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BUSINESS ASSOCIATIONS OUTLINE Prof.

Loftus Carson Spring 1998


This outline is e-mailware! While there is no cost for using the outline, you must drop me a line at dfalgoust@mail.utexas.edu to tell me what you think, if it helped you, etc.; itd also be nice if you dropped by my web page at http://www.geocities.com/NapaValley/3578/ and signed my guest book. Feel free to redistribute this outline unmodified to anyone who may find it useful. This outline is provided as is and I make no promises as to its accuracy (it worked for me, your mileage may vary). Good Luck on exams! Damien Falgoust University of Texas School of Law

I.

Introduction A. Important basic distinctions: 1. 2. 1. 2. Incorporated vs. Unincorporated associations Closely-held vs. Publicly-held s/h: shareholder; s/hs: shareholders; BoD: Board of Directors; AoI: Articles of Incorporation IRC: Internal Revenue Code; GAAP: Generally Accepted Accounting Principles; IPO: Initial Public Offering Uniform Partnership Act 1914 (UPA) has met with virtually unanimous acceptance (except in Louisiana); is exceptionally well-drafted, has very few amendments Uniform Partnership Act 1994 (UPA 1994) Only a very few states have adopted, and then only in piecemeal fashion. Not very important Uniform Limited Partnership Act of 1976 plus 1985 amendments (ULPA) have been adopted by 49 states, but with differing amendments Model Business Corporations Act of 1984 (with revisions through 1993) (MBCA) Used by over 15 states to some extent, but the differences are substantial

B. Abbreviations used

C. Key Model/Uniform Statutes in BA: 1.

2. 3. 4.

II. The Partnership and other Non-Corporate Forms A. The Basics 1. When is a partnership a partnership?
a)

UPA 6(1) An association of two or more persons to carry on as coowners a business for profit ( (2) unless its another type created under statute, i.e., a corporation)

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b) UPA 7(4) A share of the profits is prima facie evidence that one party is a partner unless the payment was received as wages, payment on a debt, interest on a loan, etc.
2.

Partnership Agreements Its usually best to have a written partnership agreement; it can prevent problems, clarify issues, and help resolve conflicts if they occur. The cons include legal expense and the possible fostering of disputes, plus the fact that no one can anticipate everything. Everything in the UPA can be modified by agreement except 13, 14, and 15 (all relating to one partners liability for the acts of another partner). All of the other provisions are merely default rules. UPA 18(a) all losses are shared in same proportion as profits unless modified by agreement A partner can, by agreement, be paid a salary in addition to sharing in the profits, but the default rule is that no partner is entitled to a salary for his services (UPA 18(f)) Liability to others a) As previously mentioned, a partnership cannot insulate a partner from liability for harms caused to a third party. (UPA 13, 14, 15) (1) UPA 13 Partnership is liable to third parties to same extent as negligent partner (2) UPA 14 Partnership must make good loss to third party if partner, acting with apparent authority, misapplies funds received (3) UPA 15 Partners are joint & severally liable for partnership liabilities under 13, 14; only jointly liable for other liabilities (a) Recall that joint means must sue all partners at once; joint and several means you can sue either all partners at once or single out individual partners to sue. b) What about non-equity partners (a.k.a. income partners)? Courts may look to substance over form, but generally a partner is a partner; Krocheski article (p.26) suggests indemnification in law firm setting, which may mean yes. c) Also note UPA 17 an incoming partner is only liable for preexisting partnership liabilities to the extent they can be satisfied by partnership property.

3.

B. Sharing Profits and Losses 1. 2.

3.

C. Management of the Partnership 1. Actual Authority a) Restatement (2d) of Agency 7 defines as the power of the agent to affect the legal relations of the principal by acts done in accordance with the principals manifestations of consent to him.

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b)

A partner cannot restrict another partners ability to act. A partner has actual authority to bind the partnership so long as a majority of the other partners hasnt acted to limit that authority (Nabisco v. Stroud) Basically only the partnership as a whole can bind an individual partners actual authority to act on the partnerships behalf.

c)

d) UPA 18(e) all partners have equal rights in conduct of business, unless expressly modified by agreement. 2. Apparent Authority a) Restatement (2d) of Agency 8 defines as the power to affect the legal relations of another person by transactions with third persons, professedly as agent for the other, arising from and in accordance with the others manifestations to such third persons. (1) Restatement (2d) of Agency 125: can terminate apparent authority by notifying third party
b)

Contrasted from actual authority: apparent authority depends on manifestations made by the putative principal (not agent!), and is designed to protect third parties who reasonably rely on those manifestations Therefore, a partner can bind the partnership to third parties even if there isnt any actual authority
(1)

c)

Ex.: Where partner enters into land contract with third party; his authority to do so is expressly limited by the agreement; third party reasonably relied on his representations, so contract is valid (Smith v. Dixon) (a) Note that the partnership could protect itself by appraising the third party of the limits of the partners authority but it may be bad business to do so. (b) The result is that the burden of having a poor agent is on the partnership, not the third party

d)

However, the partners acts must be of a type in the ordinary course of business in order to bind the partnership
(1)

Thus, when lawyer embezzles client funds (keeping them in his own personal bank accounts), the partnership isnt liable because the firm normally didnt manage funds in that way plus the client was apparently dealing with the lawyer rather than the firm as a whole (Rouse v. Pollard) (1941) Compare case where lawyer advises client to loan him money and firm is held liable because advising clients on loans is normal part of firms practice (Roach v. Mead) (1986)

(2)

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(a)

Is this really any different from Pollard? Not by much. This is probably more related to modern emphasis on the Rules of Professional Conduct (MRPC 1.8) than anything else.

(b) Generally speaking, the less sophisticated the client, the more you need to speak up. D. Duties of Partners to Each Other
1.

Partners have a broad duty to inform their fellow partners of business opportunities
a)

Thus, where 20-year hotel joint venture is close to its end, and one party signs another lease to expand the enterprise without informing the other of the opportunity, the cut-out partner may sue (Meinhard v. Salmon)
(1)

This is the most-cited case in Business Associations

(2) To avoid liability, Meinhard should have put in the agreement that no opportunities arising out of this venture would bind the partners to each other
2.

A finding of a fiduciary duty is crucial to establishing liability (we normally applaud cutthroat competition, so this finding is a must) a) UPA 21 makes all partners a fiduciary therefore, it must be disclaimed by an express agreement for the opposite to be the case

E. Partnership as an Entity 1. While technically, partnerships arent entities (unlike corporations), some are so large that they are thought of as such. UPA generally takes entity approach. Applicable statutes (UPA Part V): a) UPA 24: Property rights of a partner (rights in partnership property, interest in the partnership, right to participate in management)

2.

b) UPA 25: Rights in specific partnership property (co-owner holding property as a tenant in partnership) c) UPA 26: Partners interest in partnership = his share of profits, which is personal property

d) UPA 27: Partner can only assign his interest in profits (not management rights, etc.) (Consistent with UPA 18(e), equal management, and UPA 18(g), unanimous consent to add new partners) e) UPA 28: Court can assign partners interest to satisfy judgments (i.e., creditors cant reach partnership assets, just the interest in the partnership)

F. Dissolution

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1.

UPA 29 defines as the change in relation caused by a partners departure, as opposed to the winding up of the business a) Three stages to ending a partnership: (1) Dissolution business still continues (e.g., delivery company makes remaining deliveries) (2) Winding up closing things down, selling property, etc. (3) Termination b) Causes of dissolution (UPA 31) (1) Expiration of term of partnership, express will of any or all partners (if no assignment of interest), expulsion of any partner via terms of agreement, partnership becomes unlawful, death or bankruptcy of partner, or judicial dissolution (32) (2) Judicial dissolution (UPA 32) Court can dissolve in special cases, such as insanity of partner or child support that cannot be fulfilled otherwise
(a)

Courts are loathe to do this For example, a partner who wants judicial dissolution to avoid breaching a contract with his partner will not get judicial dissolution. (Collins v. Lewis)

c)

Note that a business can carry on indefinitely after dissolution (and most agreements provide for this)
(1)

Dont have to move to winding up stage agreement can trump (Adams v. Jarvis)

2.

Partners still owe fiduciary duty during dissolution


a)

Ex.: Lawyers leaving firm must render on demand information affecting the partnership (UPA 20); They are liable for not telling the firm when asked that they were soliciting clients to go with them. (Meehan v. Shaughnessy)
(1) (2)

Note that Meinhard standard is more stringent than the UPA probably have to tell even if they dont ask Note case (Susman) cant ditch firm on the eve of big contingency-fee settlement

(3) Noncompete agreements valid if so long as no undue geographic, scope, or time restrictions. However, cant take away partnership profits already due a partner. Also, NY makes noncompete agreements invalid as to attorneys CA permits, TX unclear
3.

Also note you can expel partner according to terms of agreement even if the contradict UPA 31, 32. (Gelder Medical Group v. Webber) UPA 16 (Partnership by estoppel) if you act like there is a partnership, you can be liable to third parties as though a partnership existed
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G. Inadvertent Partnerships 1.

a)
b)

Recall 7(4) (profit sharing as prima facie evidence) and its exceptions Martin v. Peyton Agreement between two parties does not create a partnership because it looks like a debt (and thus falls within an exception) (1) Indices of Partnership: profit-sharing, centralized, co-ownership (2) Indices of No Partnership: cap on profit sharing, other factors (which outweigh the previous indices)

2.

Appearances only count against third parties


a)

Smith v. Kelley Plaintiff called a partner, but didnt share in profits, contribute capital, participate in management, bear losses, etc.; he is not a partner with regard to the other partners since they didnt mean to make him a real partner
(1)

However, he would be a partner if third party was suing (UPA 16)

(2) Note how plaintiff gets screwed hell take losses, but not profits
b)

Third parties can get you by showing either: (1) An express agreement making you a partner, or (2) A course of conduct showing youre a partner

3.

A party must be held out as a partner


a)

Young v. Jones Price Waterhouse is not liable for bad audit by PWBahamas; they are not partners because PW-Bahamas isnt held out as a partner. (1) Carson: this demonstrates that, as a practical matter, UPA 16 only applies to creditors; Carson also thinks this is a bad case

b) Note, therefore, that the average tort victim (i.e., slip-and-fall) cant sue under a theory of partnership by estoppel. H. Other Non-Corporate Forms 1. Limited Partnerships (LPs) a) Limited Partnerships come from statutes (1) Benefits: limited liability (like corporation) but no double taxation (like corporation), plus other tax advantages (2) There must be at least on general partner who manages the partnership and is personally liable for its debts (3) A limited partner has limited liability and only contributes capital they cannot manage the corporation (but a person can be both an LP and GP(?)) b) Master LPs these are large, publicly-traded LPs; these are almost entirely extinct, except perhaps in the oil and gas field.

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c)

Kinter Regulations determine when something will be taxed as a partnership and when as a corporation. This only applies to Master LPs. (1) Requirements having five of the following results in corporate taxation: (a) Associates * (b) Objective to carry on business and divide gain * (c) Continuity of life (d) Centralized management (e) Liability for corporate debt (f) Free transferability of interest
(2)

Note that the * requirements are always met; the effect is you must lack two of the remaining ones to get partnership treatment. (c) and (f) are the easiest to avoid. Delaney v. Fidelity Lease Limited partnership had dummy corporation set up as its GP. Court looked beyond the formalities and imposed liability on the LPs since they exerted control over the partnership
(a)

d) Sometimes, an LP is liable anyway


(1)

Question: the bank in Delaney was run by grown-ups, right? Why didnt they investigate the GP and demand personal guarantees from the LP when they discovered the GP lacked assets?

(2)

Delaney would be different if it came after ULPA 303(b)(1), which provides safe harbor for corporate officers who are LPs when the corporation is the GP. (Other safe harbors follow in 2-6)

2.

Limited Liability Companies/Corporations (LLCs) a) Essentially, a limited partnership without the GP; it allows a choice between entity and aggregate (pass-through) taxation, and gives the freedom to tailor financial arrangements while maintaining limited liability. S-Corp restrictions also dont apply.

b) Recall, though, that under the Kinter regulations, transferability must not be too easy! 3. Professional Corporations (PCs) and Limited Liability Partnerships (LLPs) a) PCs originally created to take advantage of deductions otherwise unavailable to partnerships; the IRS has since extended these advantages to partnerships, so this reason is no longer meaningful.
(1)

First Bank & Trust Co. v. Zagoria Lawyer fraudulently withdraws funds; bank sues firm, which is organized as a PC.
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Held: PC status only gives limited liability for ordinary business not fraud or malpractice (a) Different result in Texas you can pursue the PCs assets, but not the uninvolved members personally. Solution: sue everyone in sight (claim aiding and abetting) b) LLPs are general partnerships where individual partners have a degree of limited liability; you can only be sued if you are personally involved with the malpractice. Does not protect against tort or contract claims. I. Selection of the Business Form 1. For limited liability, corporation or LLC is the only way to go.. However, most lawyers say dont use them. Why? a) Insurance can alleviate most liability concerns liability is thus only a real concern at the margins, beyond insurance coverage (and even this may not be worth using the corporate form, since failure to carry enough insurance is a reason to pierce the corporate veil)

b) For a new corporation banks will typically require personal guarantees anyway (but may be able to convince them to take a security interest in corporate property instead) 2. Other considerations a) Legal sometimes the choice of form is restricted legally (ex.: lawyers must practice using one of the partnership forms; regulated industries have special rules). In most cases, this isnt a big concern, though. (1) Corporations (C Corps) are subject to double taxation (corporate income, then dividends are taxed when received by individuals) (2) Partnerships treated as pass-through entity, so no double tax
(a)

b) Taxes (this is usually the #1 factor)

S Corp can give partnership treatment to corporation, but is very restrictive ( 35 shareholders, no alien or corporate shareholders, only one class of stock, etc.)

(3) Also note: have to beware state taxes on various forms as well (Texas taxes corporations, LLCs) c) Informality, Flexibility, Cost (Partnership is best; however, these arent generally important considerations) Centralized Management corporation usually better because of Board requirement (MBCA 8.01(b)); however, partnership can be structured in centralized fashion by agreement (i.e., UPA 18 can be modified) Free Transferability of Interest corporation usually better (UPA 27 [assignment of interest] and 18(g) [unanimity to admit new members]

d) Continuity of Life corporation is best e)

f)

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restrict partnerships, but can be modified by agreement; MBCA 6.27 allows restrictions in corporate charter) 3. Corporations have nonetheless predominated because of the dispersion of wealth and the need for large amounts of capital.

III. Formation of the Corporation A. A Brief History of Corporations 1. Initially, you needed a special legislative grant to incorporate a) Initially used to grant charters for colonization of the New World; Limited liability did not come until later Ex.: for a long time, Ms. Bairds could only sell bread in one county; to expand their operations required legislative approval

b) Problem: this led to corruption and influence peddling c) 2.


3.

Then general incorporation statutes gained favor Louis K. Ligget Co. v. Lee held state incorporation statutes subject to equal protection, invalidating tax statute that hit multi-store corporations harder than single retail outlets a) However, Brandeis dissent argues that states should be able to control size and scope of corporate activity demonstrates a basic fear: large economic units dominating political concerns. Since the state of incorporation (and not location) governs corporate rules, Delaware has become a popular choice because of its lax rules for incorporation (1) Internal affairs doctrine (not full faith and credit) gives this result; it says that the state of incorporations rules control the internal affairs of the corporation (2) Note the statutory language in DE isnt actually that different from other states; its just that DE was the first to give management significant freedom, and judicial interpretation snowballed it from there. b) Two theories on state incorporation statutes: (1) Prof. Cary: Race to the Bottom argues that Delawares flexibility, motivated by a desire to generate revenues for the state (i.e., franchise taxes), are too flexible and benefit management to the detriment of shareholders. He wants federal incorporation. (2) Prof. Winter Free market solves the problem stock price reflects risk of incorporation in a state with permissive laws. Argues that competition between the states is healthy. c) Issues in deciding Delaware vs. local incorporation (Prob. #3)

4.

A word on Delaware
a)

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(1) Pro-DE: Because so many corporations are incorporated there, the case law is more developed (and thus more predictable) than in other states; the lawyers in DE have more experience with corporate matters; most lawyers are familiar with DE law anyway (out of necessity); DE is very pro-management (2) Con-DE: High cost; Have to qualify as a foreign corporation in local jurisdiction; not subject to jurisdiction of DE courts (minimum contacts jurisdiction a wrinkle in internal affairs law; local law is probably more pro-shareholder (ex.: CA is most proshareholder state) 5. Theories of corporateness
a)

Entity (prevailing view in US law) corporation has all rights that a human has except those uniquely personal (i.e., 5th amendment right against self-incrimination, etc.)

b) Nexus of Contracts most laissez-faire view, popular among economists; says role of state is merely to enforce mix of contracts chosen by initial investors and agreed to by subsequent investors c) 6. a) Aggregation of individuals the realist view Some say that the MBCA is too permissive in the degree of flexibility; Hamilton disagrees, saying flexibility is good for shareholders, and that any decision is unlikely to be adopted unless it reflects consensus anyway A few miscellaneous notes (dont know where else to put em)

b) Greenmail s/hs buy up block of stock to press agenda, force management to buy block at a premium to keep them from doing so again c) MBCA 8.01(a) requires BoD unless eliminated by s/h agreement (7.32(a)(1)); BoD can only change number of directors by 30% without s/h approval (8.03(b))

B. Corporate Formation 1. What to look at in deciding what state to incorporate in? (also see above under DE vs. local); generally, two things: a) 2. Cost in each state b) Substantive law in each state What formalities must be done to incorporate? a) Corporate Name must be distinguishable on records of Secretary of State; must include corp., inc., etc. (MBCA 4.01)

b) Must comply with MBCA Chapter 2 (i.e., 2.01-07); best to use an incorporation kit to do this (saves billable hours) c) Need a person to be the incorporator 2.01 (not a big deal)

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d)

Minimum information needed in articles of incorporation: corporate name, number of shares authorized to be issued, street address of corporations initial registered office and name of agent at that office, name and address of each incorporator (2.02(a)) Optional: can include name and address of those intending to be officers, limit scope of corporations purpose, regulation or management of business, limitation of powers, par value of shares, imposing personal liability for s/h, limits on director liability, anything that could be put in the bylaws (2.02(b)) (1) Note that 3.01 sets default purpose to any lawful business. (2) Power vs. purpose: Purpose means what your in business for; if you can say to engage in the business of _____, it is a purpose; otherwise it is a power (ex.: a power is to sue or be sued). Note you can limit powers just as you can limit purpose.

e)

3.

Common formation mistakes a) c) Overlooking something obvious (best to use a checklist) Also beware of representing multiple parties Model Rules of Professional Conduct 1.7 permits it with full disclosure, but its often a bad idea anyway b) Use of boilerplate where inappropriate

4.

Post-filing issues (Corporate existence begins immediately after filing MBCA 2.03) a) Prepare bylaws b) Prepare notice of first BoD meeting, minutes, and waiver of notice (if needed) (note meeting not required if a very small closely-held corp.) c) e) Obtain corporate seal and minute book Open book accounts, etc., etc. d) Arrange for printing and issuance of shares

C.

The Doctrine of Ultra Vires (MBCA 3.04) 1. The basic doctrine: a corporation is only competent to do certain things which are outlined in its charter a) This doctrine is effectively extinct today (most corporations are engaged in any lawful business) but can bite you if there is limiting language. Note that generally the only people who can challenge a corporate act under ultra vires are shareholders, officers, and the state attorney general (3.04(b)) i.e., NOT 3rd parties
(1)

b)

Thus, a landlord cant use ultra vires to get out of lease with corporate tenant (i.e., by claiming corporation is acting beyond the

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scope of its purpose by entering the lease). (711 Kings Highway Corp. v. F.I.M. Marine Repair Service, Inc.) 2. Ultra vires and default rules a) Generally, courts apply a reasonableness standard to corporate acts falling within the statutory defaults
(1)

Therefore, a corporation that gives money to charity is OK so long as the amounts given are reasonable (Theodora Holding Co. v. Henderson)
(a) (b)

Must be reasonable as to amount court uses IRS deductibility to determine Must be reasonable in kind i.e., given to a recognized charity

(2) Note that MBCA 3.02(13) expressly gives corporations power to give donations (unless expressly revoked in articles of incorporation)
(a)

Also note, however, that these powers are still enumerated (unlike the broad, sweeping default definition of purposes); see discussion of powers vs. purposes above

(3) What if charitable gift involves quid pro quo? Ex.: CEO gets invitation to sit on prestigious opera board (Prob. 2) (a) May be outside power since purpose could be construed as personal, not charitable (b) Carson: Gift is probably OK anyway, but just to be sure its a good idea to give a recitation at BoD meeting about benefits, such as good PR. D. Defective Formation 1. Pre-incorporation Promotion a) General rule: a person signing for a nonexistent corporation is personally liable unless there is clear intent expressed to the contrary
(1)

Thus, when person signs contract for architectural services as agent for a corporation to be formed who will be the obligor, that person is liable if the corporation is never formed. (Stanley J. How & Assoc. v. Boss) The upshot is that you must make it expressly clear that the individual isnt to be liable

(2)

b) Cover Your Ass (CYA)! get a copy of the stamped, filed incorporation document before closing anything! c) Restatement (2d) of Agency 326, comment b: Intent can be shown by a revocable offer, offer made irrevocable for a limited time with promoters implied promise to use best efforts to incorporate, etc.

d) At the end of the day, though, any ambiguity is held against the agent
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2.

Incorporation by Estoppel a)
b)

Sometimes, a court will treat a corporation as formed even though there are technical defects. Thus, where a corporation has filed, paid taxes, but had a few errors in its incorporation process, it is a corporation for purposes of determining the order of payment to creditors. (Matter of Whatley) Court sets out three factors for a de facto corporation:
(1)

Existence of a valid law under which it could incorporate

(2) Bona fide attempt to incorporate (3) Actual use of corporate powers
c)

Also, where attorney botches incorporation, individual s/h still retain limited liability so long as (1) creditor thought it was a corporation at time of contract and (2) investor in good faith thought a corporation had been formed (i.e., reasonable reliance on the attorney) (Cranson v. IBM) (1) Effect of this: so long as investor had good-faith reliance, there is no liability for transactions (but liability remains for torts)

IV. Disregard of the Corporate Entity (Piercing the Veil) A. The basic question: when will a court ignore the existence of the corporation and extend liability to the investors personally?
1.

Carson: Piercing in any situation is very rare. Generally, courts are very reluctant to pierce in the context of contracts; after all, if the corporation is thinly capitalized, why doesnt the contracting party get a personal guarantee from the s/hs?
a)

B. Piercing and Contract Breaches


1.

Thus, where a corporation forms a subsidiary to build housing, and subsidiary goes bankrupt, the subsidiarys creditors cannot pursue the parent corporation for the remaining debt. (Bartle v. Home Owners Co-Op) (1) Possibly different result if fraud had been involved Ex.: Where construction corporation (WCC) purchases bowling lanes and equipment from Brunswick and then breaches, Brunswick cannot hold the construction corporations officers liable (Brunswick Corp. v. Waxman)
(1)

b)

Plaintiff here advances several arguments, including instrumentality rule (complete domination by s/h, use of that domination to commit a fraud or other wrong, and injury caused by that act) and the straw corporation theory (pierce if corporation is a dummy for purely personal ends)

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(2)

Court rejects both in this case since Brunswick knew that WCC was undercapitalized, it shouldnt be allowed to avoid the consequences now. Caveat emptor. Compare Dewitt Truck Brokers v. W. Ray Fleming Fruit Co., where corporation was run with complete disregard for corporate formalities, it was undercapitalized, president had withdrawn funds due to plaintiff, president made statements to effect that he would be liable (statute of frauds prevents enforcement). Here, court pierces veil via application of the instrumentality rule (see above)
(a)

(3)

Why the different result? Theres still no fraud, but here there is a fundamental unfairness: unlike Brunswick, here the breach of the contract goes against the good-faith assumptions of the contracting party. Instrumentality doctrine used to pierce when corporation is used as an instrument to cause a wrong not just because its an instrument

(b)

2.

Other policy reasons may also trump piercing (Cargill v. Hedge, denying reverse piercing in order to protect homestead policy creditors should have secured the loan) Key difference between this and contracts: the injured party here is not a willing party The veil will not be pierced just because the plaintiff cannot recover solely from the corporation must prove control and bad conduct
a)

C. Piercing and Tort Claims 1.


2.

Thus, in Walkovszky v. Carlton, 2-cab corporation will not be pierced even where sole s/h owns 9 other 2-cab corporations just like it. Why? Because the corporation was incorporated in perfectly legal fashion, and the fact that there are multiple entities does not constitute a fraud. (1) Also note dicta saying that undercapitalization argument fails as well the cabs carried the requisite amount of insurance mandated by law ($10,000); since the legislature says that amount is sufficient, the courts presume it is not undercapitalized. (2) To even state a cause of action that can be heard, plaintiff must allege the business was run in a personal capacity

b)

Also see Radaszewski v. Telecom Corp., where piercing was denied where corporation was thinly capitalized and went bankrupt but nonetheless carried adequate liability insurance coverage. The court says no socially irresponsible behavior here. (1) Court sets following test for piercing: (a) Complete shareholder control of corporate policy with respect to the issue at hand

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(b) Used to commit a fraud or wrong (i.e., breach of duty no such breach here because of adequate insurance) (c) Injury to plaintiff (2) Dissent: insurance isnt per se adequate capitalization; question should be submitted to a jury
3. 4.

However, cant defend yourself on the grounds that you were a temporary director (Minton v. Cavaney) Mere opportunity to control isnt enough must be actual utilization of control (American Trading and Production Corp. v. Fishbach & Moore)
a)

However, a family-owned corporation with subsidiaries where the parent corporation totally dominates the subsidiaries to the extent that its unclear to a neutral observer that they are separate entities can result in piercing. (My Bread Baking Co. v. Cumberland Farms, where it was shown that president directly ordered subsidiary to not return bread racks)
(1)

In other words, a jury could reasonably find the subsidiary was a mere instrumentality of the parent so the issue of control should reach a jury.

D. Other Veil-Piercing Issues


1.

Courts try to balance common-law theories with federal laws holding intracorporate actors liable (US v. Kayser Roth Corp.); where there is a statute, courts will apply it In some situations (notably bankruptcy) courts may hold a fiduciary duty exists to creditors
a)

2.

See, e.g., Pepper v. Litton, where dominant s/h with advance knowledge of impending bankruptcy secured a judgment for back salary (which is paid ahead of creditors, unlike s/h claims); court denies collection in favor of creditor on basis of fiduciary duty to creditors Note fraud in this instance need not be shown only inequity in a situation where a duty exists (also note this isnt really a piercing case, but an order-of-payment case)

b)

3.

Sophistication of the parties is often an issue, as is the voluntary nature of their participation (i.e., why tort victims are more likely to pierce than parties to a contract). Its also more likely that a parent corporation will be held liable than an individual investor investors in parent have put their money at risk; theres no nest egg at stake. In Texas, issue of piercing the veil is a jury issue (Castle v. Newberry)

4.

E. Summary of approach to veil-piercing problems:

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1.

Contract issues: show some kind of injustice. Could other party have foreseen this result? Could they have taken steps to prevent it? Was corporation used as an instrument to commit a wrong? Tort issues: look for thin capitalization. Also total domination.

2.

V. Closely Held Corporations A. Financial Matters and Closely-Helds 1. Types of Equity Securities a) MBCA 6.01-04 regulates issuance of shares; liquidation usually is face value of stock plus dividends in arrears. (1) 6.01(b) at least one class must have voting rights and rights to assets on dissolution (2) Par value optional in most states but not Texas (used to be corporations had to keep assets equal to par value) b) Common Shares Confers voting rights, but dividends come only after preferred shareholders; owns residual value of corporation c) Preferred Shares No voting rights, but get dividends first; can usually be redeemed at corporations discretion at a premium; sometimes convertible into common shares; priority in dissolution over common (but not over creditors)

d) Classes of Common Various classes of common stock may be issued, each with their own unique rights 2. Issuance of Shares a) MBCA 6.21 BoD has default power to issue; consideration for shares is not limited to cash (i.e., can be for services rendered, intangibles, etc.) But only for authorized number of shares in the articles of incorporation thus making number of authorized shares an important s/h issue Terminology (1) Debt basically is a fixed obligation (2) Debenture an unsecured obligation (pronounced Deh-BEN-ture) (usually short term) (3) Bond obligation secured by a lien (though commonly used to refer to both) (usually long term) (4) Zero-coupon bond no interest, sold at a discount (5) Junk bond a below-investment grade debt

b)

3.

Debt Financing and Leverage a)

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b) Leverage can greatly increase the return on equity, maintain control of a corporation, and has tax advantages (i.e., interest is deductible); the downside is that it is risky and an adversely affect financial ratios. c) Sometimes debt will be treated as equity if it looks like a sham
(1)

For example, see Slappey Drive Industrial Park v. US, where IRS considered notes held by s/h to be equity since they didnt require the corporation to make timely interest payments; IRS denied deduction for interest.

d)

Also beware of undercapitalization, especially if debt is held by coowners deep rock doctrine of Pepper v. Litton (supra) could bite you (see also Obre v. Alban Tractor Co., saying capital structure was permissible) Preemptive rights basically refers to an existing s/hs right to not have his shares diluted by a new offering; he must have first crack at buying the shares.
(1)

4.

Preemptive Rights and Dilution (Issuance of Shares) a)

However, this right does not entitle an existing s/h the right to buy at lower than the market price. (Stokes v. Continental Trust holding damages limited to price increase after issuance) This is now an opt-in provision of the MBCA (6.30) Preemptive rights are optional; however, some states have it as an opt-in provision (making preemption the default rule)

(2)

b)

There is also a fiduciary duty to not issue shares at a lowball price in an effort to dilute the shares of a s/h you dont like, even if preemptive rights are protected (i.e., must have a business justification for the issue) (Katowitz v. Sidler) No remedy for minority s/hs where majority s/hs pay themselves salaries and bonuses but issue nothing but nominal dividends (Gottfried v. Gottfried) (note: rule changes for small corporations see Davis v. Sheerin, infra) However, if its clear that management isnt working for profit maximization for the s/hs, a court can force a dividend payment (Dodge v. Ford Motor Co.)
(1)

5.

Distributions
a)

b)

Note result above is probably more due to Fords brazenness than anything else; also note that IRS can nail you with penalties (IRC 501, 502) for holding excessive surpluses

c)

Also, IRS can reclassify a salary as a dividend if it is deemed unreasonable


(1)

See Herbert G. Hatt, where excessive salary, boat, and plane are all deemed to be dividends for tax purposes

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(2) Note: if s/h wants to sue director for taking action that increases taxes unnecessarily, the standard is unreasonableness (3) MBCA 6.40 A corporation cannot make a distribution if it meets two tests: (a) Insolvency test (6.40(c)(1)): cant pay its liabilities as they come due (absence of auditors qualification on audit report meets this test; otherwise, a judgment call), and (b) Balance sheet test (6.40(c)(2)): the distribution would reduce assets to less than liabilities + distribution preferences (Must use reasonable accounting method, but GAAP isnt mandated 6.40(d)) B. Management and Control of Closely-Helds 1. Traditional Roles of Shareholders and Directors
a)

McQuade v. Stoneham an incredibly important case it is still the black-letter law in all 50 states. (1) Three stockholders, as part of contract for sale of stock, agree to do their best to keep themselves as directors and officers of the company. Later, two of them kick the third guy out.
(2)

Held: The contract is void as against public policy. Directors must be free to act in the corporations best interests. You cant enforce a contract that requires a director to vote for a particular person. How does this square with the MBCA? Directors are in charge (8.01(b)) subject only to any limits in AoI or in a shareholder agreement authorized by 7.32 (including those restrict[ing] the discretion or power of the BoD) Some courts will enforce the contract if there is only a slight impingement of the interests (Clark v. Dodge, where there 1) was only two s/hs; 2) weasel words like so long as he remains faithful; and 3) is only a minor infringement of McQuade).

(3)

b)

Exceptions to the McQuade Doctrine


(1)

(2) Small, closely-held corporations can deviate from corporate norms to effectuate the intent of the parties
(a)

Ex.: Where widow sues for enforcement of agreement between her deceased husband and his brother (combined 95% s/hs in company) which called for them to vote for themselves and their wives as directors, and pay a 5-year salary continuation to widow upon either brothers death, the contract is enforceable (Galler v. Galler)
(i)

This has the effect of exempting close corporations from McQuade when the rationale for that rule isnt present

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namely, the BoDs discretion is unfettered by this agreement


(ii)

Note, however, that dead-hand rule is most likely going to be stricken if it cant otherwise be avoided (Estate of Hirshon) Also, some legislative enactments (i.e., special close-corp statutes) can restrict this further (but clever attorneys can usually work around) (Somers v. AAA Temporary Service)

(iii)

(3)

Only the portion of the contract which is violative of McQuade will be unenforceable; if other provisions are permissible, they are enforceable (Triggs v. Triggs) Also, if states corporation statute permits s/h agreement to limit BoDs power, its OK (Zion v. Kurtz DE law) (also see MBCA 8.01(b) above)
(a) (b)

(4)

Key: legislatures can deviate from McQuade; so long as statutory requirements are followed, everythings OK Key here is notice Statutory prescriptions are designed to furnish notice

2.

Shareholders (S/H Voting & Agreements) a) Voting by Proxy (1) Only a record owner has the power to execute a proxy, not the beneficial owner (a) Record owner = owner on corporate records (b) Beneficial owner = the real owner can compel the record owner to give him dividends, etc.
(2)

Salgo v. Matthews Election inspector refuses to recognize proxies from old beneficial s/h in bankruptcy, claiming that bankruptcy trustee (now the real beneficial owner) is the only one who can execute the proxies. Holds:
(a)

A corporation cannot require that shares be voted only by their beneficial owner an inspector can only look to the record owner

(b) Plaintiff here could have won had he waited until after the s/h meeting (when decision is final) to oust the person (before final decision, election inspector has discretion under Texas law) (c) Note MBCA 7.24(b)(3) trustee can vote, even if bylaws say owner must be recorded in corporate records (but corporation has discretion, and trustee must show authority) b) Straight and Cumulative Voting
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(1) Straight voting means basically that each share gets one vote per board position; Cumulative voting means that you multiply the number of shares times the number of board positions open (shares x positions), and each s/h can apportion his votes among the board candidates.
(a)

Formula to figure number of shares needed to put a given number of people on the board:
nS D +1 +1

(b)

In the above: n = number of directors you wish to elect; S = total number of shares voting; D = total number of directors being elected

(2) Basic intent is to give minority s/hs more power to control the BoDs composition (a) The intent of cumulative voting can be frustrated by staggering the election years so fewer directors are voted on each year, thus requiring a higher percentage of stock to place a director (b) Ostensibly, staggered voting guarantees continuity and familiarity on the BoD, but practically its just an instrument of majority s/h control
(i)

Humphreys v. Winous State law guarantees cumulative voting; P sues over staggered voting which effectively undercut cumulative voting. Court says that staggering is OK equal dignity rule says cant disregard one legislative mandate because it hurts another

(c) MBCA 7.28(b) makes cumulative voting an opt-in provision (like preemptive rights) thus default is centralized control (i) Also: 8.04 allows separate directors for separate classes of stock; 8.06 permits staggered terms, so long as 3 per class with 3 classes (i.e., at least 9 total) c) Shareholder Voting Agreements (1) MBCA 7.31(b) voting agreements are specifically enforceable
(2)

Ringling Brothers Barnum & Bailey Combined Shows v. Bailey (another important case) Widows agree to vote together for ten years to insure election of 5 of 7 directors. Later, one breaks from the group and votes her own way, others sue for performance. Court upholds agreement, but instead of performance just doesnt count defendants votes.
(a)

Is this agreement violative of McQuade? NO. The agreement only applies to votes; the directors arent bound once elected.

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(b)

Court also says this isnt a voting trust (i.e., voting rights separated from other incidents of stock ownership; not illegal per se, but law is skeptical of them)
(i)

See Brown v. McLanahan members of voting trust give debenture holders voting rights, where most members were also debenture holders. Held: trustees have fiduciary duty to the s/h they vote for, and this is a violation Lehrman v. Cohen must be separation of ownership and control for a voting trust to exist

(ii)

(iii) MBCA 7.30 Voting trusts are OK, with certain technical requirements. 10 year limit unless extended. (iv) Positive reason for voting trusts: puts management in hands of professionals (making loans, etc., easier to get) 3. Directors
a)

The BoD must act formally as a group


(1)

Baldwin v. Canfield Sole s/h of corporation with only one asset (land) pledges his stock for two loans. He then agrees to sell the land to a third party, giving him a deed signed by some directors. There was no directors meeting held to discuss the sale.
(a)

Held: the deed was not a valid conveyance. Board must act as a group

(b) Lots of BS here. Creditors should have gotten a lien on the land (they knew it was the only asset); land purchaser knew about pledge of shares and thus should have known sale wasnt valid. Also, this case is very old (1879) so its worth is questionable. b) However, a single director can bind a corporation with the knowledge and acquiescence of the other board members.
(1)

Mickshaw v. Coca-Cola Bottling Co. Coke publishes ad that they will pay its workers if they are drafted for WWII the difference between their current and military pay. Mickshaw is drafted, but joins the Coast Guard. He sues.
(a)

Held: Of three directors, one made it, one knew about it and agreed to it, and a third never disavowed it. Therefore, the corporation is liable.

(2)

Minority view: only formal board action can bind corporation (Hurley v. Ornsteen, disallowing one board members offer to settle a debt with a creditor) The rule is flexible courts can pretty much apply in any matter they wish.

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(a)

In Hurley, some possible reasons for denying the agreement include its gratuitous nature (no benefit to corporation) and the fact that it harms other creditors.

c)

Other BoD issues (Prob. 7) (1) Can unanimous vote of four directors (on 8 person board) bind corporation where other directors are unavailable? NO. Quorum is required i.e., at least a majority of directors (5) (see Model Bylaws 3.5, default rule in MBCA 8.24(a)) (2) Can a sick board member sign a proxy for another member? NO
(3)

Alternatives include conference calls (MBCA 8.20(b)), written consent to substitute for an actual vote (8.21) (note this would change Baldwin)

(4) You can reduce the number needed for quorum in the bylaws no lower than 1/3 (8.24(b)); Director can take prescribed steps to disclaim assent (8.24(d)); BoD can delegate to committees except for certain things (8.25) 4. Officers a) At common law, officers have very little actual authority to bind the corporation (only the BoD can do so)
(1)

Black v. Harrison Home Co. Bylaws require authorization by president and secretary to bind corporation on land sale. Secretary dies. President (and now sole s/h) authorizes sale. Corporation (via dead secretarys estate) refuses to hand over; buyer sues. Held: President cant bind corporation contrary to bylaws (a) No actual authority because of bylaws; no apparent authority because no course of dealing, and its just not apparent (1909 case, today it may be apparent)

b) Modern Rule officer can bind corporation for things in the ordinary course of business, but not for extraordinary things
(1)

Lee v. Jenkins Bros. President guarantees pension to worker hes trying to lure away. BoD never approved. Worker later sues for pension after he is fired. Held: Hiring this guy was an ordinary thing for the president to do and this wasnt an outrageous contract, so the company is liable.
(a)

Note that the bylaws can still trump if they specifically deny a power to an officer thus, today Harrison Home would still come out the same since the bylaws had an express restriction on the presidents power. However, this rule (bylaws trump) only applies to actual authority

(b)

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c)

An otherwise invalid act by an officer can still be enforced if he represents himself as having adequate authority
(1)

In the Matter of Drive In Development Corp. Bank asks for evidence of authority for loan; officers supply board minutes showing authorization. Corporation files for bankruptcy; bank sues, but at trial minutes dont show authorization. Held: the bank can recover on estoppel principle (a) Bank wins because the officers 1) appeared to have the authority to act, and 2) it was reasonable for the bank to think they had such authority based on the minutes they received (b) Note that if there is any reason to doubt the validity of the information establishing authority, you cannot reasonably rely on it.

(2)

Scientific Holding v. Plessy President agrees to contract modifications at closing, but tells party that hes not sure if he has the authority to do so. Corporation later sues to invalidate contract. Held: since president can ordinarily bind for ordinary things, the BoD must repudiate within a reasonable time (a) Thus, where president normally would be within his powers, the BoD is deemed to have been ratified because 1) knowledge is imputed to them and 2) they must repudiate in a reasonable time

C. Shareholders: Oppression, Dissension, Deadlock, and Dissolution 1. Shareholders owe each other a fiduciary duty in closely-held corporations
a)

Donahue v. Rodd Electrotype Co. Retiring Chairman of BoD (and majority s/h) gets rest of BoD (family members) to vote for the corporation to buy back some of his stock. Min. s/hs sue, since they werent given the opportunity to sell at the same price. Held: Majority s/h breached a fiduciary duty. (1) Note this means the rules are different for close corporations and widely-held corporations
(2)

This case cites to Meinhard (see prev., Cardozos fiduciary duty to partners case) (a) Few s/hs (b) Little or no market for shares (c) Substantial s/h participation in management (d) Note that some states have different statutory definitions (e.g., DE makes it < 30 s/h; others say if not publicly traded)

(3) Note definition of close corporation:

(4)

DE doesnt follow this decision (Nixon, n5 at 438)

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(5) Law & Economics criticizes this approach it says law should try to approximate what parties would have agreed to if they had contracted beforehand
(6)

Also note the Wilkes case (n.3 at 437), holding that a court must consider if the majority has a legitimate business interest and if there is an alternative available less damaging to the minority s/hs; this could change Donahue, since BoD could just claim hes a crazy old coot and they had to buy him out to get rid of him. Smith v. Atlantic Properties, Inc. one s/h refuses to vote for dividend issuance (bylaws call for 80% approval); IRS ends up penalizing corporation for excessive surplus. Held: Min. s/h owes fiduciary duty where he has a de facto controlling interest

b) Minority s/hs also owe a fiduciary duty


(1)

(2) Burden shifting: Minority alleges unfair treatment, must show injury; then, majority must show legitimate business purpose; then, minority must show availability of less harsh measure 2. Deadlocks a) If there are not enough directors to form a quorum, a mere majority will do.
(1)

Gearing v. Kelly Three directors makes quorum (only four BoD spots); One resigns, leaving only three active directors; another director (a min. s/h) refuses to come to the meeting, preventing a quorum to prevent the other two from electing a replacement. Held: this is a breach of fiduciary duty, election should stand The problem in Gearing is alleviated by MBCA 8.10(a)(3) (if number of directors falls below quorum, a simple majority will suffice)

(2)

(3) Also note 8.05(e) current directors continue to serve if there is a deadlock in election b) A court can order dissolution in the event of a deadlock, but the decision is discretionary
(1)

In Re Radom & Neidoff, Inc. Brother and sister each own of company, but they dont get along. Brother sues to dissolve under NY deadlock statute. Held: dissolution denied; statue makes dissolution discretionary to court, and the corporation is functioning just fine despite the fighting
(a)

Why doesnt brother just start a new, competing company? Hed run into Meinhard and Donahue fiduciary duty problems.

(b) Also note that dissolution would seriously hurt the sister most of the businesses assets were goodwill; brother would

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have bought the assets for a song at auction, effectively taking all the goodwill for himself at no cost.
(c)

Note case In Re Hedley-Freidman court orders dissolution due to infighting despite corporations continued profitability (n4 at 546)

(2) Same result under MBCA 14.30 judicial dissolution for deadlock is wholly within the discretion of the court (3) Also note 14.01-03, 14.07 Voluntary dissolution 3. Modern Remedies for Oppression, Dissension, and Deadlock a) Originally, involuntary dissolution was the statutory remedy; most are like MBCA 14.30 (discretionary; court looks to see if deadlock is causing harm to corporation, directors acting illegally or fraudulently, or for two meetings s/h have been unable to elect directors)
(1) (2)

b) Court-enforced buyout Davis v. Sheerin Court orders 55% s/h to buy out 45% s/h; its ability to do so is based on its general equity power This case broadens the view of what oppression means the modern view is a wide one basically, if the majority substantially defeats the reasonable expectations of the minority which were central to the minoritys joining the enterprise, a remedy will lie.

(3) This is codified in MBCA 14.34, which also provides that a buyout can be elected by a s/h in lieu of a court-ordered dissolution c) Appointment of provisional directors
(1)

Abreu v. Unica Industrial Sales, Inc. Illinois statute provides for appointment of provisional director in a dissolution where oppression exists; s/h argues that courts appointment the s/h moving for dissolutions son-in-law cannot be the director. Held: the son-in-law is fine he is qualified and the choice is up to the courts discretion (a) Also note: provisional director can only vote in the event of a deadlock

(2) Policy: favor collegial nature of BoD; its better to have someone familiar with the business, etc. 4. Restrictions on Shares a) Generally, restrictions on transferability are permissible so long as they are conspicuous and reasonable
(1)

Ling & Co. v. Trinity S&L Assn Stock certificates show on their face a restriction on transferability (had to get NYSE approval, had to give first shot to corporation and all current s/hs of same class). Held: this restriction is OK; it was not
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conspicuous, but is reasonable; remand to trial court to see if S&L knew of the restriction (a) Since it wasnt conspicuous, the question turns on the S&Ls actual knowledge (2) MBCA 6.27 restrictions are OK so long as they are 1) reasonable (ex.: no flat prohibitions) and 2) conspicuously noted on both front and back of certificate (3) Policy: allows close corporations to retain that status, especially for tax purposes; to avoid SEC regulation; to control who gets to be a shareholder (much like a partnership) b) Waldbaum Article: Buy-Sell Agreements (1) Cross-purchase agreements: each s/h buys his proportionate share of stock upon another s/hs death; estate agrees to only sell to s/hs (2) Stock-redemption agreements: corporation buys back upon death (3) Why use them? Most closely held corporations dont pay dividends; when a s/h dies, his heirs will want dividends and theres a problem for them selling no market to set the price; this method provides an out. (4) MBCA 6.27 broadly endorses these devices VI. Publicly Held Corporations - Management & Control A. Social Responsibility: Good or Bad? 1. Basic issue: corporate giantism --- many are larger in economic terms than the states they are incorporated in are they obliged to serve societal as well as economic interests? a) Barber less than .1% of firms (<100) account for 1/3 of manufacturing, employ 25% of manufacturing workers, make 40% of all new capital expenditures, and own half of the assets used in manufacturing.

2.

Milton Friedman (Playboy interview) Corporations should not do things based on social responsibility; rather, they should do good things because they are cost-effective and make economic sense. Let the market decide social responsibility issues. a) Why? Because to do otherwise means taking money from someone else (s/h, employees, etc.) Ex.: reduce pollution because it makes town an easier place to attract qualified labor to, not because of morality-based reasons

3.

Fischel article Really a question of costs and who pays them; free market generally yields best balance (Carson thinks there should be a backdrop of regulation due to externalities) ALI Corporate Governance 2.01 Corporations may act in societal interest, and that they should (Same in IL, PA statutes)
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4.

5.

Judge Allen trend is away from private property view (i.e., s/h own the corporation to do as they please) to view that corporations are societal institutions created by the legislatures. US Temporary Natl Economic Committee (1940): 3 types of control: 1) majority (rare in publicly-held); 2) minority (small but substantial number of shares can get control via proxies); 3) management (results from s/h being sufficiently diffuse) Livingston, The American Stockholder Basic problem: big corporations BoD may not advance s/h interest once in power. Solution? Wall Street Rule disenchanted s/h can sell his shares Fischel, Efficient Capital Market Theory: discusses weak/semistrong/strong market theories. Bottom line: stock price reflects all available information, and this acts as a check on management. Barber, The American Corporation: issue for the future real power lies in institutional investors (e.g., mutual funds, pensions, insurance, etc.) Black article legal rules encourage passivity Hamilton, Reliance and Liability Standards for Outside Directors: big corporations are just too diffuse for BoD to control CEO calls the shots, and even he doesnt manage the details Land, Building a More Effective BoD: Management effectively controls the corporation (McQuade notwithstanding) a) Model says that s/h elect directors, but the reality is that most directors are elected via proxy; since management can use corporate funds for proxy elections, they effectively choose their own overseers

B. Shareholders and Widely-Held Corporations 1.

2.

3.

4.

5.
1.

C. Directors and Widely-Held Corporations

2.

b) Thus, in publicly-held corporations, management is less concerned with the shareholders since they usually arent shareholders, and neither are the inside directors c) Post-Watergate led to the rise of the outside director people put on the board specifically to look out for s/hs interests. Question: if outside directors are beholden to management/inside directors for their positions, how objective can they be?

3.

Corporate Directors Guidebook: several committees should be composed solely of outside directors (ex.: compensation, audit committees) When can the BoD sell a big part of the corporation without s/h approval?
a)

D. Conflicts Between Shareholders and Directors in Publicly-Held Corporations 1. Gimbel v. Signal Corp. BoD wants to sell a subsidiary that is worth a considerable chunk of the corporations operations (26% of assets, 41% of net worth, produces 15% of revenue); s/h sues, saying they

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need s/h approval. Held: This is not substantially all of the business, so its OK no need for approval b) Under DE law, it is substantially all if it is either numerically so (i.e., over half) or the sale makes the corporation cease to function as a substantial business. This is not the case here corporation is a conglomerate, so dropping entire lines of business is ordinary c) MBCA 12.01-02 is even less restrictive you only need to perform the substantially all test if the sale isnt in the ordinary course of business (i.e., real estate holding company could sell most of its land without s/h approval because thats what it does)

E. Management and Control of Widely-Held Corporations: Traditional Roles 1. Officers must call meeting if required to do so by by-laws, even for an improper purpose
a)

Matter of Auer v. Dressel Class A s/h tell president to call meeting, which is required under bylaws; he refuses. The meeting is so they can replace the president with their guy as well as amend the bylaws to make it easier to put their people on the BoD. Held: president must call meeting even though it is for an improper purpose.
(1)

Meeting violates McQuade directors, not s/h, elect the corporations officers; however, court says the meeting can result in a nonbinding recommendation, which is permissible

(2) Move to remove directors is permissible s/h have an inherent right to do this for cause
b)

Campbell v. Loews 2 factions vie for control of Loews; when some of one factions directors resign, the other calls s/h meeting to fill vacancies, increase BoDs size, and remove opposing directors. Several issues ruled on:
(1)

Calling meeting is permissible bylaws permit president to call one for any purpose to the extent that the meeting once called violates McQuade, the court may step in, but the meeting in and of itself is not a violation Fact that DE law gives right to directors to fill vacancies does not remove that right from the s/h (who have an inherent right to do so)

(2)

(3) S/h also have inherent right to remove directors for cause (but not for mere policy disagreement)
(4)

Important point: to remove directors for cause, must give them a chance to be heard some semblance of due process is in order

c) 2.

MBCA 8.08(a) s/hs can remove directors with or without cause unless AoI says otherwise

BoD cant deliberately try to frustrate s/h action

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a)

Schnell v, Chris-Craft BoD moves up s/h meeting date, shortening time for min. s/h to engage in proxy fight; Court disallows, even though its legal they are acting inequitably.

VII. Duties of Directors, Shareholders, and Officers A. Duty of Care and the Business Judgment Rule 1. Directors are only liable for actions which are grossly negligent or worse
a)

Litwin v. Allen Derivative suit brought when Guarantee Trust purchases bonds with highly unfavorable buyback provision. Held: Directors not liable for ordinary lapses of business judgment (i.e., ordinary negligence), but are liable here because accepting these provisions is grossly negligent (1) Note language p.737 directors are like trustees, p.739 are not like trustees. Which is it? Point is they owe a high duty of care (like trustees) but arent personally liable for mere negligence (unlike trustees) (2) Policy: dont want to prevent the BoD from taking ordinary business risks we just dont want them to act stupid

2.

Business Judgment Rule Court wont disturb business judgment of BoD


a)

Schlensky v. Wrigley min. s/h sues to get the Cubs to play ball at night by adding lights to Wrigley Field (this is 1968 lights werent added til the late 80s). Held: This is business judgment and court wont interfere. Decision between, say, installing lights and getting a new pitcher is within the discretion of the BoD. Paradigm case on business judgment rule.
(1)

This is business judgment in its most pristine form wont disturb decisions unless fraud, illegality, or conflict of interest. Litwin adds gross negligence (serious improvidence) to this list. Compare Francis v. United Jersey Bank (n2 at 748) Bankruptcy trustee sues director when corporation become insolvent and wins. Why the difference? Because the director here made no decisions (as opposed to a bad decision). Shes not really a director its just a label. (a) Also, you cant claim you were a figurehead director a director has to make decisions

(2)

(3)

Note that Litwin dicta may also mean that bank and other financial institution directors owe a higher duty (especially after the S&L scandals)

b) MBCA 8.30(a) directors must act in good faith with the care of an ordinarily prudent person in manner reasonably believed to be in corporations best interest. (Really just aspirational, since this standard must be judged by the case law)

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c)

Graham v. Allis-Chalmers Derivative action against directors for employees getting busted violating antitrust laws; no evidence that directors had actual knowledge of violations. Held: no liability if no actual knowledge directors in modern corporations cant be expected to know what every single employee is doing (1) Extremely important case in publicly-held context, since decentralized management is a necessity; test remains ordinary care of a prudent person

d)

Joy v. North general commentary on the policy behind the business judgment rule. Says s/h take risk of bad judgment when they invest, hindsight is always 20/20, and increased risk means increased potential rewards we shouldnt discourage risk-taking. Smith v. Van Gorkom Chairman of Board negotiates sale of corporation; he presents offer to BoD with no analysis, tells them they can be sued if they dont accept; they accept, and ten days later two better offers come in. Held: Directors guilty of gross negligence; business judgment means acting in good faith and trying to make an informed judgment.
(1)

e)

This case is also important because it demonstrates another aspect of the business judgment rule: the presumption is in favor of the BoD, and plaintiff must shift that burden (as plaintiff did here, by showing they acted too quickly without making an adequate inquiry)

(2) This case was very controversial; most academics think it was totally wrong
(3)

Compare MBCA 8.30(b) director can rely on information from other directors, lawyers, CPAs, etc., if he reasonably believes the information to be reliable and competent (doesnt directly affect Van Gorkom, but is related)

(4) Also note 8.24(d) director can shield himself from liability by either dissenting or abstaining from the vote 3. Possible alternatives to the duty of care a) Law and Economics says market should take care of duty of care s/hs will sell if duty violated, and takeover guys will come in and shake things up

b) Others: remove barriers to hostile takeovers, align BoD interest with s/h interest (i.e., pay them in stock) B. Duty of Loyalty and Conflict of Interest 1. Self-Dealing (i.e., transactions between director and corporation) a) In a duty of loyalty case, the burden is on the defendant to demonstrate the fairness of the transaction

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(1)

Shlensky v. South Parkway Building Corp. Major s/h has the corporation do business with other corporations he owns (most of BoD is in his pocket). Held: the BoD is not disinterested, and the burden is on the defendant to show fairness, so plaintiff wins.

(2) Note there are two ways for the corporation to prove it has met the duty of loyalty: (a) Show a disinterested BoD
(i)

Note that at common law, only have to show that the majority of the BoD is disinterested and approved; facts in Shlensky show those advising the BoD are interested parties, so burden does not shift to plaintiff (i.e., must be informed vote of majority of independent directors)

(b)

Demonstrate the fairness of the transaction but the presumption is that the transaction isnt fair have to prove the deal is one that would be done even if at arms length.

(3)

Marciano v. Nakash Deadlocked corp (2 s/hs each with 50% share); one s/h made loan to corporation; corporation is now being liquidated; other s/h claims breach of duty of loyalty and seeks to void the loan. Held: the loan meets intrinsic fairness test for deadlocked corporations, so defendant wins.
(a)

Under DE law, transaction is per se voidable unless it is disclosed to and authorized by BoD or the s/hs, or if the deal is fair. Since the s/hs cannot approve in this case (due to deadlock), the court just looks to the intrinsic fairness of the deal.

(b) Policy: frequently, s/hs are the only ones willing to loan money to a corporation (4) Today, the problems of director conflict are handled by statute. MBCA 8.31 is used by most states (though in the MBCA itself, it has been supplanted by subchapter F)
(a)

8.31: Deal where conflict of interest exists is not voidable if 1) disclosed and approved by disinterested BoD, 2) disclosed and approved by s/hs, or 3) is a fair transaction Also note that a quorum under 8.31 is a majority of the disinterested directors; also note that s/hs who are interested dont have their votes counted

(b)

(5) Duty of Loyalty contrasted with Duty of Care key is burdens; in care case, burden is on plaintiff; in loyalty, it is on defendant b) Executive compensation rarely raises a duty of loyalty issue
(1)

Heller v. Boylan minority s/h sue over excessive officer compensation based on companys performance. Held: no waste or spoilation, so no breach of duty of loyalty

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(a) Note that waste/spoilage is a very high burden to meet


(b)

Also, compare Rogers v. Hill, cited in Heller, where increase in executive pay resulted not from executive skill but an unforeseen increase in the number of women smokers; since no relation to executive skill, this amounts to an impermissible gift (and thus waste) from the majority s/hs to management at the expense of the minority s/hs. (i) Bottom line: there must be some semblance of a relationship between services rendered and compensation

(2) Basic rationale: s/hs can raise the issue of executive compensation at meetings, so courts shy away from reviewing them
(3)

Wilderman v. Wilderman s/h sues over large pay authorized by president to himself (he is s/hs ex-husband). Held: President cant raise his own salary without approval from BoD amounts paid over those approved by BoD must meet reasonableness standard (a) This case principally illustrates that courts are more willing to look at executive compensation in closely-held corporations than they are in publicly-held corporations.

(4)

Executive compensation is typically a duty of care rather than a duty of loyalty issue

(5) Note IRS puts limits on deductibility of executive salaries > $1M. c) Be careful to distinguish duty of loyalty from duty of care
(1)

Sinclair Oil Corp. v. Levien Sinclair has Venezuelan subsidiary, Sinven; Sinvens BoD is are almost all affiliated with Sinclair in some way (as officers, directors, or employees). Sinven s/h sues over three issues: (a) Sinvens paying of excessive dividends not a duty of loyalty case because there was no self-dealing; thus, merely duty of care (b) Restricting Sinvens ability to expand Again, no selfdealing; its business judgment (and thus duty of care) because Sinclair has an interest in atomizing its subsidiaries along country lines
(c)

Sinclairs causing breach of contract between Sinven and Sinclair International Oil and refused to let Sinven sue for breach This is self-dealing, and therefore a duty of loyalty issue it must be judged by intrinsic fairness and burden shifts to defendant.

(2)

Basic question: ask 1) is defendant on both sides of the transaction, and 2) is there a disparate impact on minority s/hs?

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2.

Corporate Opportunity a) Why have a doctrine of corporate opportunity? To find out which things are owned by a corporation and which things arent. (1) Director is a fiduciary for corporation and must give it his best uncorrupted business judgment to render unto Caesar at the best possible price that which is Caesars.
b)

Miller v. Miller min. s/h in MWM sues founders of MWM (who is a also an officer and director) for other corporations started by them that allegedly diverted corporate opportunities from MWM. (1) Rule is: one with fiduciary duty cant appropriate for himself a business opportunity belonging to the corporation (2) Tests for business opportunity:
(a) (b)

Interest or Expectancy Test does corporation have a beachhead in the opportunity Line of Business (LOB) Test corporate opportunity exists if a managing officer is involved in activity closely related with existing/prospective activities of the corporation Fairness Test is officers conduct fair and equitable?

(c) (3)

Held: Appropriate test to use is a combination of line of business and fairness; no corporate opportunity usurped here.
(a) (b)

The Interest/Expectancy Test is old and losing favor; the more modern test is LOB; combo in Miller predominates today. Unspoken policy at work in Miller unskilled family members should not benefit from opportunities available to skilled family members.

c)

An officer must present opportunities to the BoD in order to successfully say the corporation could not have taken advantage of the opportunity.
(1)

Klinicki v. Lundgren min. s/h in air taxi company sues Lundgren (a s/h, director, and CEO) for forming another, private corporation to get an air service contract. Held: he must disclose to BoD and give them the chance to reject even if corporation cant take advantage of the rule.

(2) This is a prophylactic rule based on ALI study it replaces old common law rule that usurper only had to show corporation couldnt take advantage of opportunity; it was easier under that formulation for a director to take secret advantage of opportunities. Its much harder to unfairly usurp when notice must be given to the BoD.

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(a)

Note: approach is different for outside directors cant limit them, because to do so would discourage people from serving as outside directors.

VIII.

Government Regulation of Securities 1. History & Statutes a) State Regulation and Blue Sky laws. (1) 1911 Kansas adopts first blue sky law (designed to keep promoters from selling lots in the clear blue sky) (2) Today, all states have blue sky laws. State commissioners can review the merits of all investments offered for sale in the state. Compliance is a hassle and very expensive, but necessary because of substantial civil penalties for noncompliance. Insuring one investment complies with all 50 states is called blue skying. (3) They are largely ineffective, though. Why? Because they dont differ that much from common-law fraud, and because the interstate reach of most fraudulent schemes made enforcement difficult. b) Federal Regulation (1) 1933 Truth in Securities Act Requires registration and disclosure. Focus is on IPOs. Only covers distributions and protections extend only to securities purchasers
(a)

A. Regulation of Securities Distributions

2(a)(11) Underwriter is defined very broadly to prevent 4(1) problems

(b) 4(1) 5 doesnt apply to non-underwriter/dealer/issuer (c) 4(2) 5 doesnt apply to non-public offerings
(d)

5 cant do anything (even give a speech) without filing a preliminary registration statement (so long as youre using interstate commerce or the mails which means any offering) (i) Preliminary statement can only be circulated to dealers (its called a red herring because of its red border)
(ii)

Both preliminary and final registration statements are made up of a prospectus and additional information

(e)

11(a) (11 is for fraud) imposes liability for omissions as well as false statements (unlike common-law fraud) (also lists who you can sue essentially anyone who had anything to do with registering and selling the security) 12 liability for false statements/omissions connected to sale or offer to sell even if 5 doesnt apply.

(f)

(g) The IPO process


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(i) Traditional/Old Fashioned IPO: Underwriter (investment bank) insures success by buying any securities not purchased (ii) Modern Firm Commitment IPO: Underwriter buys securities and resells to public (like retailing) (iii) Best Efforts IPO not really underwriting; investment bank just promises to make best efforts to sell. Only used in small offerings, and then only rarely. (2) Securities Exchange Act of 1934 More comprehensive; it created the SEC and regulates all aspects of securities trading. Sloppy registration means personal liability for attorneys. (a) Covered in more detail under proxy regulation (3) The major theme of both acts: disclosure, disclosure, disclosure! 2. Preparing the Registration Statement a) Conflicting purposes: to disclose adverse facts, yet sell the security. b) Hardest part for IPO is description of companys business, properties, material transactions with insiders, and use of proceeds, plus required emphasis on adverse facts. c) SEC only focuses on disclosure, not the quality of the offering (unlike blue sky laws); traditionally only hard facts were allowed, but today you can include soft facts (predictions, etc.) so long as they have reasonable basis in fact and are made in good faith.

d) Statement becomes effective in 28 days, but company usually waives this minimum since it takes longer to get everything together. 28 days re-starts with every amendment. Can get SEC to waive this. 3. Regulation under the 1933 Act a) What is a public offering?
(1)

SEC v. Ralston-Purina R-P offers stock to its key employees; is this a public offering, subject to 5 or does it meet the 4(2) non-public exception to required registration? Held: It is a public offering.
(a)

4(2) exception is designed for offerings to people who are in a position to know the facts i.e., where the Acts protections are not needed. R-Ps plan defines key employees so broadly that this isnt the case here.

(2) Burden of proof is on issuer to show offerees are sophisticated enough to not need formal registration. (3) Recall that underwriter is broadly defined (2(a)(11)), so cant get around this by having an officer sell the securities.

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b)

SEC Release 33-5450 (1974) This explains 3(a)(11) (designed to foster local financing)
(1)

Basically, a local business can raise local capital without registration: Any security which is part of an issue offered and sold only to persons resident within a single State or Territory, where the issuer of such security is a person resident and doing business within, or, if a corporation, incorporated by and doing business within, such State or Territory.

(2) Rule 147 defines part of an issue (look to facts & circumstances) resident within (interpret narrowly, wait until securities have come to rest) and doing business within (viewed strictly, both principal place of business and substantially all of offerings proceeds are used locally) (a) Thus, 147 creates a safe harbor it is only binding on the SEC, but courts usually defer to it in private civil suits as well. (Before this rule, you had to seek a no-action letter from the SEC) (b) Note part (c) 80% floor local amounts; part (e) resales within 9 months have to stay local (neither is dispositive failure to meet just creates a rebuttable presumption)
c)

SEC Release 33-6389 (1982) Announces Regulation D (rules for not registering small issues) (1) Rule 501 definitions
(a)

Accredited investor: one who is, or reasonably appears to be, a bank, etc.; a business association with $5M in assets; any director, officer, or partner of issuer Number of purchasers: dont count relatives of a purchaser, or a trust or corporation related to purchaser, or an accredited investor (Why? Because theyre rich and can absorb losses)

(b)

(2) Rule 502 General conditions to meet if sold under rules 505/506 to non-accredited investors, need a prospectus; have to get representations from purchaser that they arent buying for resale. (a) Note that 12 of 33 Act even if you dont need to comply with 5 and provide a registration statement, you can still be liable for simple negligence.
(3) (4) (5)

Rule 504 Exemption for offerings < $1M (only need blue sky compliance) Rule 505 Exemption for offerings <$5M (no more than 35 nonaccredited purchasers) Rule 506 Exemption for limited offers in general (no more than 35 sophisticated investors)

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(6) Rule 508 Good faith effort to comply is sufficient to avoid liability. d) What is a security?
(1)

Smith v. Gross Gross sells worms to Smith with agreement to buy back all the bait-quality offspring. Is this contract a security? Held: Yes. Elements of a security: (a) An investment of money, (b) In a common enterprise, (c) With profits (d) Coming solely (actually, principally) from the efforts of others (this is met because the Smiths were assured their work effort would be minimal)

(2) Basic gist: if its a passive investment, its a security


(3)

Labels are unimportant (United Housing Found. v. Forman, label saying share of stock didnt make it stock; court looks to see if it has the characteristics of stock dividends, negotiability, voting rights, etc.)

B. Proxy Regulation and the 1934 Act 1. The Securities Exchange Act of 1934 an amalgamation of provisions a)
b)

Companies must file an annual 10-K report, plus supplemental quarterly 10-Q reports, all of which are publicly available. You must register if 1) on a national exchange; 2) have assets $5M and have 500+ equity s/hs Integrated disclosure eliminates most overlap between 33 and 34 acts. Three types of form: (1) Form S-1 long-form disclosure (2) Form S-2 shorter; must have three years of disclosure under the 34 act. (3) Form S-3 least detailed
(4)

c)

Also, simplified form SB for small businesses ( $25M annual revenues, US/Canada-based, not an investment company, no public float over $25M)

d) It also sets proxy rules: officers, directors and 10% s/hs must report their holdings to the SEC (16(a)) and any profits from swing sales, i.e., purchase and sale within 6 months (16(b)) 2. Key provisions of the 34 Act: a) 14(a) broad grant of power to the SEC; makes it illegal to transact in securities registered under 12 in violation of SEC rules.

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b) 12(a) No stock can be sold on a national exchange unless registered under this section. c) 12(g) Issuers engaged in/affecting/traded via interstate commerce must register if held by over 500 people and assets > $10M (unless an exempt security) Studebaker v. Gittlin NY law requires s/hs with 5% of any class of stock to inspect the book so long as there is a business purpose to do so. Gittlin gets authorization from other s/hs to meet the 5% requirement, but did not comply with SEC proxy rules (here, Rule 14a3 requiring disclosure of information of purpose for soliciting a proxy). Held: Studebaker doesnt have to furnish the list because Gittlin violated federal securities laws. (1) This case stands for the proposition that s/hs should not be asked to make a decision without full disclosure of all facts relevant to that decision.
(2)

d)

Note Rule 14a-1(l)(2) safe harbor for speeches, press releases, etc. stating how one will vote. Also note Rule 14a-2(b)(1) safe harbor for communications that dont ask for a proxy.

3.

Proxy Forms, Proxy Statements, and Annual Reports a) Federal Regulations are complicated and numbered illogically. Among the key provisions: (1) Rule 14a-4 requirements as to proxy form, to insure s/hs have the opportunity to vote or disapprove issues submitted to them (2) Rule 14a-3 For proxy statements, requires certain financial and non-financial data (from Reg. S-X and S-K, respectively). Also requires annual report to integrate reporting information and have discussion and analysis in the MD&A section.
b)

In the Matter of Caterpillar, Inc. Company fails to disclose in its 10K the performance of its Brazilian subsidiary. Held: this is a violation; it is material, so they must disclose the possible risk inherent to the subsidiary. (1) Note Item 303(a) of Reg. S-K requires information necessary to understand operational results, including trend analysis and discussion of unusual items. (2) This case stands for proposition that technical compliance isnt sufficient if it obfuscates material consequences and changes in operational results.

4.

False Or Misleading Statements In Connection With Proxy Solicitation


a)

Key provision: Rule 14a-9 no false or misleading statements in proxy solicitations

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(1) Misleading may include predictions of future value, unwarranted character attacks, failure to clearly identify the proxy form, etc. (2) Safe harbor for predictions Reg. S-K, Item 10(b) permits them so long as there is a reasonable basis for them, and they are presented with appropriate facts. b) Federal courts can hear private suits and grant appropriate remedies
(1)

J.J. Case Co. v. Borak s/h sues to rescind merger, claiming their names were falsely used in connection with a proxy solicitation (i.e., a 14(a) violation). Held: private cause of action implicit in the act, federal courts are not limited to declaratory judgment.

(2) This decision is bad in the sense that its inconsistent with the statutory language (i.e., other sections specifically designate private causes of action, but this one doesnt); however, its good because it makes enforcement more effective the SEC cant catch everything. c) What does a plaintiff have to prove?
(1)

Mills v. Electric Auto Lite Co. s/hs bring derivative over proxies which did not disclose the fact that Mills was majority s/h and controlled BoD. Held: a plaintiff need only prove that 1) the misleading statements were material and that 2) the votes solicited were an essential link to winning the proxy fight. He does not have to prove actual reliance on the statements. (a) Note court rejects the fairness test used in the trial court TSC Industries, Inc. v. Northway Inc. National buys 34% of TSC, puts 5 people on the BoD. It then proposes a stock-for-stock buyout of TSC by National; BoD approves (less abstaining National members). Northway (a s/h) brings suit, claiming lack of disclosure of Nationals degree of control and various other things. Held: no summary judgment because the omissions may not be material.
(a)

(2)

A statement is material if there is a substantial likelihood that a reasonable s/h would consider it important in voting. Reasonable minds could differ on if these things are material, so it goes to the jury. As a practical matter, this means that materiality cant be assumed as it was in Mills it must be litigated.

(b) (3)

See also Shidler v. All American Life & Fin. Corp. incorrect statement of novel issue of law on proxy is not a violation so long as the position taken isnt negligent. In other words, negligence is the standard this isnt strict liability. (6th Cir. exception requires scienter for professionals, but not for directors and officers)

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(4)

Virginia Bankshares, Inc. v. Sandberg company seeking merger gets investment bankers report saying that $42 is a fair price; it reports this and describes the merger value as high and the price as fair in the solicitation. Sandberg sues, jury finds for Sandberg. Held: this is a statement of fact, not opinion.
(a)

This is important because statements of directors opinion that the price wasnt fair are only material if they make a misleading objective statement.

(b) Also held that there is no essential link here: dissenting s/hs could not possibly block the transaction.
d)

What is a solicitation? Rule 14a-1(l)(3) communication reasonably calculated to result in procurement of a proxy. Prob. #14 press releases are questionable they may be considered a first shot and thus a solicitation. Key Rule: 14a-8, Proposals of security holders. It allows a s/h to submit a proposal for the proxy statement, which management must include unless there is a reason to reject it. Designed to provide a modest s/h forum. (1) Rule 14a-8(a)(1) Each s/h must own $1,000 or 1% (2) Rule 14a-8(a)(2) S/h must attend meeting, provide notice (3) Rule 14a-8(b)(1) Can submit supporting statement to further explain proposal; need not include proponents name (to discourage publicity) (4) Rule 14a-8(c) reasons to reject s/h proposals:
(a)

5.

Shareholder Proposals a)

Not a proper subject under state law (easily circumvented by putting the proposal in the form of a recommendation Auer recommendation form makes it OK even if otherwise violative of McQuade)

(b) Proposed violation of the law (c) Inconsistency with SEC proxy rules
(d)

Relates to a personal claim or grievance of the s/h (construed narrowly)

(e) Relates to < 5% of assets, revenues, and net earnings and is not otherwise significantly related to the business (f) Relates to problem beyond registrants power (g) Relates to ordinary business operations (h) Relates to election to office
b)

Rauchman v. Mobil Corp. Saudi is up for reelection to Mobils board; s/h submits proposal to be included with proxy that bylaws be
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amended to prohibit citizens of OPEC nations from sitting on the BoD. Held: this proposal may be omitted as a matter related to election. (1) No bootstrapping! If you want an alternate slate of directors, you have to wage the proxy fight on your own.
c)

Lovenheim v. Iroquois Brands s/h submits proposal to investigate companys use of force-feeding geese to produce pat. Company refuses because pat is less than 5% of net assets, etc. and not otherwise significantly related to the companys business. S/h says that they are so related because of their ethical or social significance. Held: Addition of otherwise in statute means significance is not limited to economic significance. S/h wins. Rule 14a-7 At s/h request, registrant must provide list of s/h, or mail soliciting material to them at proponents expense. Proponent must provide affidavit that information will be used for solicitation purposes only, and that it will not be disclosed, and that he will reimburse the registrant for reasonable expenses.

6.

Communicating with Shareholders a)

C. Corporate Books and Records 1. MBCA Chapter 16 provides guidelines for corporate books and records. However, note that some states deviate from the MBCA here significantly. a) MBCA 16.01(a) requires corporation to keep minimum set of core documents

b) 16.01(e) All corporations must keep certain documents (articles, bylaws, s/h meeting minutes, etc.); all must be made available to s/h for inspection during business hours (16.02(a)) (1) 16.02(b) other records (BoD minutes, accounting records, etc.) must similarly be made available, but only for good faith reason for a proper purpose, described with particularity, and records are directly connected to purpose (16.02(c)) c) 16.01(b) must maintain appropriate accounting records (only current records)

d) 16.01(c) must maintain record of s/hs (record holders only, not beneficial holders) e) f) 16.03 s/hs agent or attorney has same inspection rights; have to let s/h photocopy records; may charge s/h a reasonable charge. 16.22 if corporation has professionally prepared financial statements, they must be distributed to s/hs (only affects non-public corporations since SEC rules make this mandatory for them; many states omit this one)

g) 16.21 must disclose indemnification or advancement of expenses to directors, issuance of shares for promissory notes or future services

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2.

What is a proper purpose for inspection?


a)

BBC Acquisition v. Duer-Fillauer Medical BBC competing to take over D-FM. It owns 100 shares. BBC demands to see s/h list and other records so it can value its shares. Held: no right to inspect because no proper purpose. (1) Its pretty clear here that BBC doesnt want to value its 100 shares, but rather to value the company as a whole so it can make a better takeover bid. In other words, theyre not asking as a s/h, but rather as a bidder. (2) Note that only the primary purpose counts. It doesnt matter that perhaps incidentally BBC was interested in valuing its own shares. (3) Note the balance between number of shares and proper purpose a very small number of shares is judged more harshly that a s/h with a large number the larger number shows seriousness of purpose. (4) Also note that primary purpose of valuation is really only valid in closely-held corporations for publicly-helds, the market tells you the value.

b)

Often look to motive in determining primary purpose; see Pillsbury v. Honeywell, denying a right to inspect to anti-war s/h who wanted records on munitions production. Unlike s/h proposals, a social or political may not be a proper purpose for inspection.

3.

A shareholder can only compel existing records he cannot compel creation of records.
a)

Parsons v. Jefferson Pilot Corp. s/h requests NOBO (non-objecting beneficial owners) list (which isnt maintained) and accounting records to look for mismanagement. Held: Corp. doesnt have to create NOBO list. (1) Also: s/hs still have their common law rights of inspection (MBCA 16.02(e)(2))

4.

Directors inspection rights states are split on this. Common law grants them broad right to inspect. Generally, corporation has burden to show improper purpose when denying director inspection rights; ALI Corporate Governance 3.03 says directors have almost unfettered inspection rights. Introduction: State Court Approaches a) Common-law fraud 1) an affirmative representation 2) of a material fact 3) which is known to be false (scienter) 4) and was relied on 5) and caused damages.

D. Transactions in Shares 1.

b) Pre-federal regulation state cases limited to when a fiduciary duty to s/hs existed.

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(1)

Goodwin v. Aggasiz (Mass. 1933) Director buys stock from s/h after hearing about geologists report; no disclosure to s/h; Held: No breach of duty transaction was impersonal (on an exchange); no personal connection.
(a)

Note federal law applies to omissions as well as affirmative statements.

(2)

Strong v. Riptide Majority s/h takes steps to hide his identity and the probability of a pending sale of corporate property. Held: Breach because of affirmative acts. Hotchkiss v. Fisher Widow relies on CEOs statements, sells her stock to the CEO at a low price. Held: Fiduciary duty special facts and circumstances windfall from taking advantage of unsophisticated investor. Diamond v. Oreamuno (NY 1969) Officers sell on inside information of poor stock performance. Held: s/h can sustain derivative suit against them, even if no actual harm to the corporation. This is the minority rule.

(3)

(4)

2.

Rule 10b-5: The Basic Federal Antifraud Provision a) 10(b) of the 1934 Act and Rule 10b-5 issued under it: it is illegal to use interstate commerce to use any manipulative or deceptive device in contravention of the rules supporting this section. (1) This is the most heavily litigated provision of the Act. (2) The rule applies to all transactions, even if not registered (unlike Rule 14a-9, regulating proxies) (3) Pre-1975 this rules use was continually expanded; post-1975, Supreme Court rulings narrowed its scope.
(4)

Why was it enacted? Because its the only rule that reaches buyers (ex.: buyer tells seller company is in lousy shape when in fact its doing fine)

(5) Note that 10(b) gives the SEC broad powers to establish fraud rules; the SEC has the best reputation among federal agencies they rarely lose (but do upon occasion). (a) It is also less susceptible to political winds because of the large number of lifers, the fact that enforcement of securities doesnt depend heavily on ones political disposition (unlike, say, antitrust), and of the 5 Commissioners, there must be two of the minority party.
b)

Rule 10b-5 only applies to fraudulent inducement, not deterrence


(1)

Blue Chip Stamps v. Manor Drug Stores Blue Chip issues an overly pessimistic prospectus; Manor sues under 10b-5, saying he would have bought if the prospectus had been more accurate.

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Held: the rule only applies to devices to get one to purchase or sell no liability for someone not buying.
(a)

This is a literal reading of the Rules text. Contrast Virginia Bankshares (where directors opinions were enough for liability); this is the opposite.

(b) This is really to prevent vexatious litigants how can we be sure there really was a harm if there is no transaction consummated? c) Scienter (intentional conduct) is required for liability under 10b-5
(1)

Ernst & Ernst v. Hochfelder CEO embezzles money; independent accounting firm (E&E) fails to catch it, i.e., they were negligent. S/h sues. Held: No violation. The Rule does not reach conduct which is only ordinary negligence.
(a)

Why? Because the statute requires an intentional act (in connection with a purchase or sale) and the Rule cant go beyond the limits of the statute. Some lower courts have permitted a cause of action for reckless conduct, i.e., gross negligence. This case hasnt discouraged litigation much now all you have to do is allege scienter. However, note Central Bank of Denver, which took away the ability to sue for aiding and abetting fraud. So today, you must allege both scienter and direct responsibility.
(i)

(b) (c)

Securities Reform Act of 1995 restored aiding and abetting for the SEC only.

(2) Note that 10b-5 doesnt expressly create a private cause of action the Supreme Court has permitted it, though, because of its widespread acceptance among the lower courts. d) Compliance with state law can satisfy ones fiduciary duty under 10b-5
(1)

Santa Fe Industries, Inc. v. Green Min. s/hs sue to stop merger, saying their shares were fraudulently appraised; the offer gave them the right of having a DE court set the value of the shares. Held: no breach s/hs had an adequate remedy.
(a)

The point of the rules is full disclosure. Fiduciary duty is a state-law issue so long as all material facts are disclosed (as they were here).

(b) Under the statute, you have to show a manipulative practice this could be very broad, but the courts have read it narrowly.
e)

Statements must be materially misleading

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(1)

Basic, Inc. v. Levinson Basic begins merger talks, but denies publicly that it is doing so. S/hs sell after denials, sue when merger is consummated. Held: this may be material remand for determination under rule established by this decision.
(a)

The court establishes that the probability/magnitude test is the proper one to use in determining if statements are material; that is, what is the probability of the event occurring and the magnitude of that event. (i) Simpler way of putting it: is there a substantial likelihood that a s/h would consider it important?
(ii)

The Supreme Court rejects the tests applied in some other circuits: the agreement in principle test (too arbitrary, doesnt look at materiality) and the false denial test (again, because it would create liability for immaterial matters.

(b)

The court also establishes that there is a rebuttable presumption in favor of the plaintiff that investors rely on public statements. This is the fraud on the market presumption. (i) To rebut, defendant only has to show that plaintiff could reasonably have known the statements were false with minimum effort (ex.: leak of merger talks in newspaper) (ii) Note the court is adopting the semi-strong (i.e., all public data is reflected in the stock price) version of efficient capital markets theory, (a.k.a. random walk theory) (a) Strong version says both public and private data are reflected; Weak says only past stock performance is reflected.
(b)

[Note from personal experience: for a good, easily accessible introduction to efficient markets theory, read Burton G. Malkiels A Random Walk Down Wall Street]

(2) So what is the result for today? Cover Your Ass! (CYA) A no comment is the only safe answer for a director or officer to make in response to questions about mergers, etc. and even then, a no comment cant mean yes (i.e., if you say no comment only when you mean yes, your pattern of behavior will betray you)
(a)

Remember, you are under no affirmative duty to do anything under 10b-5. You only have to say something if you, yourself, are buying or selling and then only to prevent insider trading.

3.

Insider Trading
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a)

Introduction
(1)

The first case to suggest that insider trading in public markets would be covered by Rule 10b-5 was In the Matter of Cady, Roberts, & Co. (1961). Liability for insider trading is premised on two things: (a) Access to information that only has a corporate purpose, and (b) Inherent unfairness in using that information

(2)

Should we prohibit insider trading? Cartlon & Fishels The Regulation of Insider Trading: (a) Many say no. Argument goes that insider trading can reveal information that can be incorporated into the stock price that otherwise wouldnt be revealed. Any risks inherent to insider trading will also be reflected in the market price. (b) Others say yes. They say insider trading is immoral (the Judeo-Christian ethic at work), plus it amounts to additional compensation to insiders.

b) Regulation of insider trading under 10b-5


(1)

SEC v. Texas Gulf Sulphur Co. (1968) TGS has geological reports indicating discovery of a potentially rich copper deposit. Employees start buying stock, but dont disclose the report to the public. Held: this is a violation insiders cant use information unavailable to those theyre dealing with.
(a)

The information must be 1) extraordinary in nature, and be 2) reasonably certain to have a 3) substantial effect on the market price (the latter two parts stem from the Basic probability/magnitude test)
(i)

Also recall that Ernst established scienter requirement.

(ii) Basically, an insider has a choice: keep his mouth shut and dont trade, or publicly disclose and trade. (b) Tippers are liable as well; anyone using information in connection with a purchase or sale is liable, even if not directly involved with the transaction. (i) Later cases show tippees liable as well (restitution can be sought from them as well); have to prove scienter for each defendant, though. (c) The justification for this under 10b-5: it is a deceptive practice that may be proscribed. (d) This is the leading case on insider trading
(2)

There must be a fiduciary relationship for 10b-5 liability

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(a)

Chiarella v. US Printer who was printing takeover bids buys stock in target companies before the bids are issued. Held: no duty for him to speak because no fiduciary duty to shareholders (i.e., printer wasnt in such a relationship with the shareholders) (i) The duty to disclose arises from ones relationship, not from ones ability to gather information.
(ii)

SEC later adopts Rule 14e-3, which covers tender offers and imposes a duty on anyone who gets information from any insider with a duty (i.e., officers, directors, etc.). This expressly limits Chiarella. Dissents: Burger wants liability imposed using misappropriation theory; the court doesnt actually reject this approach they just say the plaintiffs didnt plead it!

(iii)

(3) Liability for non-insiders using inside information


(a)

Carpenter v. US Defendant writes influential Wall Street Journal column giving investment advice; he gave a few of his stockbroker friends advance information on which stocks hed be recommending. Held: this is a 10b-5 violation.
(i) (ii)

10b-5 applies to all manipulative trading, regardless of where the information originates from. Thus, here the court is evenly divided (4-4) on the use misappropriation theory mentioned in the Chiarella dissent. (a) There must be a special relationship that creates a duty not to use information for personal gain here, it is Carpenters relationship with the WSJ. Doesnt matter that WSJ is neither a buyer or a seller.

(iii) They end up nailing Carpenter with mail fraud, though.


(b)

Dirks v. SEC Dirks is an investment analyst. Insider (a whistle-blowing vice president) tells him that his companys assets were being overstated. Dirks investigates, tells some clients that the allegations are true, but doesnt trade on the information himself. Held: no liability, because the tipper (i.e., the officer) did not stand to gain by telling the tippee (Dirks). (i) Basically, a tippees liability hinges on the tippers liability; here, there is no liability for the tipper because there is no personal gain to him. (a) Note that Dirks is also a tipper (he told his clients); however, recall that the tippees liability is derivative from the tipper; since Dirks isnt liable the

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information wasnt for his benefit neither are his clients.


(b)

See SEC v. Switzer, where the former OU and Dallas Cowboy coach overheard some inside information from a companys owner talking to his wife during a track meet. No liability because he was just an eavesdropper and the information was not disclosed for the owners benefit.

(ii)

Also note that Dirks stands for the notion that temporary insiders (lawyers, CPAs, etc.) have the same duty as officers and directors.

(iii) Also note that personal benefit is broadly defined by the SEC, including close personal relationship or enhanced professional relationship.
(c)

US v. OHagan (1997) Lawyer trades on inside information from one of his firms clients (but he doesnt actually do any of the clients legal work, and thus isnt a temporary insider). Held: OHagan is guilty; the court finally adopts misappropriation theory.
(i)

Key to the courts decision willful means that scienter must be proven. This distinguishes Dirks, where the vice president didnt have such scienter. (a) Note this means you can have a guilty tippee but innocent tipper (i.e., if tippee is unsophisticated)

(ii)

Thus, today a 10b-5 insider trading violation requires appropriation of information where a duty is owed to the source, not to the person with whom the defendant trades. (a) Contrast: classic theory says cant trade on inside information if you owe a duty to your trading partner; modern rule says cant do so if you owe a duty to your source to keep information confidential and not profit from it.
(b)

Note you can avoid 10b-5 problems by giving full disclosure of your plan to your source because this eliminates the deceptive element of the transaction.

(iii) Also note that the fraud must relate directly to the transaction for example, a fraudulently obtained loan doesnt count, because loan proceeds can be used for anything. (4) Insider trading penalties: private plaintiffs limit to profit or loss avoided. (20A 34 Act). SEC can get treble damages (21A) IX. Additional Topics

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A. Fundamental Changes 1. Recapitalizations


a)

Bove v. Community Hotel Corp. of Newport, RI CHC has common and preferred shares outstanding. Preferred dividends are in arrears. It forms a new empty corporation to merge with itself in order to retire the preferred shares. RI law requires 2/3 vote of s/hs; amendment of AoI (setting preferred dividends) requires unanimity. Held: the merger is permissible.
(1)

The equal dignity rule says you cant say one statutory provision undercuts another. Only the legislature can prioritize laws it passes.

(2) Why is this transaction structured as a merger instead of a recapitalization? The contract clause of the US Constitution (Art. I, 10, cl.1); old view was that preferred s/hs had a contract that could not be amended without their consent. (a) MBCA 1.02 reserves power of state to amend or repeal any part of the Act; thought to handle this issue by giving s/hs notice)
(b)

MBCA 16.01(b) a s/h does not have a vested property right resulting from anything in the AoI.

2.

Reorganizations
a)

Farris v. Glen Alden Corp. GAC sells stock to large holding corp. in exchange for holding corporation assets with requirement to dissolve and distribute the shares to GAC s/hs. Min. s/hs sues, saying this is a de facto merger. He wants his shares of GAC appraised and purchased for cash. Held: this is a de facto merger. (1) Court basically looks at results: at the end of the day, s/hs own part of a company completely different from the one they started with. Their shares have lost much value. (a) Later, PA legislature adopted measures to eliminate this doctrine. (2) Why is this structured as minnow swallowing a whale? Since consideration is shares (not cash), its an attempt to avoid letting dissenting shareholders get an appraisal and purchase. (This is back before debt financing was common). (3) Compare: (a) MBCA 13.02 Dissenters Rights can get appraisal and purchase of shares in merger, certain other situations. (i) Includes sales of all/substantially all assets, unless proceeds distributed within one year, and other exceptions. (13.02(3))

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(b) 12.02 Rules for asset sales (c) 11.01 Merger statute (11.04 short-form merger if you own over 90%, you dont need s/h vote)
b)

Hariton v. Arco Electronics, Inc. Two-step reorganization plan: 1) A sells to B in exchange for Bs stock; 2) A dissolves, distributes Bs stock to its s/hs. Min. s/h asserts this is a de facto merger. Held: the fact that the company has complied with DE law on sale of assets means it is not a merger. (1) Again, the equal dignity rule or, theres more than one way to skin a cat! If you comply with one, the other cant be used against you. (2) Summary: DE law says no dissent and appraisal rights for asset sale; technical compliance with the asset sale statute will satisfy DE law.
(3)

How does this square with Farris?


(a) (b)

In Farris, GAC already owned some shares; the transaction wasnt as arms-length as it is here. Diminution in value here is much less than it was in Farris

(c) Modern s/h less concerned with product identity and is more concerned with return. c) The de facto merger doctrine is frequently used in products liability cases where the acquiring corporation is the only deep pocket available; sometimes the same result is achieved via the line of business or continuity of business doctrines.

d) Note that once a dissenter has failed to exercise his rights, the door is closed to further action. 3. Cash Out Mergers a) Cash-out merger lets parent owning over 50% of subsidiarys shares force the minority s/hs to sell at a price set by the parent (subject to dissenters appraisal rights) Weinberger v. UOP Signal Corp. wants to buy its 50.5% subsidiary, UOP. Minority s/hs sue for damages. Held: Breach of loyalty by Signal.
(1)

b)

This is really a duty of loyalty case Signal owes a duty to the minority s/hs. Why? Because Signal is on both sides of the transaction, plus disparate impact on minority (who lose their interest in the company). The merger must meet a test of intrinsic fairness.

(2) This duty was breached because the study setting the price was done by the directors of both entities (i.e., interested parties). Plus

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the report was hastily prepared, but s/hs were led to believe it had been carefully done.
(3)

Court separates duty into fair dealing and fair price.


(a)

If objection is to fair dealing, then minority can seek recissory damages or injunctive relief. (Recissory means the price shorn of the mergers effects on price meaning the price at the time of the mergers announcement) If the objection is to fair price, minoritys remedy is limited to appraisal.

(b)

(4) Because of this case, cash-out mergers have two characteristics: 1) use of an independent negotiating body; and 2) no sharing of studies by directors of both corporations. (5) Note MBCA 11.03(b)(3) its OK for some s/hs to get cash, others to get other consideration. B. Indemnification and Insurance 1. 2. The availability of indemnification/insurance is vital to getting directors to serve most arent willing to assume the liability solo. Indemnification a)
b)

This is when the corporation pays expenses of defending a director in a lawsuit for his actions as a director. Most state statutes require indemnification if the suit is successfully defended. (1) Common law rule even employees had a right to indemnification if they werent culpable. (2) Most issues here arise as to what successfully defended means
(a)

Merritt-Chapman & Scott Co. v. Wolfson holds that charges which are dropped against a corporate officer have been successfully defended and the corporation must indemnify. Why? Because the DE statute says successful on the merits or otherwise so an actual acquittal isnt required. Fidelity Federal Savings & Loan v. Felicetti Officer commits racketeering and fraud using corporate assets. Bylaws clearly would grant indemnification. Held: Corporation (who is suing) doesnt have to indemnify. Duty of care is superior to bylaws. (i) Note that many courts dont follow this rule.

(b)

(3) Duty of care can trump right to indemnification in bylaws


(a)

(4) Indemnification and the MBCA

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(a)

8.51 Permissive indemnification director must have acted in good faith; (i) Directors making decision to indemnify must be disinterested (8.55) (ii) If whole BoD is in trouble, they can increase the number of spots or get rid of a few directors to open up spots for disinterested persons

(b)

8.52 Mandatory indemnification if defense is wholly successful, on the merits or otherwise.

(c) 8.53 Court-ordered indemnification (d) 8.58(d) Can pay for lawyer where director is a witness 3. Insurance a) Naturally, many corporations cut the risk of indemnification by buying director & officer (D&O) insurance.
(1)

b) Insured must follow the letter of the D&O policy to collect McCullough v. Fidelity & Deposit Co. Insurer doesnt have to pay because policy requires notice of specific acts, and insured only made a general claim.

(2) Idea is that insurance companies put requirements in for a reason: so they can plan for future risk. So you have to stick to them. c) Two types of insurance policy: claims made (covers claims made during policy term) and occurrence (covering incidents occurring during policy term); claims made is more common (easier to anticipate risks) Like any insurance policy, you cant insure against your own malfeasance they cover negligence only, not intentional conduct; typical deductible is 5%. Common exclusions for D&O policies: personal profit/advantage; dishonesty; bodily injury/property damage; ERISA claims; 16b shortswing profits; return of illegal remuneration; pollution; insured v. insured (i.e., derivative suits are only covered if brought by uninsured party); pending/prior litigation; regulatory exclusion

d)

e)

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