm v. Eisner (1): Stock option: a right at some time in the future to purchase stock at a discounted price. The standard for judging the informational component of the directors decision-making does not mean that the Board must be informed of every fact... the Board is responsible for considering only material facts that are reasonably available. It is the essence of the business judgment rule that a court will not apply 20/20 hindsight to second guess a boards decision, except in rare cases [where] a transaction may be so egregious on its face that the board approval cannot meet the test of business judgment. The board is not liable when relying on an expert, or on the officers of the company (unless the director has reason to believe, or should have reason to believe, that the officer cannot/should not be relied upon). To survive a... motion to dismiss in a due care case where an expert has advised the board in its decision-making process, the complaint must alleged particularized facts (not conclusions) that, if proved, show that: The directors did not rely in fact on the expert Their reliance was not in good faith They did not reasonably believe that et experts advice was within the experts professional competence The expert was not selected with reasonable care by or on behalf of the corporation, and the faulty selection process was attributable to the directors The subject matter that was material and reasonably available was so obvious that the boards failure to consider it was grossly negligent regardless of the experts advice or lack of advice, OR That the decision of the board was so unconscionable as to constitute waste or fraud. Requirements of the waste test: An exchange that is so one sided that no business person of ordinary, sound judgment could conclude that the corporation has received adequate consideration. If... there is any substantial consideration received by the corporation, and if there is a good faith judgment that in the circumstances the transaction is worthwhile, there should be no finding of waste, even if the fact finder would conclude ex post that the transaction was unreasonably risky. Duty to Act in Good Faith: Brehm v. Eisner (Disney 2): (2006) 3 Categories of Fiduciary Bad Faith Category 1: Subjective Bad Faith: Intent to do harm; also a breach to the duty of loyalty. Category 2: Lack of Due Care: gross negligence with no malevolent intent This can be a violation of the duty of care, but will not rise to a finding of bad faith.

 The lack of intent to do harm to the corporation is crucial here (i.e., Gross negligence, without more, cannot constitute bad faith). It is important to distinguish between duty of care and bad faith because, in Delaware: Directors may be indemnified and insured against gross negligence/duty of care, but not if they acted in bad faith. (This must be included in the articles of incorporation.) A director, by statute, may be exculpated from monetary liability for a breach of the duty of care, but not the duty to act in good faith. A corporation cannot insure against bad faith. Category 3: Intentional Dereliction of Duty; a Conscious Disregard for Ones Responsibilities: To protect corporations, fiduciary conduct of this kind, which does not involve disloyalty but is quantitatively worse than gross negligence, should be proscribed. (e.g., Whistleblower comes to a director and says the CEO and CFO are systematically cooking the books by showing income that doesnt exist, and raising inventory that doesnt exist. The director has a duty (duty of loyalty), when receiving this information, to not see any harm come to the corporation, and must inform all the other board members of the information. The director must bring the board together and disclose the information received. If he or she does not do this, it will constitute an intentional dereliction of duty, and/or a conscious disregard for ones responsibilities: the director, by not disclosing the information, is essentially sticking his head in the sand.) The court labels this as deliberate indifference and inaction in the face of a duty to act... [and says] it is the epitome of faithless conduct.Basically that the director or officer did not do anything in the face of a responsibility to act. Intentionally disregarding a duty to act; sticking your head in the sand. e.g., CEO and CFO are cooking the books because they need to raise money. They go to a wealthy investor and show him the cooked books; here they are not exactly disloyal. Their fraud is perpetrated on some third party. This also constitutes bad faith of the third category, as it represents a conscious disregard for ones responsibilities. The officers here also have the 3 duties of good faith, loyalty, and due care. And the duty of good faith is implicated here; it encroaches beyond gross negligence because it is intentional. Corporate Opportunity Doctrine: Implicates a violation of the duty of loyalty. Basically fully disclose everything; unless its obvious that it is not in the line of the business, eg. Like the company doesnt have the financial or no it all to do that opportunity. Recognizes that a corporate fiduciary should not serve both corporate and personal interests at the same time. Corporate fiduciaries owe their whole duty to the corporation, and they are not permitted to act when duty conflicts with interest. They cannot serve themselves and the corporation at the same time. N.E. Harbor Golf Club, Inc. v. Harris. Corporate officers and directors bear a duty of loyalty to the corporations they serve. Meinhard v. Salmon. Determinations to consider are: If an opportunity is outside the line of business, whether the company has the financial ability to do it. The Harris court realized these were weak tests, and instead adopted the ALI test. N.E. Harbor Golf Club, Inc. v. Harris: Corporate fiduciaries must discharge their duties in good faith with a view toward furthering the interests of the corporation. They must disclose and not withhold relevant information

concerning any potential conflict of interest with the corporation, and they must refrain from using their position, influence, or knowledge of the affairs of the corporation to gain personal advantage. ALI Test: A director or senior executive may not take advantage of a corporate opportunity unless: The director or senior executive first offers the corporate opportunity to the corporation and makes disclosures concerning the conflict of interest and the corporate opportunity, The corporate opportunity is rejected by the corporation, and Either: The rejection of the opportunity is fair to the corporation, The opportunity is rejected in advance, following such disclosure, by disinterested directors, or, in the case of a senior executive who is not a director, by a disinterested superior, in a manner that satisfies the standards of the business judgment rule, or The rejection is authorized in advance or ratified, following such disclosure, by disinterested shareholders, and the rejection is not equivalent to a waste of corporate assets. Full disclosure is key here prior to taking any advantage, under the ALI test: Full disclosure to the appropriate corporate body is an absolute condition precedent to the validity of any forthcoming rejection, as well as to the availability to the director or principal senior executive of the defense of fairness. A good faith but defective disclosure by the corporate officer may be ratified after the fact only by an affirmative vote of the disinterested directors or shareholders.

Securities Fraud: Rule 10b(5):

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange, (Interstate commerce to get Federal JX) (a) to employ any device, scheme or artifice to defraud, (b) to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statement made, in the light of the circumstances under which they were made, not misleading, OR The first clause embodies common law fraud. Now, silence will get you securities fraud if you know a material fact which will change all the other information already out there, and you fail to disclose it. In common law silence was not fraud unless asked. This is the critical part when it comes to insider trading. e.g., CPA knows the financial statements are false, but he says nothing. Then he sells his stocks on the NYSE. He is now guilty of securities fraud. (c) to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security. Narrows the scope here to the buying/selling of securities: stocks, bonds, preferred stock, debentures. Who could be possibly hurt by securities fraud? Who is harmed? Buyer Seller Creditors Employees Potential buyer

 Shareholder (Potential seller) Stock Market Investors in the market (anyone who owns shares of stock) Who of the aforementioned groups would have standing to bring an action against the party(ies) perpetrating the fraud? Buyers Sellers Who are the potential defendants, i.e., who are you going to sue? Parties preparing and distributing the false information. The party must have knowledge that the information is false (scienter), and Intent to do defraud (therefore, negligent dissemination would not qualify) Buyers (maybe the buyer has inside information that hes not telling, or false information hes not telling) Sellers Blue Chip Stamps v. Manor Drug Stores (1975): Issue: Who can bring a private action for securities fraud? Rule:Private action can only be brought by Buyers and Sellers Regarding the ability of potential buyers and potential sellers to bring suit, the Supreme Court says we would have litigation where we wouldnt know for sure if the potential buyer even saw any information regarding the company. Perhaps he saw a newspaper article blasting the company, and he decides that he would have bought stock, but for the article. It would lead to all sorts of uncertain litigation, so the Court eliminated potential buyers and sellers. The rationale is that the potential buyer offers only his testimony to prove he ever consulted a prospectus of the issuer; this is too unreliable and unpredictable. The Supreme Court held that only buyers and sellers have standing. If an employee is a buyer or seller, then he will have standing as well. Creditors have other ways to make a claim; they dont need securities fraud; they can use common law fraud by alleging that the company published untrue financial statements. Stockmarket protected by the criminal laws by strictly enforcing criminal rules. Shareholders can bring derivative suits instead of alleging securities fraud. Investors in the market would probably be too tenuous to assert securities fraud. If the securities fraud hurts the whole market, most likely it will enter the realm of criminal liability, and the SEC would bring the lawsuit. Ernst & Ernst v. Hochfelder: The Rule (10b-5) applies only to scienter: there must be knowledge and intent to defraud Negligence does not come within the Rule; although it could be used for malpractice purposes. The Rule also does not apply to aiding and abetting. Santa Fe Industries, Inc. v. Green: Supreme Court limits the scope of 10b-5. Manipulation is a term of art here, meaning there is intent to mislead investors by artificially affecting market activity. Even conscious disregard would probably not fall within the scope of the rule.

In Re Enron Corporation Securities, Derivative & ERISA Litigation: Buyers of Enron stock bring the suit; they establish a period of time (10/19/98- 11/27/01), during which anyone who purchased Enron stock can join as Plaintiffs. Enron created Special Purpose Entities (SPEs, Enron owned 85% of them, with the officers owning the rest) which would purchase energy from Enron at a profit to Enron; then the SPE would sell the energy to another SPE at a further profit, and so the circle perpetuated. Somewhere along the line, the energy has to be sold to an outside buyer. Enron had on its books all the profits here, but none of the liabilities. There were different categories of Defendants: Attorneys (law firm of Vinson and Elkins) Accountants/auditors Investment banks Board of Directors, CEO, CFO, President (they were also subject to criminal charges) Attorneys: Limited as aiders and abettors here, so find a way to bring them in. What could bring them into securities fraud liability under 10b-5? Here Enron is dealing with itself (self-dealing) through the SPEs, and reporting the profits, but not the liabilities. A lawyer must ensure this conflict has been rectified. Failure to do so is negligent. How does this turn into securities fraud? For the lawyers to actually promote Enron in a transaction involving loans from investment banks, which they did. Enron needed the money to stay afloat. The attorneys also created the SPEs and drafted all the necessary paperwork. They were never convicted of securities fraud, but were for malpractice. Investment Bankers: They were helping Enron make money through the public. For example, selling bonds. These bankers were flouting Enron as financially stable or better. If they knew this was false, and had the intent to defraud, then they will be held liable. Arthur Andersen: Initially, they destroyed all the papers; so they were charged criminally. They were never convicted of securities fraud, but they were involved in several other companies that tanked. So AA is pretty much gone now. Why Does Anyone Buy Stock in a Company? To make money, a return on investment. Before making this bet, though, an investor will want as much information as he can get, because this will technically reduce the risk inherent in the bet. An investor is generally betting that the stock value will go up. How does an investor make this determination, though, that the stock will increase? Can be on information that is false, or on information that is not complete (which means someone else has information that he doesnt have): these constitute securities fraud). The government has an interest in regulating the stock market in order to keep it honest and stable; an unstable market would dry up companies ability to raise capital. In what manner is the government effecting stability of the market? Level the playing field: every investor in the market should have an equal opportunity to make money. Insider Trading:

 Rule 10(b)-5 proscribes as securities fraud insider trading. (b) Failure to disclose a piece of material information that would render the statements made not misleading. Cannot get away with silence here! Silence, when there is a duty to speak, can itself be a fraud. TGS. The obligation to refrain from insider trading is rooted in 2 principal elements: The existence of a relationship giving access, directly or indirectly, to information intended to be available only for a corporate purpose and not for the personal benefit of anyone, and The inherent unfairness involved where a party takes advantage of such information knowing it is unavailable to those with whom he is dealing. Whats an insider? Officers working for the company; e.g., CEOs, CFOs, etc. If you have information that must be kept silent for corporate purposes, you have a duty to keep it silent. If you want to refrain from insider trading, do not engage in trading while knowing information that must be kept silent. You can trade if you disclose, but here you are not allowed to disclose the information. Lawyers, consultants, and accountants working/contracted for the company. SEC v. Texas Gulf Sulfur Co.: The mining company discovered a large quantity of minerals during a test drill. During this time until the time drilling was resumed, certain defendants and persons said to have received tips from them, purchased TGS stock. During the period of mining, TGS stock gained in value. Rules: Rule 10b-5... was promulgated to prevent inequitable and unfair practices and to insure fairness in securities transactions generally. The Rule is based in policy on the justifiable expectation of the securities marketplace that all investors trading on impersonal exchanges have relatively equal access to material information. Anyone who, trading for his own account in the securities of a corporation has access, directly or indirectly, to information intended to be available only for a corporate purpose and not for the personal benefit of anyone may not take advantage of such information knowing it is unavailable to those with whom he is dealing. The Rule is also applicable to one possessing the information who may not be strictly termed an insider. Anyone in possession of material inside information must either disclose it to the investing public, or if he is disabled from disclosing in order to protect a corporate confidence, or he chooses not to do so, must abstain from trading in or recommending the securities concerned while such inside information remains undisclosed. An insiders duty to disclose information or his duty to abstain from dealing in his companys securities arises only in those situations which are essentially extraordinary in nature and which are reasonably certain to have a substantial effect on the market price of the security if [the extraordinary situation is] disclosed. The only regulatory objective is that access to material information be enjoyed equally... Before insiders may act upon material information, such information must have been effectively disclosed in a manner sufficient to insure its availability to the investing public. The time that an insider places an order, rather than the time of its ultimate execution, [is] determinative for Rule 10b-5 purposes. (dont try to beat the news.)

 Either disclose, or refrain from trading! If a corporate officer having such knowledge (that the stock will likely rise) persuaded an unknowing board of directors to grant him an option at a price approximating the current market, the option would be rescindable in an action under Rule 10b-5. Silence, when there is a duty to speak, can itself be a fraud. Holding: The defendants were guilty of insider trading here. Chiarella v. U.S.: Misappropriation Theory: this concept was not pled by the SEC, says the Court, so the Court cannot make a conviction stick. Carpenter v. U.S.: Writer notices the stock goes up whenever he mentions the company. He tells his 2 friends to buy the stock. He is then charged with misappropriation of information. He misappropriated the information with the intent to defraud, but the Court only ruled 4-4 on this theory. He was also charged with wire fraud, and convicted 8-0. Note: Technically if you overhear something and act on it, you are not committing a crime. e.g., Barry Spritzer, ex-coach of the Cowboys, overheard a CEO say he was going to acquire another company, and he acted on it. Misappropriation Theory: U.S. v. OHagan: The vote was 6-3, and the majority used the misappropriation theory to uphold his conviction. The Williams Act was a result of the Chiarella case. The series of cases leading up to this one, there were many decisions of the Supreme Court where there were concurring opinions, an agreement in the judgment but not the reasoning; thats how this theory rolled along. (They didnt consider it in Chiarella because it wasnt brought up.) Criminal liability under 10(b) may be predicated upon the misappropriation theory. The misappropriation theory holds that a person commits fraud in connection with a securities transaction, and thereby violates 10(b) and 10b-5, when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information (breach of the duty of loyalty and confidentiality). The misappropriation theory premises liability on a fiduciary-turned-traders deception of those who entrusted him with access to confidential information. A companys confidential information... qualifies as property to which the company has a right to exclusive use. The undisclosed misappropriation of such information, in violation of a fiduciary duty... constitutes fraud akin to embezzlement. The misappropriate theory outlaws trading on the basis of non-public information by a corporate outsider in breach of a duty owed not to the trading party, but to the source of the information. Liability under 10b-5... does not extend beyond conduct encompassed by 10(b)s prohibition.

 Full disclosure forecloses liability under the misappropriation theory... if the fiduciary discloses to the source that he plans to trade on the non-public information, there is no deceptive device and thus no 10(b) violation. So if OHagan received permission from his law firm to trade on the information, there would be no basis for the misappropriation theory. The deception essential to the misappropriation theory involves feigning fidelity to the source of the information, and if there is no such feigning or deception, misappropriation cannot stand. Here, there is an interest in the government in ensuring the integrity of the markets. This provides them an impetus for policy reasons to impose criminal liability. But here OHagan doesnt have any duty to either corporations because he is an outsider. Hes not defrauding, or intending to defraud, either of these companies either. They have to get him on the misappropriation theory.

Corporate Scandals:
WorldCom: started from next to nothing by Ebbers. He started acquiring other companies (65) using WorldCom stock as currency. His fraud: treating certain transactions as capital investments instead of expenses against revenue, which grossly overstated income. He also borrowed money on his stock (margin option) and used it to buy other personal assets; when the price decreased, he had to make a margin call, but instead of paying it (maybe he couldn't?) he went to the board of directors and asked them for a loan to cover the margin (because if they didnt give him the money, the bank would start selling the stocks, leading to a further decrease in value). The board loaned him the money without informing the stockholders; they were sued as a result for violating the duty of loyalty. Tyco: Doing deals with ADT (subsidiary); also, the CEO borrowed money from the company (e.g. $19M to build a home in FL), which the board subsequently forgave. The CEO used the company as his own piggy bank. Backdating: CEO backdates his stock options to earlier years when the share price was lower, therefore generating greater profits. This certainly violates the duty of loyalty. So Congress enacted the Sarbanes-Oxley Act: Only applies to publicly held companies. Every board has to have a financial expert, and if not, then explain why. A financial expert is generally defined as someone who is familiar with financial information of this nature, either by virtue of being a CPA or a partner in an accounting firm, or even a CEO in a similar company. Must also have an audit committee of the board, made up of outside directors (not employed by the company; i.e., independent directors), and only they can interact with the auditors. The financial information (financial statements) going to the auditors and the SEC is internally-prepared, and now public companies are required to have the CEO and the CFO sign the statements (essentially saying they vouch for the statements, and that they are correct); if the financial statements are wrong, the CEO and CFO are liable. There is now a national auditing board, and auditors of companies have to be approved by this board, and have to follow certain rules, one of which mandates that no conflict of interest exist. Enhanced financial disclosure: all off-balance sheet transactions will have to be explained in notes on the financial statements and disclosed to the public. The company must have a code of ethics and explain any lack thereof. All transactions made by the company

constituting self-dealing must also be disclosed. Also, there was a recommendation (maybe a provision now) that stock options be registered and disclosed at the time theyre granted. Moving a whistleblower to another department (Ken Lay and Sharon Watkins), or firing him/her, is now prohibited, and also provides for criminal liabilities. Executive/Senior Management of a Company: CEO: part of his compensation includes stock options: right to buy stock in the company at some point in the future at a discounted price. A CEO can borrow on that stock as well (marginal). (e.g., If A has $100K of stock in Apple, he can borrow $50K on that with relatively low interest; a margin call from a bank will arise when the stock dips and A has to cover the loss; the bank will call A and tell him he needs to cover any decrease in value.) So it is in the best interest of the CEO to ensure the stock maintains its value, at the very least, during the quarter (90-day pressure). If there is enough pressure to keep the stock up, the CEO will (instead of enduring a margin call) cook the books. Exam Review: Laws for the class, included in the supplement: Model Business Corporation Act (MBCA) Uniform Partnership Act of 1998 esp. various duties partners owe each other. Uniform Limited Liability Co. Act Sarbanes-Oxley A corporation can opt out of statutory structure (i.e., no board of directors, only one director, and you dont even have to label him a director) by a unanimous shareholder agreement, if less than 100 shareholders. All new buyers of the stock will be put on notice of the agreement by the stamp on the stock; so if they buy stock, they agree. How can you opt out of the shareholder agreement? Or when would you no longer be eligible for opting out? Exceed the specified number of shareholders A majority of the shareholders vote to opt out If the stocks become traded on a national or regional exchange Cumulative v. Straight Voting: Some states allow cumulative voting if the articles of incorporation provide it as an option; most states dont permit it at all anymore, though. If cumulative voting is allowed, it is announced before the vote. Cumulative voting is a mechanism whereby a minority of shareholders may be able to get some representation on the board. Usually applies only to closely-held corporations. How do partners vote? Each partner gets an one vote, regardless of the share of ownership, unless there a partnership agreement provides otherwise. Directors also vote like this. Know agency principles! Difference b/w agent and principal, relationship and how its formed (principal offers agency to the potential agent, and the agent must accept) or dissolved (either party manifests an intent to discontinue the agency, usually verbally), and how does the relationship work with respect to outsiders? Also know the scope of authority. Know the chart regarding Formation, Tax Treatment, Formality, etc, of business entities. Know GAAP = Generally Accepted Accounting Principles

 Know how overstating assets affects the corporations value. Know how a corporation is funded, and how they raise money. They have the power to issue their securities to the public. Know the investment instruments as well (e.g., debentures, preferred stock and convertibility, common stock, junk bond, bond), cumulative dividends (if youre not paid now, youll be paid what youre owed later) and convertible stocks. Know about shareholder voting rights too. Understand what a corporation has to do when conducting an IPO (Securities Act of 1933). Typical way smaller companies do this is going through Regulation D, which exempts them from certain requirements. Prospectus: If you want to offer common stock to the public, you would first have to register that stock with the SEC. In that registration are items that must be disclosed in the prospectus: financial statements, who the management/board of directors are and their bios, how much stock they own, how much they are paid, etc.; basically, it contains all the information an investor would need/want before hedging a bet on the stock. When there is an exemption under Reg. D, the prospectus does not have to be as detailed, and it will be called a private placement memorandum (PPM) instead of a prospectus. Duty of care: negligence or gross negligence rule. You didnt do what someone in a similar position would have done. You can screw up and not be liable if you operated in good faith (the business judgment rule). Its not the bad result that counts, but the process that must be examined: be informed, then give it due deliberation. (this satisfies the business judgment rule.) No indemnification for those actions committed in bad faith. Know securities fraud: insider trading, securities fraud under 10b-5. You cannot hold an accounting firm liable for negligent accounting because of the requirement of scienter: there must be intent to defraud. Also, there is no aiding or abetting either. Only buyers and sellers have standing to bring the action. Format: 60-70 MC One essay What to know from the supplement Agency Restatements RUPA 1997 Revised Uniform Partnership Act Partnership becomes the default rule if you cannot properly organize some other entity MBCA Model Business Corporation Act

I.

In the matter of caterpillar, Inc. (Disclosures raising money under an exemption) a. CFR code of federal regulation b. Regulation S-K disclosure statement c. Section 303 at issue any known trends or uncertainties that have had or that the registrant reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations. d. Disclosure 1989 annual report of caterpillar failed to discuss the Brazilian subsidiary profit was extraordinary and lead to a large part of the parent companys profit. This

was because a political and economical situation of inflation and tax breaks in Brazil, chances are in wont happen again it was a one shot situation. They knew of a political change would drastically alter the profits that caterpillar made in the previous year. Rule 10b-5 Walkthrough -Who can bring a private claim? Buyers and Sellers. -Can Lawyers and Accounts be sued? Yes, an exception, tried Scienter under the knowledge and intent. -Merger that squeezes out minority shareholders is not going to violate 10b-5 rules.