Loewenstein, Corporations Spring 2012

TOC
1. History Of Partnerships And Corporations (# 1: p.1-7; 135-149 2.01-2.06, 4.01) ..................................................................5 2. Process Of Incorporation (Ch.4) .................................................................................................................................. 11
2.1 2.2 2.3 2.4 2.5 2.6 2.7 Mechanics of Incorporation ..........................................................................................................................................................................11 Tailored Articles of Incorporation (private ordering) ......................................................................................................................11 Choice of the State of Incorporation .........................................................................................................................................................11 Ethical Considerations ....................................................................................................................................................................................11 Taxonomy of Corporations ...........................................................................................................................................................................11 Defective Incorporation..................................................................................................................................................................................11 Corporate Death (Involuntary Dissolution) (#2: p.149-163; 189-203; 3.01-03; 6.01-03; 6.20-24; 6.30) . ...................................................11

Thompson & Green Machinery Co. v. Music City Lumber Co. ................................................................................................................................ 11 Equipto Division v. Yarmouth ............................................................................................................................................................................................. 11

2.8 Promoters Liability on Preincorporation Contracts ..........................................................................................................................11 2.9 Liability on Preincorporation ContractsThe Corporations Viewpoint .................................................................................11 2.10 Ultra Vires ..........................................................................................................................................................................................................11 2.11 The Organizational Meeting ......................................................................................................................................................................11

3. Basic Corporate Finance, Accounting, And Distributions (Ch.6) ..................................................................... 13

3.1 3.2 3.3 GLOSSARY .............................................................................................................................................................................................................13 BASIC CORPORATE FINANCE ......................................................................................................................................................................13 BASICS OF FINANCIAL STATEMENTS......................................................................................................................................................13
Corporate Securities .............................................................................................................................................................................................................. 13 Debt Secruirites ....................................................................................................................................................................................................................... 13 Double-Entry Bookkeeping................................................................................................................................................................................................ 13 Balance Sheets .......................................................................................................................................................................................................................... 13 Income Statements................................................................................................................................................................................................................. 13 Basic Types of Distributions .............................................................................................................................................................................................. 13 Board of Directors Discretion (#3) ................................................................................................................................................................................ 13 Limitations on Corporate Distributions under Corporate Statutes ............................................................................................................... 13 Director Liability for Improper Distributions ........................................................................................................................................................... 13 Shareholder Liability for Improper Distributions .................................................................................................................................................. 13 Contractual Restrictions on Corporate Distributions ........................................................................................................................................... 13

3.4

DIVIDENDES AND OTHER DISTRIBUTIONS TO SHAREHOLDERS ..............................................................................................13

4. Limitations On Limited Liability (Ch.7) .................................................................................................................... 15

4.2 4.3

GENERAL CHARACTERISTICS OF PIERCING THE CORPRATE VEIL ..........................................................................................15 FACTORS TO PIERCE THE CORPORATE VEIL ......................................................................................................................................15

Lack of Corporate Formalities .......................................................................................................................................................................................... 15 Commingling of Corporate Affairs .................................................................................................................................................................................. 15 Undercapitalization ............................................................................................................................................................................................................... 15 Tort vs. Creditor ...................................................................................................................................................................................................................... 15 Misrepresentation/Fraud ................................................................................................................................................................................................... 15 Individualy Shareholder Liability ................................................................................................................................................................................... 15 Business Enterprise Liability Doctrine ........................................................................................................................................................................ 15 Phillips v. Englewood Post.................................................................................................................................................................................................... 15

4.4 4.5 4.6 5.1 5.2 5.3

CONTEXT MATTERS WHEN PIERCING THE CORPORATE VEIL (#4: p.224-45) ............................................................................15 REVERSE VEIL PIERCING ..............................................................................................................................................................................15 EQUITABLE SUBORDINATION: THE DEEP ROCK DOCTRINE .......................................................................................................15 SOCIAL RESPONSIBILITY...............................................................................................................................................................................17 CORPORATE PURPOSE ...................................................................................................................................................................................17 CORPORATE GOVERNANCE (#6: p.11-34; 8.01; 8.03-.07; 8.20-.24) ...............................................................................................................17

5. Management & Control Of The Corporation (Ch.8) (#5) ....................................................................................... 17

A.P. Smith Mfg. Co. v. Barlow .............................................................................................................................................................................................. 17 Dodge v. Ford Motor Co. ........................................................................................................................................................................................................ 17 Voting for the Election of Directors ............................................................................................................................................................................... 17 Procedural Requirements for Shareholder and Director Meetings ............................................................................................................... 17 A Larger Role for Shareholders (of Publicly Held Corporations)? .................................................................................................................. 18

A Comparative Law Perspective ...................................................................................................................................................................................... 18

5.4

THE BOARD OF DIRECTORS AND ITS COMMITTEES .......................................................................................................................18

The Function of the Board .................................................................................................................................................................................................. 18 Board Structures ..................................................................................................................................................................................................................... 18 Removal of Directors (#7: p.34-55; 8.08-.09; 8.40-.44; 7.01-.02)..................................................................................................................................... 18 Equitable Restraints on Board Action .......................................................................................................................................................................... 18 Board Committees .................................................................................................................................................................................................................. 18 The Role of Officers ................................................................................................................................................................................................................ 18 Internl Brotherhood of Teamsters General Fund v. Fleming Co. Inc. ............................................................................................................... 18

5.5 5.6 5.7

ROLE OF SHAREHOLDERS ............................................................................................................................................................................18 DUTY TO CREDITORS ......................................................................................................................................................................................18 SHAREHOLDER VOTING (#8: p.55-72; 7.04-.08, .20, .22) ................................................................................................................................18

Proxy Voting .............................................................................................................................................................................................................................. 18 State Regulation....................................................................................................................................................................................................................... 18 Federal Regulation: Proxy Solicitations ....................................................................................................................................................................... 18 Federal Regulation: Shareholder Proposals (#9: p.72-87; SEA Rules 14a-1 and -4) ................................................................................................ 18 State Ex. Rel. Pillsbury v. Honeywell, Inc. ....................................................................................................................................................................... 18 Seinfeld v. Verizon Communications, Inc. ...................................................................................................................................................................... 18

5.8

SHAREHOLDER INSPECTION RIGHTS .....................................................................................................................................................18

6. Problems In Closely Held Corporations (Ch.9)....................................................................................................... 19

6.2 FIDUCIARY DUTIES AMONG SHAREHOLDERS ....................................................................................................................................19
Donahue v. Rodd Electrotype Co. ...................................................................................................................................................................................... 19 Wilkes v. Springside Nursing Home, Inc. ........................................................................................................................................................................ 19 Smith v. Atlantic Properties, Inc. ....................................................................................................................................................................................... 20 Merola v. Exergen Corp.: ....................................................................................................................................................................................................... 20 Sletteland v. Roberts ............................................................................................................................................................................................................... 20 Rosenthal v. Rosenthal ........................................................................................................................................................................................................... 20 Hagshenas v. Gaylord ............................................................................................................................................................................................................. 20 Meiselman v. Meiselman ....................................................................................................................................................................................................... 21 In the matter of Kemp & Beatley, Inc. ............................................................................................................................................................................. 21 Gimpel v. Bolstein ..................................................................................................................................................................................................................... 21 Preemptive Rights, Supermajority Voting and Classified Stock ....................................................................................................................... 21 Shareholder Voting Agreements and Irrevocable Proxies.................................................................................................................................. 23 Shareholder Agreements Restricting Board Discretion - MBCA 7.32: ....................................................................................................... 23 Restrictions on Transfers of Shares (#13: 362-74; 381-93; prob on p.379; 6.27; 8.30-31) .......................................................................................... 24 Fiduciary Duties in Implementing Restrictions on Transfer ............................................................................................................................. 26

6.3

OPPRESSION, DEADLOCK, AND DISSOLUTION 14.30 ...............................................................................................................21

6.4

SHAREHOLDER AGREEMENTS & OTHER CONTROL DEVICES (p. 343-362; 6.30; 7.24-28; 6.01-.02; 7.30-.32) ...............................21

7. Fiduciary Duty (Ch.10) .................................................................................................................................................... 27

7.2 7.3 7.4 7.5 7.6 7.7 7.8

THE DUTY OF CARE .........................................................................................................................................................................................27 VIOLATION OF DUTY .......................................................................................................................................................................................28 CAREMARK DUTIES (#15: p.398-415; MBCA 8.30-.31, 8.33; CRS Draft Legislation) ...................................................................................................29 PROXIMATE CAUSATION ...............................................................................................................................................................................30
Barnes v. Andrews

Brane v Roth............................................................................................................................................................................................................................... 27 Francis v. United Jersey Bank.............................................................................................................................................................................................. 28 NACEPF v. Gheewalla ............................................................................................................................................................................................................. 29 Stone v. Ritter. ........................................................................................................................................................................................................................... 29

THE BUSINESS JUDGMENT RULE ..............................................................................................................................................................30

Smith v. VanGorkom

THE DUTY OF LOYALTY (#16: 415-428) ..........................................................................................................................................................32 INTERESTED DIRECTOR TRANSACTIONS .............................................................................................................................................32

Hayes Oyster Co. v. Keypoint Oyster Co. ......................................................................................................................................................................... 32 Interested Director Statute(Del. 144) ................................................................................................................................................................... 33 MBCA Subshapter F8.608.63 .............................................................................................................................................................................. 33

7.9 USURPATION OF A CORPORATE OPPORTUNITY (#17: 432-445; 462-66; Broz case, Del on Corp opp) .....................................................34 7.10 COMPETITION WITH THE CORPORATION.........................................................................................................................................35 7.11 DIRECTORS AND OFFICERS COMPENSATION ................................................................................................................................35 7.12 ADDITIONAL FIDUCIARY DUTIES (INCOHATE)...............................................................................................................................36 2

Ryan v. Gifford ........................................................................................................................................................................................................................... 35 In re Tyson Food, Inc. ............................................................................................................................................................................................................. 36

8. Derivative Litigation (Ch.11) ........................................................................................................................................ 39

8.2 8.3 8.4 8.5 8.6

PREREQUISITES FOR A DERIVATIVE SUIT (nutshell) ......................................................................................................................39 SPECIAL LITIGATION COMMITTEE (SLC) AND THE SCOPE OF JUDICIAL REVIEW ...........................................................39 WHEN IS DEMAND EXCUSED AS FUTILE? .............................................................................................................................................40 UNIVERSAL DEMAND......................................................................................................................................................................................41 AVOIDING DERIVATIVE CHARACTERIZATIONDIRECT VERSUS DERIVATIVE ................................................................41

Zapata Corp v. Maldonado ................................................................................................................................................................................................... 39 Desigoudar v. Meyercord ...................................................................................................................................................................................................... 40 Aronson v. Lewis ....................................................................................................................................................................................................................... 40 Rales v. Blasband (handout) ............................................................................................................................................................................................... 41 In re Guidant .............................................................................................................................................................................................................................. 41 Tooley v. Donaldson, L&J Inc. .............................................................................................................................................................................................. 41

9. 10(b) Of The Securities Exchange Act (#20: 517-531; 551-558)........................................................................................ 43

9.1 9.2 9.3 9.4 9.5

RULE 10b-5 AND WHO CAN ENFORCE IT ..............................................................................................................................................43 ELEMENTS OF A 10b5 CLAIM ...................................................................................................................................................................43 The Deception or Manipulation Requirement ..............................................................................................................................44 Materiality ............................................................................................................................................................................................................44 The Reliance Requirement ............................................................................................................................................................................44

Santa Fe Industries, Inc. v. Green ...................................................................................................................................................................................... 44

Basic, Inc. v. Levinson ............................................................................................................................................................................................................. 44

10. Insider Traiding .............................................................................................................................................................. 44

10.1 10.2 10.3 10.4 10.5 10.6 INTRODUCTION ..............................................................................................................................................................................................44 DUTY THEORY (#21: 558-569; 574-583; 584-587; Boudreaux on Insider Trading) ...............................................................................................44 TIPPER-TIPPEE LIABILITY .....................................................................................................................................................................44 MISAPPROPRIATION THEORY .............................................................................................................................................................44 POSSESSION VS. USE .............................................................................................................................................................................44 DAMAGES AND PENALTIES .......................................................................................................................................................................44
Chiarella v. U.S........................................................................................................................................................................................................................... 44 Dirks v. SEC ................................................................................................................................................................................................................................. 44 U.S. v. OHagan. ......................................................................................................................................................................................................................... 44

Damages10(b) Actions ................................................................................................................................................................................................. 44 Penalties ...................................................................................................................................................................................................................................... 44 Contemporaneous and Option Traders ....................................................................................................................................................................... 44

11. The Regulation of Securities Offerings (ch5: #22: p.165-187) ......................................................................................... 45

11.1

WHAT IS A SECURITY ...................................................................................................................................................................................45

Wartzman v. Hightower Productions, Ltd. ................................................................................................................................................................... 45 Stock .............................................................................................................................................................................................................................................. 45 Notes ............................................................................................................................................................................................................................................. 45 Investment Contracts ............................................................................................................................................................................................................ 45

11.2 11.3

THE EXEMPTION-REGISTRATION QUERY .........................................................................................................................................45 EXEMPTIONS FROM REGISTRATION ....................................................................................................................................................45

The Statutory Private Offering Exemption4(2) ................................................................................................................................................ 45 Rule 506 of Regulation D..................................................................................................................................................................................................... 45 The Limited Offering Exemptions ................................................................................................................................................................................... 45 Intrastate Offerings ................................................................................................................................................................................................................ 45

11.4 11.5 11.6 11.7 11.8 11.9

OVERVIEW OF THE REGISTRATION PROCESS .................................................................................................................................45 GOING PUBLICPROS AND CONS ......................................................................................................................................................45 A BRIEF LOK AT THE PROCESS OF A PUBLIC OFFERING ............................................................................................................45 STATE BLUE SKY LAW .............................................................................................................................................................................45 THE REGISTERED OFFERINGFRAMEWORK OF SECTION 11 ...............................................................................................45 THE SARBANES-OXLEY ACT .....................................................................................................................................................................45

Escott v. Barchris Construction Corp............................................................................................................................................................................... 45 CEO and CFO Certifications ................................................................................................................................................................................................ 45 Audit Committee ..................................................................................................................................................................................................................... 45 Forfeiture of Bonuses and Profits ................................................................................................................................................................................... 45 Officer and Director Bars .................................................................................................................................................................................................... 45 Prohibition of Loans to Directors and Officers ......................................................................................................................................................... 45 Management Assessment of Internal Controls......................................................................................................................................................... 45 Real-Time Disclosure ............................................................................................................................................................................................................ 45 Accounting Oversight Board.............................................................................................................................................................................................. 45

12. Basic Corporate Changes (ch.15: #23: p.605-625) ............................................................... Error! Bookmark not defined.
12.1 12.2 12.3 OVERVIEW........................................................................................................................................... Error! Bookmark not defined. CHARTER AND BYLAW AMENDMENTS ................................................................................. Error! Bookmark not defined. STATUTORY BUSINESS COMBINATIONS .............................................................................. Error! Bookmark not defined.

Statutory Mergers and Consolidations .......................................................................................................... Error! Bookmark not defined. Statutory Share Exchanges.................................................................................................................................. Error! Bookmark not defined. Dispositions of All or Substantially All of a Corporations Assets (#24: p.625-648) ....................... Error! Bookmark not defined. Appraisal Rights ....................................................................................................................................................... Error! Bookmark not defined. De Facto Mergers ....................................................................................................................................................... Error! Bookmark not defined.

12.4 13.1

DISSOLUTIONS .................................................................................................................................. Error! Bookmark not defined. OVERVIEW.........................................................................................................................................................................................................49

13. Change of Control of the Corporation (ch.16: #25: p649-70) ........................................................................................ 49

Shareholder Primacy............................................................................................................................................................................................................. 49 Director Primacy ..................................................................................................................................................................................................................... 49 Managerialism .......................................................................................................................................................................................................................... 49 Resulting Theoretical Confusion ..................................................................................................................................................................................... 49 Market for Corporate Control ........................................................................................................................................................................................... 49 A Birds-Eye View of Change-of-Control Transactions .......................................................................................................................................... 49 Charter Amendments and Business Combinations ................................................................................................................................................ 49 Proxy Contests (aka Proxy Fights) and Other Changes in Control of the Board ...................................................................................... 49 Tender Offers and Other Share Purchases ................................................................................................................................................................. 49 Going Private Transactions ................................................................................................................................................................................................ 49

13.2

TYPES AND REGULATION OF CHANGE OF CONTROL TRANSACTIONS................................................................................49

History of Partnerships and Corporations

1. History Of Partnerships And Corporations (# 1: p.1-7; 135-149 2.01-2.06, 4.01

Commercial ass'ns in medieval Italy affected partnership law: Commenda and Societas o Commenda Gave partners investment opportunities with limited liability Influenced later forms of limited liability assns, esp. LPs o Societas Form of contractual general partnership Established key principles of partnership law Each partner represents the others, can bind others w/ his Ks made on behalf of the firm Each partner personally liable w/o limitation to creditors Law merchant (uniform international body of law) recognized the societas Law merchant also contributed to principle that each partner has rt to accounting from other partners Partnership as entity separate from members (aggregate theory) Withdrawal/death of individual partner = dissolution of the partnership Aggregate theory persisted until 1994 in US o First treatise on partnership law - William Matson American development o Uniform Partnership Act (1914): Allowed partnership agt to K around its provisions o Revised Uniform Limited Partnership Act (RULPA) (1976) o RUPA (1994): Made partnerships more stable by treating as entity instead of aggregate of individuals RUPA (UPA if RUPA not adopted) is default law for unincorporated business entities (parties that "carry on as co-owners a business for profit") o 1970s - limited liability extended to GPs via the LLP o 1997 - RUPA amended to include Uniform Limited Liability Partnership Act (ULLPA) o 2001 - Re-RULPA - allowed limited liability for the GPs of an LP if partnership files as LLLP w/ state State law provides options of: Corporation, GP, LP, LLP, LLC Rise of corporate law o Offers limited liability protection o Perpetual life o Greater continuity of mgt o Transferable shares o Can bring suit against third parties o Can bring suit against own members o Majority vote allowed for decision making Partnerships require unanimity o Individual member not personally liable for the debts of the corporation Lack of general incorporation acts problematic for states in colonies o NJ was first state to liberalize incorporation - used fees as sources of revenue o 20th century - all states moved to liberal "enabling" statutes o 1930s - fed started to regulate public corps through securities law o Delaware is now the hub for incorporations Most important corporate law Most desirable corporation law Court of chancery efficiency/expertise Del. Legislature keeps law current Legal practitioners, sophisticated debt/equity providers familiar w/ Delaware law Delaware franchise fees now the highest in the nation o Many states now use Model Business Incorporation Act o LLC is entity of choice for most newly formed businesses o Possible trend toward reducing # of forms to LLC, GP, and corp.

CLASS 1: 135-149, PROCESS OF INCORPORATION Introduction: Issues of legal personality o Choice of entity, state of incorporation, form of capital structure, etc. 5

History of Partnerships and Corporations

Whether the separate legal personality of the corp will be recognized Defective incorporation/defective existence o Other issues of personality Doctrine of corporate disregard/piercing the corporate veil Ultra vires doctrine = May permit recognition of legal personality but permit challenges to corporateness of entity's activities in 2 ways Strong form ultra vires = May permit challenges to Ks as "beyond the corporation's powers or purposes" Ultra vires = May only permit suits inter se when allegedly defendants have caused corp to exceed purposes in its articles/cert of incorp. o Shareholder vs. director o Director vs. director Mechanics of incorporation o Standard All states have general incorp acts; Any business can incorporate under them Except special carveouts like banking, insurance ("affected with the public interest") b/c consumers don't pay immediately for the service Granting of corporate existence is ministerial, not political Modern statutes: corp can have a single shareholder and a single director Some states require 2 directors if 2 shareholders etc.) o Purpose clauses State law: purpose of a corp can be, and can be stated to be, any lawful purpose, MBCA 54(c) (1969) Latest MBCA (1984): "lawful limitless purpose corporation" If articles silent, purpose is any lawful purpose - MBCA 3.01(a) No requirements for duration (now perpetual) or purpose Articles of Incorporation = 4 requirements: - MBCA 2.02(a) o Corporate name o # of shares authorized to issue o Street address (not PO box) of registered office, name of registered agent o Name and address of each incorporator Del. Gen. Corp. Law 102: similar, but requires 5-6 items instead of 4 o Also requires statement of purpose but sufficient to state "any lawful purpose" o Board of directors Delaware requires on cert of incorp. the names and addresses of directors until 1st annual shareholder meeting only if powers of the incorporator terminate upon filing of cert. of incorp. Many attorneys instead have incorporators continue as 1st directors until org meeting where incorporators resign one by one? o Name Must meet 3 requirements Can't be same as/deceptively similar to name of any other corp. licensed in the JD o Some statutes: can use if written permission & doesn't confuse the public o Model Act: need only be "distinguishable on the records of the secretary of state" - Del. Gen. Corp. Law 102(1) o Many states retain "deceptively similar test" Can't imply that corp is organized for other than a permitted purpose Name must contain word of corporateness (ex. inc.) - MBCA 4.01 House rules No profane/scatological words Can pay fee to reserve a name, usually limited to 6 months to avoid "name squatting" Lawyers have protocols for name clearances Checking list in red book/electronic list Secretary of State publishes Researching yellow pages Trademark search 6

History of Partnerships and Corporations

Statutes have long lists of corporate powers, MBCA 3.02, Del. Gen. Corp. Law 122 Also contain catch-all to give corp the legal abilities of a real person

Tailored articles of incorporation (private ordering) o Optional "charter" provisions - both MBCA and Del. Gen. Corp. Law have these, they are exemplary, not exhaustive MBCA 2.02, Del. Gen. Corp. Law 102(b) Law firms have their own specimen articles of incorporation Choice of whether to include in articles, bylaws, or shareholder agt - consider confidentiality (Art of Incorp made public) Tailored shareholder agt may be too expensive to justify legal fees o Charter provisions - situational use for a particular client 7 types of optional provisions Naming initial board of directors Including article narrowing purpose Capping/eliminating director's duty of care liability (exculpatory clause) Writing special governance provisions - i.e., eliminating board of directors Installing shareholders' preemptive rights Electing treatment as close corp (15 or so JDs have chapters for this) Implementing indemnification of directors o Initial board of directors Statutes no longer require organizational meeting But careful - Grant v. Mitchell - trial over whether corp had one director or two, never had org meeting o Including a purpose clause and drafting it narrowly Used by less active participants to box in more active parties o Exculpatory clauses 102(b)(7) clauses (after Del. Gen. Corp. Law section) Exculpate directors from duty of care liability or cap liability for violations Doesn't eliminate duty of care Ps can still try to enjoin transactions for faulty process Current Model Act: corp can adopt a provision eliminating/limiting liability except for: Financial benefit received by director to which he is not entitled Intentional infliction of harm on corp or shareholders Violation of 8.33 (illegal distributions) Intentional criminal violations Model Act would also eliminate liability for many duty of loyalty violations Majority of incorporations don't include this o Special governance provisions Modern statutes allow elimination of board of direcotrs - MBCA 7.32; can do so by shareholder agt or by articles of incorp. provision Most states permit (don't require) cumulative voting to elect directors o Provision for preemptive rights ROFR (in shares offered to 3rd parties for cash) Doesn't apply unless articles or certificate provide for it Shareholder has rt to match price offered (not par value or bargain price) Modern statutes: presumption that preemptive rts don't exist (MBCA 6.30(a)) To preserve proportionate interests among shareholders, share transfer restriction also necessary (buy-sell agt) o Close corporation election About 15 states have special chapters for close corps o Indemnification provisions Corp directors are sui generis - not agents of the corp, can't make Ks for the corp Statutes enable corporations to provide for indemnification if desired (MBCA 8.508.59, Del. 145) Exception: MBCA 8.52 - indemnification mandatory when the director has been "wholly successful, on the merits or otherwise), also Del. 145(c) o Filing Model Act allows electronic delivery of filing (MBCA 140(5)) Some law firms have "shelf corporations" if incorporation needed immediately 7

History of Partnerships and Corporations

Can also specify a delayed effective date - MBCA 1.23 Otherwise, corp existence starts on date Secretary of State accepts articles for filing MBCA 2.03 Some states still require second filing w/ local officials (i.e. county recorder) Some states also require publication in local/regional newspaper Filing fees: franchise tax, filing fee Del charges variable fee based on authorized stock - Del. 391 Model Act 1.25(d) makes filing a "ministerial act" to prevent delays, rejections, etc. Some states reject, want to have broader power of rejection

Choice of the state of incorporation o MBCA is law in 39 states o Business lawyers stay at home 95% of the time Exceptions: Del lends itself to large corporations, those used in business combination w/ another large entity, those who want to start acquiring quickly CA, other western states might incorporate in Nevada - "Delaware of the west" No need to "run away" But might want to run away b/c U.S. courts follow the internal affairs choice of law rule Law in place of incorporation would govern conflicts among shareholders, directors, officers, other internal matters True even if shareholder files suit in another state But ct will uphold JD over corporate officers/directors, held to have consented to suit in place of incorporation, might involve travel costs etc - Del. 3114 might also have to get local counsel Runaway corporations must have registered agent, pay fees in state of incorporation o Some companies provide this service - Prentice Hall, CT Corporation, $100-$150/yr But then have to register as foreign corporation in home state and have registered agent there - 2 sets of fees Ethical considerations o RPC 1.13 - attorney's client is organization o Must disclose past connection with any of the participants in the corp., must be prepared to resign if conflict arises Taxonomy of corporations o Closely held vs. other species Closely held - restriction on share transfer Usually small - 3-5, maybe 10 members o Family vs. family-owned Family: interests of owners co-extensive w/ those of the corporation o Size Small - 10 or fewer shareholders Quasi-public - 11-299 Public - >300 Securities Exchange Act of 1934: public is >500 holders of a class of equity securities & $10m or more in assets - 12(g) companies Careful: difference between holders of a class and shareholders To fall back out of SEC system, must decline below 500 holders in a class o Foreign issuers: avg value of class must fall to 5% or less of total traded globally o SEC Rule 12b-6, 17 CFR 240.12b-6 SEC governs 12(b) corporations (those on a nat'l stock exchange) and OTC traded companies o Must file periodic reports, obey proxy rules in soliciting proxies (agencies to vote shares) o How shares are traded OTC Traded on dealer basis Brokerage firms make markets, take markup 8

History of Partnerships and Corporations

NASDAQ computerized part of OTC list Exchange traded Usually agency rather than dealer trading - commission instead of markup Used to be a progression from local OTC to bigger exchanges, now less common NASDAQ now does 13% of trading in NYSE list NYSE does only about 70% of trading in stocks of its own listed companies AMEX has gotten smaller, now trades ETRs (exchange traded funds), other baskets of stock o Aggregate value of shares Small cap: market cap <$1bn Mid cap: $1-5bn Large cap: over $5 or $10bn Defective incorporation o Process of incorporation simplified o Common law fallback defense was that if corporation were not de jure (good against all the world) it was de facto (good against all the world but the state) o Elements of de facto corp: Existence of a law under which corp could be formed Good faith attempt to come under the law Conduct of business by the putative shareholders as if the corp existed o Promoter could assert that creditor dealt w/ business as if it were a corp Evidence: invoices, correspondence Estoppel doctrine - liberal use No affirmative misrepresentation, reliance, or change of position required Cranson v. Internat'l Business Machine - creditor had invoiced, was estopped to deny that a corp existed later o

Thompson & Green Machinery Co. v. Music City Lumber Co. Citation: Tenn. 1984 Parties: Plaintiff: Thompson, sold wheel loader to Walker (pres of Music City) who returned it later Defendant: Music City, failed to incorporate before date of purchase Type of Existence of de facto incorporation defense case: Procedural History: Facts: Walker (president of Music City/Sawmill) bought a wheel loader then returned it. Thompson sold the wheel loader and then brought suit against Music City for the balance due, then amended the complaint to include Walker as a defendant after finding that Sawmill wasn't incorporated at the date of purchase. Tennessee had passed the Tenn. General Corporations Act which said that "all persons who assume to act as a corporation without authority so to do shall be jointly and severally liable for all debts and liabilities incurred or arising as a result thereof." It also provided that "a corporation shall not...incur any indebtedness...until (a) the charter has been filed by the secretary of state and (b) there has been received the amount stated in the charter as the minimum amount of consideration to be received for its shares before commencing business" Issues: Whether the concept of de facto corporation is still valid in Tennessee. Rule: Tennessee General Assembly abolished the concept of de facto incorporation in Tenn. Concepts of estoppel and de facto corporation have been eliminated under the Business Corporation Act and the District of Columbia, as well as Oregon. Model Act states: "Under the unequivocal provisions of the Model Act, any steps short of securing a certificate of incorporation would not constitute apparent compliance. Therefore a de facto corporation cannot exist under the Model Act." Holding: Judgment for plaintiff. Notes: Timberline Equip. Co. v. Davenport - Supreme ct of Oregon held that MBCA 146 abolishes de facto corporation doctrine o In OR and other JDs that follow the case, corporations are de jure or nothing o But some wiggle room left by OR ct if attempted incorp. is defective - only persons "who assume to act as a corporation" will be personally liable Doesn't include "those whose only connection with the organization is as an investor...but 9

History of Partnerships and Corporations

does include those persons who have an investment in the organization and who actively participate in the policy and operational decisions" of the enterprise o MBCA 2.04: people acting on behalf of corporation knowing there was no incorporation are J&S liable for results Corporations by estoppel o Official comment to 2.04: if someone urges defendants to execute K in the name of the corporation despite knowledge that there is no corporation yet, that person is estopped from imposing personal liability on the defendant

10

Process Of Incorporation (ch. 4)

2. Process Of Incorporation (Ch.4)

2.1 Mechanics of Incorporation 2.2 Tailored Articles of Incorporation (private ordering) 2.3 Choice of the State of Incorporation 2.4 Ethical Considerations 2.5 Taxonomy of Corporations 2.6 Defective Incorporation
A. Thompson & Green Machinery Co. v. Music City Lumber Co.

2.7 Corporate Death (Involuntary Dissolution)

A. Equipto Division v. Yarmouth: disolved for failure to pay annual fee; Personal Liability governed by MBCA 2.04 requring actual knowledge there was no corp

2.8 Promoters Liability on Preincorporation Contracts 2.9 Liability on Preincorporation ContractsThe Corporations Viewpoint 2.10 Ultra Vires
A. Intro: means powers beyond corp B. Reasons for decline of the Doctrine C. Ultra Vires Statutes 1. Total Access v. Caddo (OK 2000) a. Parties: : Total, appealing motion to dismiss in favor of Caddo; : Caddo b. Type of case: Ultra vires statute c. Facts: Total sued Caddo (competitor) for injunctive relief, alleged acts of Caddo in providing internet service to compete w/ Caddo were ultra vires. d. Issues: Whether ultra vires action can be brought by a competitor. e. Rule: OK General Corp Act provides (MBCA 3.04) that no act of a corporation shall be invalid b/c it was ultra vires, but lack of capacity of corp can be asserted by i. A shareholder to stop corp from performing certain acts or transferring property ii. By corp in action against director for loss or dmg due to unauthorized acts iii. By AG to dissolve corp or enjoin it from transacting unauthorized business f. Holding: Action can only be brought by parties listed above, not by a competitor. Affirmed.

2.11 The Organizational Meeting

11

Basic Corp Finance, Accounting, and Distributions (ch.6)

3. Basic Corporate Finance, Accounting, And Distributions (Ch.6)

3.1 GLOSSARY 3.2 BASIC CORPORATE FINANCE
A. Corporate Securities 1. Equity Securities a. Common stock b. Preferred Stock B. Debt Secruirites

3.3 BASICS OF FINANCIAL STATEMENTS

A. B. C. D. Intro Double-Entry Bookkeeping Balance Sheets Income Statements

3.4 DIVIDENDES AND OTHER DISTRIBUTIONS TO SHAREHOLDERS

A. Intro B. Basic Types of Distributions C. Board of Directors Discretion 1. Gottfried v. Gottfried (NY 1947) ct did not forced dividends because did not find board acted in bad faith. a. Parties: : minority shareholders; : majority shareholders/mgt b. Type of case: Board of directors' discretion in dividends c. Facts: Minority shareholders upset at majority (family dispute) b/c of failure to pay a dividend, alleged bad faith/hostility etc. Facts supporting bad faith: hostility of controlling faction, exclusion of minority from employment, high salaries, bonuses, corporate loans made to officers, majority subject to high income tax if dividends issued, controlling directors wanted to acquire minority stock cheaply. 2 of Ps had been discontinued from payroll. i. Defendants asserted reasons for not issuing dividend: earnings during war years unreliable, need for CAPEX for new stores, increased cost of opening new stores, new bakery opened, unstable labor conditions, financing expansion through earnings. d. Issues: Whether dividend was withheld in bad faith. e. Rule: If adequate surplus available for dividends, directors may not withhold the declaration of dividends in bad faith. Mere existence of adequate surplus is not sufficient to invoke ct action to compel. There must also be bad faith. i. Ct will not substitute its judgment for that of the board of directors. f. Holding: Plaintiffs failed to prove that the surplus was unnecessarily large and that Ds recognized duty to pay dividends but failed to do so. Complaint dismissed. 2. Dodge v. Ford Motor Co.: purpose of looking at shareholders as your primary constitutancy (class note) 3. Miller v. Magline, Inc. (p.203): Ct forced payment of dividends b/c a large surplus was evidence of a breach of fiduciary duty to minority shareholders a. In a closely held corporation, the fiduciary duty may run directly to shareholders, in addition to the corporation D. Limitations on Corporate Distributions under Corporate Statutes 1. Policies Supporting Limitations: protect creditors 2. Balance Sheet or Capital Impairment Restrictions a. Del 160 and 170(a): generally states cannot exceed amount of the corporations surpluss 3. Earned Surplus Restrictions 4. Solvency Restrictions E. Director Liability for Improper Distributions: 1. Klang v. Smiths Food & Drug (p.210): Rule: No corporation may repurchase or redeem its own shares except out of surplus as statutorily defined, F. Shareholder Liability for Improper Distributions G. Contractual Restrictions on Corporate Distributions 13

Limitations On Limited Liability (ch.7)

4. Limitations On Limited Liability (Ch.7)

4.1 INTRO 4.2 GENERAL CHARACTERISTICS OF PIERCING THE CORPRATE VEIL
A. Only been succesfully invoked in context of privately held corps, although theoretically could be a publicly-held corporation B. Doctrine is almost entirely judge-made law, thus very fact-based C. Two general Factors: (1) domination or control by a shareholder, whether an individual or another corporate entity, over the subject corp; and (2) some type of fraud, wrong or injustice 4.3 FACTORS TO PIERCE THE CORPORATE VEIL A. Lack of Corporate Formalities B. Commingling of Corporate Affairs C. Undercapitalization D. Tort vs. Creditor E. Misrepresentation/Fraud F. An Empirical Study 4.4 CONTEXT MATTERS WHEN PIERCING THE CORPORATE VEIL (1/25: p.224-45) A. Individualy Shareholder Liability 1. Individual Shareholder Piercing: Tort a. Minton v. Cavaney (p.224) b. National Labor Relations Bd v. West Dixie (p.225) c. Baatz v. Arrow Bar (p.227) 2. Individual Shareholder Piercing: Contract a. Brunswick Corp v. Wakman B. Business Enterprise Liability Doctrine 1. Business Enterprise Liability: Tort a. Walkovsky v. Carlton b. Gardemal v. Westin Hotel Co. 2. Business Enterprise Liability: Contract a. OTR Associates v. IBC Services

4.5 REVERSE VEIL PIERCING

A. Phillips v. Englewood Post

4.6 EQUITABLE SUBORDINATION: THE DEEP ROCK DOCTRINE

15

Management & Control Of The Corporation

5. Management & Control Of The Corporation (Ch.8)

5.1 SOCIAL RESPONSIBILITY
A. A.P. Smith Mfg. Co. v. Barlow (N.J. 1953), p.2

1. Issue: does the board of direcotrs have the power to make decisions that do not directly benefit shareholders? 2. Rule: courts give lots of discretion to boards and consider charitable contributions a business judgment 5.2 CORPORATE PURPOSE
A. Dodge v. Ford Motor Co. (Mich. 1919), p.5:

1. Issue: when directors make decisions, must they have the shareholders best interest foremost? 2. Rule: can not operate as a semi-charitable corporation; must act in corporations best-interest; breack of fiduciary duty to act in 3rd partiy constitutents best interset 5.3 CORPORATE GOVERNANCE (#6: p.11-34; 8.01; 8.03-.07; 8.20-.24)
A. Voting for the Election of Directors 1. Straight Voting 2. Cumulative Voting 3. Weighted Voting 4. Pooling Agreements and other voting arrangements 5. Ringling Bros.-Barnum & Bailey v. Ringling, (Del. 1947), p.15

6. Mountain Manor Realty, Inc. v. Buccheri, (Md 1983), p.21: because the other two directors had resigned, Conway, being the only remaining director and thus necessarily a majority of the remaining directors had the authority under Maryland Code 2-407(a)(2)(i) to fill the two remaining vacancies on the board, notwithstanding that there was a lack of a quorum. B. Procedural Requirements for Shareholder and Director Meetings 1. Shareholder Meetings a. Must hold an annual meeting of shareholders (7.01; Del 211); and give notice not less than 10 days, nor more than 60 days prior - (7.05; Del 222) b. A quorum of shares must be present; A quorum is typically a majority of the shares outstanding but can be changed in bylaws - 7.25(b) c. Simple majority approves most actions - 7.25(c) d. Special Meetings: shareholders typically have right to call special meetings where they may vote to remove directors from office or for other purposes i. MBCA: shareholders holding 10% of all votes to be cast on the matter may demand a special meeting; 7.02 ii. Del: s/h can only call a special meeting if AOI so provide 211(d) 1. Provides more protection for directors 2. Director Meetings a. No notice required for regular board of directors meetings; but at least two days notice for special meetings - 8.22 b. Typically, a minimum quorum is a majority of directors - 8.24; Del 141(b) i. Gearing v. Kelly, (Ct.App. 1962): held that the absence of a member of the board, who did not attend so that the board would not have a quorum did not render the boards action invalid c. Fogel v. U.S. Energy Systems, Inc, (Del.Ch.), p.27: Issue: What constitutes a meeting of the board of directors?RULE: mere fact that directors are gathered together does not a meeting make (no formal call, no vote, no opportunity for CEO to defend himself) 3. Informal Action a. Consent Solicitation = In lieu of meeting and voting on a proposoal, the s/h or directors could sign a consent describing the action being approved i. If Shareholders: usually need consent of at least the minimum number of votes that would be required to authorize action at a meeting 7.04(b) 17

Management & Control Of The Corporation

ii. If Directors need unanimous consent - 8.21(a); Del 141(f); based on idea that directors have a fiduciary duty and if there are dissenters, they should have opporutnity to pursuade others C. A Larger Role for Shareholders (of Publicly Held Corporations)? D. A Comparative Law Perspective

5.4 THE BOARD OF DIRECTORS AND ITS COMMITTEES

A. The Function of the Board B. Board Structures 1. Independent Directors 2. Staggered Boards C. Removal of Directors (#7: p.34-55; 8.08-.09; 8.40-.44; 7.01-.02) 1. Superwire.com, Inc. v. Hampton, (Del 2002), p.34: Under Del law, directors can be removed for cause or, where permitted by governing docs and law without cause a. Procedural Safeguards: A for cause removal of a director requires that the individual be given (1) specific charges for his removal, (2) adequate notice, and (3) a full opportunity to meet the accusation D. Equitable Restraints on Board Action 1. Schnell v. Chris-Craft, Inc., (Del 1971), p.37:

2. Blasius Industries, Inc. v. Atlas Corp., (Del 1988), p.39: Standard of Review: Two possibilities for reviewing management activity relating to S/H vote: the Blasius standard and the BJR Peerless. a. Under the Blasius standard the BOD has the burden of demonstrating a compelling justification for the action; but as a threshold matter, the must show that (1) the primary purpose of the BODs action was to interfere with or impede exercise of the S/H franchise AND (2) that the S/H were not given a full and fair opportunity to vote. b. If cannot demonstrate the predicate facts under Blasius, the BJR applies. E. Board Committees F. The Role of Officers 1. Grimes v. Alteon, Inc., 804 A.2d 256 (Del. 2002), p.45

5.5 ROLE OF SHAREHOLDERS

A. Internl Brotherhood of Teamsters v. Fleming Co. Inc., 975 P.2d 907 (Ok 1999), p.48

5.6 DUTY TO CREDITORS 5.7 SHAREHOLDER VOTING (#8: p.55-72; 7.04-.08, .20, .22)
A. Proxy Voting B. State Regulation 1. Lacos Land Co v. Arden Group, Inc., 517 A.2d 271 (Del. 1986), p.57 2. Schreiber v. Carney, 447 A.2d 17 (Del 1982), p.62 C. Federal Regulation: Proxy Solicitations 1. Mills v. Electric Auto-Lite Co., 396 U.S. 375 (1970), p.66: D. Federal Regulation: Shareholder Proposals (#9: p.72-87; SEA Rules 14a-1 and -4) 1. The Not Significantly Related Exception a. Lovenheim v. Iroquois Brands, ltd., (DC D.Ct, 1985), p.73 b. Note on Ordinary Business Exception and Socially Significant Issues 2. The Election of Directors Exception

5.8 SHAREHOLDER INSPECTION RIGHTS

A. State Ex. Rel. Pillsbury v. Honeywell, Inc., 191 N.W.2d 406 (1971), p.80: B. Seinfeld v. Verizon Communications, Inc., (Del 2006), p.82

18

Problems In Closely Held Corporations

6. Problems In Closely Held Corporations (Ch.9)

6.1 Intro/Definition of CHC:
A. CHC are generally defined as corporations having a small number of shareholders who normally expect to be involved in the daily operation, and who have shares which are not registered with the SEC, listed on a stock exchange or otherwise regularly traded. 1. Donahue defined CHC a. Small number of shareholders b. No ready resale market for its stocks c. Substantial majority shareholder participation in the management, direction, and operation of the business B. Donahue court characterized CHC like partnerships (ownership limited to orig parties, and owners dependent on each other for success of the enterprise) and fiduciary duties owed not only to corporation but to each other as well. C. Many problems in CHC arise out of their closeness. S/h anticipate to take certain positions in the board or as an officer. Moreover, CHC do not usually distribute profits as dividends but instead pay salaries (which are tax exempt business deductions). That means whenever there is conflict there is potential that minority shareholder can be removed form the office and cut out from the profits and have no ready market to dump the shares. Freeze outs often used to compel sale of stock for less than FMV.

6.2 FIDUCIARY DUTIES AMONG SHAREHOLDERS

A. Rule: Stockholders in the close corportation owe one another substantially the same fiduciary duty in the operation of the enterprise that partners owe to once another. This is the duty of utmost good faith and loyalty. They may not act out of avarice, expediency or self-interest. Violation of this duty can be compensated in damages. (Donahue) B. Donahue v. Rodd Electrotype Co., (Mass 1975), p.310: All s/h in CHC owe a strict fiduciary duty of good faith directly to each other similar to partnerships. To meet this test, ct adopted an equal opportunity to sell rule applicable to controlling shareholders: if a CHC repurchases shares from one stockholder, it must offer to repurchase from other holders on the same basis. 1. Facts: P was a minority holder and had inhereited her shares from her husband, an employee. The coprporation (controlled by the Rodd family) had previously bought back shares from its majority stockholder at a high price ($800 per share for a total of 36k). But had refused to buy a similar portion of Ps shares back from her, thus leaving her with a largely unmarketable interest. 2. Ps Claim: the distribution constitutes a breach of the fiduciary duty owed by the Rodds as controlling stockholders to her a minority stockholder, because Rodds failed to give her an equal opportunity to sell. 3. Holding: Ct held the corporation was required to repurchase shares form P in the same portion and at the same price as it had purchased from the majority holder. Rule of equal opportunity provides equal access for all S/H to the benefits of stock purchases by CHC 4. Cts Reasoning: a. Based on the trust and confidence essential in the small scale, and the inherent danger to minority interests from a lack of market to reclaim capital (majority freeze-outs), CHCs fundamentally resemble partnerships, thus s/h owe a similar strict fiduciary duty to each other b. Where the controlling s/h causes the coproation to buy back shares from him and not from minority holders, he is effectively using corporate funds for his personal benefit, in violation of this strict duty of good faith C. Wilkes v. Springside Nursing Home, Inc., (Mass, 1976), p.317: (Squeeze-Outs) if the majoirty refuses to pay dividends, and refuses to employ the minority holder, so that the minority has no way to participate in the economic fruits of ownership, this may be a violation of the majoritys fiduciary obligation 1. Facts: P and three other stockholders each owned 25% of the corporation. Based on longterm policy, each holder participated in management, and received an equal salary. When relations between P and another stockholder deteriorated, the other holders caused the corporation to terminate Ps salary and to drop him from the board. 19

Problems In Closely Held Corporations

2. Holding: Majority violated fiduciary duty by this freeze-out because it stripped P of his ability to obtain his expected return on his investment. (cutting off salary along with not issuing dividends.) Furthermore, they did not have a legitimate purpose for dropping P from payroll and from the board. (no misconduct by D). 3. Legitimate Business Purpose Test: Ct cautioned that not every action by the majority that disadvantages minority will be a breach of the strict fiduciary duty. Majoritys conduct is given discretion and will be upheld if there was a legitimate business purpose, and that purpose could not have been achieved through an alternative course of action less harmful to the minority holder. a. Burden Shift: If majority can assert a legitimate purpose, its then up to minority to show less harmful alternative to achieve same objective b. Ct must weight the legitimate business purpose against the practicability of a less harmful alternative D. Smith v. Atlantic Properties, Inc., (Mass. App.Ct., 1981), p.322: this strict fiduciary duty also applies to minority shareholders, especially if they have a veto power 1. Facts: E. Merola v. Exergen Corp., (Mass 1996), p.324: 1. Facts: F. Sletteland v. Roberts, (Mont 2000), p.327: the strict fiduciary duty of utmost good faith and loyalty among shareholders of CHC extends not only to majority or controlling shareholders, but to minority shareholders as well; Rule: Whenever a minority shareholder has the power to do damage to the corporation or his fellow shareholders, he must strictly observe utmost good faith and loyalty standards 1. Facts: Plaintiff sued two other directors seeking recovery of excessive legal fees; They counterclaimed that the law suit was a breach of fiduciary duty and negligence because it derailed a refinancing that would have benefited all parties. 2. Holding: Plaintiff breached duty of care to his fellow shareholders by filing a disruptive lawsuit that was specifically intended to derail financing. He did not use the care an ordinarily prudent person would in a similar position 3. Ct Reasoning: a. Applied a Substantial Factor test to determine whether Ps actions caused the refinancing to fail and as a result cause damage to Corp b. Ordinarily Prudent Person test: he knew of the refinancing and would have been aware of the effect that a lawsuit, alleging misconduct of board members, would have. Thus he either did it intentionally (because the other parties wouldnt do refinancing on his terms) or he was so careless that unreasonable person

G. Rosenthal v. Rosenthal, (Me. 1988), p.330: [scope and character of duty] 4 specific fiduciary duties owed by shareholders to each other: 1. (1) to act with the degree of diligence, care and skill which ordinarily prudent persons would exercise under similar circumstances in like positions; 2. (2) To discharge the duties affecting their relationship in good faith with a view to furthering the interests of one another as to the matters w/in scope of the relationship; 3. (3) To disclose and not withold from one another relevant information affecting the status and affairs of the relationship; 4. (4) To not use their position, influence or knowledge respecting the affairs and organization that are subject to the relationship to gain any special privilege or advantage over the other persons in the relationship H. Hagshenas v. Gaylord, (Ill. Ct.App. 1990), p.331: A fiduciary relation exists in all cases in which a confidential relationship has been acquired. Origin of the confidence is immaterial. It may be moral, social, domestic, or purely personal (Kelp); The important point in time is when they entered into the business relationship, not when their differences became irreconcilable 1. Facts: P resigned from Imperial as officer/directors. The next day purchased a new competing agency. Claims he was free to compete and does not owe a FD once he resigned as officer. 20

Problems In Closely Held Corporations

2. Holding: The court applied C/Law principles and found that as a 50% shareholder in a CHC, he owed a duty similar to a partner and violated his fiduciary duty when he opened a competing business and hired away all of corps employees.

6.3 OPPRESSION, DEADLOCK, AND DISSOLUTION - 14.30

A. As an alternative to bringing a direct action against majority s/h for breach of fiduciary duty, a minority s/h can bring a statutory action against the corporation itself for involutnary dissolution on the grounds of oppression. MBCA 14.30(a)(2)(ii) 1. Must prove oppression has occurred: a course of misconduct (not a single instance) intended to harm interests of the minority s/h or to otherwise frustrate his expectations. 2. If oppression found, ct may dissolve the corporation which means it ceases to exist as a legal entity, Assets are sold off, depts paid, and any surplus distributed to s/h 3. Given extreme nature of dissolution remedy, majority shareholders may be given option to avoid dissolution by buying out minoritys shares at a fair value. MBCA 14.34 B. MBCA 14.30(a)(2) A shareholder may obtain Involuntary dissolution of corporation only if he shows one of four things: (1) Directors deadlocked in the management of corp (and shareholder are unable to break deadlock) in a way that is causing irreparable injury to the corp or its s/h; or (2) Oppression: that the directors or those controlling corporation have acted in a manner that is illegal, opressive, or fraudulent; or (3) Shareholder deadlock in voting power, and have failed in two or more annual meetings to elect successor directors; or (4) Waste: corporate assets are being misapplied or wasted C. Meiselman v. Meiselman, (N.C. 1983), p.334: a court should give relief, dissolution or some other remedy to a minority s/h whenever corporate managers or controlling s/h act in a way that disappoints minority shareholders reasonable expectations even though the acts fall within the literal scope of corporations powers. 1. These reasonable expectations are ascertained by examining entire history of participants relationship. In order for Ps expectations to be reasonable they must be known to or assumed by the other shareholdrs and concuured in by them D. Kemp & Beatley, Inc., (NY Ct of App. 1984), p.335: Oppression of a shareholder is a statutory ground for dissolution. Oppression arises when those in control of the corp have acted in such a manner as to defeat those expectations of the minority stockholders which formed the basis of their participation in the venture. The court may find oppression even though majority has not acted fraudulently or illegally. 1. Facts: Ps worked for corp for 35+ years. Together they own 20%. After employment ended, Corp changed long standing method by which they pay out corp earnings: instead of payin based on stock ownership, they pay based on services rendered. Majority also altered unofficial practice of Corp buying back employee shares when they leave. 2. Test: Oppression arises only when majority conduct substantially defeats expectations that, objectively viewed, were both reasonable under the circumstances and were central to the petitioners decision to join the venture. E. Gimpel v. Bolstein, (NY 1984), p.339: k

6.4 SHAREHOLDER AGREEMENTS & OTHER CONTROL DEVICES (p. 343-362; 6.30; 7.24-28;
6.01-.02; 7.30-.32) A. Intro: Many issues arising in closely held corps can be avoided through careful corporate planning. Requires considering the usual and reasonable expectations of S/h in CHC and develop control devices to prevent their frustration (set forth in AOI, bylaws, or s/hs agrmt) 1. Common s/h expectations include: board membership, anti-dilution, voting/veto rights, employment, liquidity rights, and limits on corporate powers (p.343) B. Preemptive Rights, Supermajority Voting and Classified Stock 1. Preemptive Rights - MBCA 6.30: 21

Problems In Closely Held Corporations

a. Device to retain and guard ownership share through a right to purchase their pro rata share of any additional shares issued by the corporation to avoid dilution of their voting power. Under MBCA shareholders do NOT have preemptive rights unless AOI specifically include such provision. b. Opt-in provisions 6.30(b)(3): pre-emptive rights do not apply to shares: i. Issued as compensation to directors, officers, or employees; ii. authorized shares issued w/in the first six month of the incorporation or iii. shares sold otherwise than for money c. Waiver: preemptive rights can be waived by conduct; If waiver in writing, it is irrevocable even if not supported by consideration 2. Supermajority Voting and Quorum Provsions - 7.25, 8.24: a. Corps can change their purpose by amending AOI, which can adversely affect minority shareholders. Therefore, consideration need to be made on procedural rules like quorum and voting. b. Default in statute: sets quorum as a majority of shares to be cast (i.e., majority of voting shares must be present to start the meeting) and the required vote as a majority of votes present c. Supermajority Quorum: statutory requirement of only majority for quorum can be changed to supermajority (up to shareholders and corporation to decide what is supermajority) so nothing major can be decided in absence of the minorities i. But, if s/h does attend and then leaves before the vote, quorum provision would be ineffective because deemed present for quorum purposes for the remainder of meeting, see. 7.25(b) ii. Supermajority Voting provisions usually more effective because allow opportunities for compromise d. Determining required voting % for a supermajority: unanimious requirements may be disadvantageous because can cause deadlock 3. Classification of Stock 6.01: a. Can issue mutliple classes of stock (with equal or disparate voting rights) to allocate control among minority shareholders; Ex., if founding s/h want equal voting representation but contribute different amts of stock, can issue same amount of shares of voting class and then issue shares of non-voting class in proportion to respective capital investments b. Lehrman v. Cohen, (Del 1966), p. 346: may create a class of stock that gives its holder voting power without any real economic ownership. Useful as a tiebreaking device. (Ct. rejectedk Ps claim: that issue of class AD stock was in substance a voting trust, and as such, illegal b/c does not conform to statutory criteria for such trusts) i. Facts: L & C families each owned half of stockclass AL and AC each was entitled to vote 2 directors in. Concerned there would be a deadlock so ammended AOI to issue a single share of class AD stock to D, which could elect 1 director. AD share has no right to dividends or assets and can be redeemed at any time by the company for its $10 par value. After arrangement worked for 15 yrs, the AD stock sided with AC stock and voted in favor of giving D an employment K as president; ii. Holding: Valid arrangement and not a voting trust. Merely created new class of stock. Creation of AD stock did not separate the voting rights of the AC/AL classes from the other ownership aspects of those classes. 1. (1) Holders of AC or AL classes retained right to vote his stock as he sees fit and did not transfer right to a trust. The fact that new class somewhat dimished voting power of the old classes does not amount to creation of a voting trust.. 2. (2) Valid class of stock: nothing in Del law prevents creation of stock which has voting power but no substantial econmic stake in corporation; Del statute 22

Problems In Closely Held Corporations

permits creation of stock having voting rights only, as well as stock having property rights only C. Shareholder Voting Agreements and Irrevocable Proxies 1. Pooling Agreements - 7.31: a. agreements in which 2 or more s/h agree to pool their shares to vote together as a voting block; enforceable by specific performance. - 7.31 b. Proxy: May appoint an irrevocable proxy, for life of the agreement, authorized third party to vote in accordance with the agreement (7.22); or may designate an arbitrator to vote parties shares pursuant to a revocable or irrevocable proxy, where parties have been unable to reach consensus 2. Voting Trusts - 7.30: a. shareholders actually transfer legal title to their shares to the trustee who they designate in the agreement; trustee has exclusive power to vote b. Usually s/h gets a voting trust certificate representing their equitable ownership interest in trust (retain right to dividends/assets, but no longer have voting power) c. Formal Requirements for creation7.30: must meet all statutorily terms. Generally, court will find agreement entirely invalid if fail to meet all the terms i. Must be in writing and signed by each of the party shareholders and implemented by a formal transfer of shares registered in trustees name ii. Disclosure: the trust agreement and a detailed list of all shareholders participating in it must be delivered to the corporations office (where can be inspected by other s/hs) iii. Maximum Term: unless extended, valid not more than 10 years after its effective date d. TEST: Abercrombie v. Davis, (Del 1957): 3 req for VT: (1) Stocks voting rights are separated from the other attributes of ownership (Lehrman); (2) Voting rights granted are irrevocable for a definite period of time; (3) principal purpose of the grant of voting rights is to acquire voting control of the corporation 3. Irrevocable Proxies - 7.22: a. Essentially it is an agency arrangement that grants another person binding authority to vote their shares; and is typically revocable at any time; b. Can be irrevocable if: 1) apppointment form expressly states that it is irrevocable and 2) appointment is coupled with an interest - 7.22(d) i. When this interest is extinguished, proxy becomes revocable 7.22(f) ii. Policy: proxy holder should have an economic interest in the viability of the corp that motivates him to vote in a manner that advances corps best interest. Otherwise, separation of the voting right from ownership could pervert objectives of corporate democracy D. Shareholder Agreements Restricting Board Discretion - MBCA 7.32: 1. Many concerns/expectations of minority s/h in a CHC can be addressed by shareholder agreements which can limit boards discretion. However, such agreements may conflict with fundamental principle of corporate law that corporation is govern by the board a. Policy concern: may unbalance the symmetry of balancing the broad grant of power to the board with a corresponding fiduciary duty b. MBCA 7.32 gives a list of things which are permissible limitation on the board despite their inconsistency with other statutory provisions. (As long as authorized by AOI, bylaws, or unanimous vote or written agreement by all s/h) 2. So under MBCA shareholders can get huge control over the CHC. But still got to be careful always keep in mind what u are using these provisions for oppression or legitimate purpose?

23

Problems In Closely Held Corporations

3. McQuade v. Stoneham & McGraw, (N.Y. App. Ct. 1934), p.353: the majority s/h (S) and two minority shareholders (MQ, MG) agreed that all would use their best efforts to keep one another in office as directors and officers at specified salaries. S and MG refused to try and keep McQ in office and he was terminated without cause. a. Holding: S/h agreement invalid. Court said that an agreement that binds a directors discretion is barred here, impinged on functions of the BoD by saying who the officers were and how much they could be paid/how long they would be in their roles. b. Reasoning: Stockholders may combine to elect directors, but that does not extend to taking over BoD duties by placing limitationson power of directors to manage the business of the corp by the selection of agents at defined salaries. In other words, board must be left free to exercise its own busines judgment. 4. Clark v. Dodge, (N.Y. App.Ct. 1936), p.355 (overrules McQuade): As sole S/Hs, P owned 25% , D 75%. Agreement: D was to vote for P as director and mgr, and pay him 1/4th of the business income, so long as he remained faithful, efficient and competent. a. Holding: Ct upheld agrmt. Distinquished it from one in McQuade in 3 respects: (1) all shareholders had signed agreement, and (2) there was no sign that anyone would be injured by the K (damage test); (3) impairment of boards powers was negligable: (b/c P could always be discharged for cause, and his one-fourth income could be calculated after board determined, in its discretion, how much should be set aside for operating needs) 5. Galler v. Galler, (Ill. 1965), p.357: Two principal owners owned 47.5% each. Signed agreement to pay certain dividends each year and that if either died, would pay to a specified pension to widow. Ben died, Isadore refused to carry out agreemnt a. Holding: Ct upheld agreement even though limited BoD discretion to issue dividends. Stressed close corporation context and the practical importance of broad and enforceable stockholder agreements as necessary to protect s/hs financial interest. Reflects modern trend of courts to relax statutory complicane and approve arrangements that may slightly interfere with boards discretion. b. Rule: An agreement will be enforced if it satisfies three tests: (1) does not injure any minority shareholder; (2) does not injury creditors or the public (3rd-parties); and (3) does not violate any express statutory provision 6. Notes and Questions, p.361 a. Close Corporation Statutes: only a few jurisdictions require corporations to opt in to statutory close corporation statuts before shareholders are permitted to enter into their own private agreements re corporate governance i. Ramos v. Estrada (Cal. 1992): Cali ct did not invalidate an otherwise valid shareholder agreement for failure to elect close corporation status. ii. But Nixon v. Blackwell, (Del. 1993): Del court refused to fashion any special judicial rules for the protection of minority shareholders in a corporation that failed to elect close corp status. Held Del statutes special provisions for CHC preempted the field. b. Liability: Where s/hs have entered agrmts granting themselves managerial power while depriving the BoD of its traditional managerial authority, these s/h properly assume the fiducidary duties of those directors. MBCA 7.32(e) E. Restrictions on Transfers of Shares (#13: 362-74; 381-93; prob on p.379; 6.27; 8.30-31) 1. Gen Rule: historically, restrictions on the transfer of stock were often struck down as unreasonable bc conflicted with Claw rule prohibiting restraints on alienation; Now, most statutes permit if for any reasonable purpose 6.27(c) a. Purpose of restrictions: 1) to limit transfers to third parties in order to contorl the entry of new participants, and 2) provide liquidity (by structuring restrictions to create a private contractual market) 24

Problems In Closely Held Corporations

b. Whos Bound?: Restricitons do not apply retroactively to s/h who purchased shares before restriction was adopted (unless such s/h voted for it) - 6.27(a) c. Notice: restriction must be conspicuoulsy noted on the share certificate; can NOT be enforced against a person without knowledge of restriction 6.27(b) d. Judicial Interpretation: Even though statutes allows some restrictions courts interpret them as narrowly as possible to promote free sale of property. Any ambiguity will be interpreted in favor of free transferability 2. MBCA 6.27(d) 4 Types of restrictions expressly authorized, without limitation: a. First Options and Refusals - 6.27(d)(1) i. Right of First Refusal: prohibit sale to 3rd party unless first offered to the corp or s/h on the same terms, incl price offered to that 3rd party. (least restrictive, virtually always upheld) ii. First Option At Fixed Price: must first offer at a specificed set price or at a price determined by formula set forth in restriction (gen upheld) iii. In re Estate of Mather, (Penn 1963), p.364: option price was fixed at $1, well below stocks actual value (the original price bought). Written stock option agreement between family members. Agreement clearly reflected their intentions to keep the stocks within a family. However, P claimed agreement invalid as an unreasonable restraint on alienation because price was unfair and unchangeable. 1. Holding: upheld first option at fixed price of $1, the original purchase price. Based on nature of contract: where there is no overreaching fraud, the great difference between the sale price and the actual value of the stock, is not sufficient to invalidate the agreement. (Ct ordered specific performance) iv. Lash v. Lash Furniture Co. of Barre, (Vt. 1972), p.365: a stock option agrmt among 3 brothers, w/ equal ownership. The corporation, by vote, rejected the purchase. (seller didnt vote, D voted against, remaining s/h voted for puchase) Then the brother that voted against corporations purchase, personally bought the stock and gained 2/3 control. 1. Holding: Ds interest in purchasing the stock himself conflicted with his obligation to evaluate the purchase based on proper corporate policy, in violation of his fiduciary duty as a director. (reversed his acquisition, ordered transfer of stock to corp) b. Mandatory Buy-Outs - 6.27(d)(2) i. Obligate the corporation or other s/hs to acquire the shares. A buysell or cross-purchase agreement is where the shareholders agree to an obligation to buy a shareholders shares upon a triggering event (termination of employment, death, etc.); when corporation and shareholder both agree to do so, its called a redemption agreement. ii. Funding: redemption agrmts often funded by life insurance policies purchased by the corp on each shareholder iii. Russian roulette buy out: useful in deadlocks; permits a s/h to offer to sell his shares to the other s/h on specific terms and at a specific price, but on the condition that, if the offer is refused, the offeror is obligated to buy and the offeree obligated to sell on offered terms and price c. Consent Restraints - 6.27(d)(3) i. S/h needs approval by board or shareholders before selling to a third party. Authorized by MBCA as long as not manifestly unreasonable ii. It is one of the most restrictive methods; Legality depends on how court interprets this statutory phrase 25

Problems In Closely Held Corporations

d. Marketability Restraints - 6.27(d)(4) i. Prohibits s/hs sale to a specific people or group. Such provisions are enforced unless manifestly unreasonable (ok if u cant sell to competitors etc.) Otherwise if it is done to severely limit your ability to sell might not be enforceable 3. Pricing Provisions: sets the price or pricing formula to be applied when a triggering event occurs. Caution favors an arms length pricing mechanism. (Martin: ct rejected requirement that terminated employee sell back shares at price he paid) a. Book Value: an accounting concept, derived form corporations balance sheet. Equal to net asset value (corporations assets liabilities) i. Advantage: determined objectively and quickly by looking at financial statements and is a number generally familiar to parites; ii. Disadvantage: reflects asset values at their historical cost, so may undervalue current worth; also wont reflect value of goodwill b. Capitalized Earnings: attempts to estimate future earnings of the business, and then discounts these earnings to present value by using discount rate. i. Disadvantages: disagreement over formula for the future earnings; earnings are also distributed in form of salaries thus making earnings an unreliable factor for valuation c. Periodic Revisions: price per share set at time the restriction is approved, subject to re-evaluation at regular intervals d. Appraisals: price determined at time of transfer by a neutral third party appraiser F. Fiduciary Duties in Implementing Restrictions on Transfer 1. Gallagher v. Lambert, (NY App. Ct. 1989), p.369: court more deferential to contract, perhaps inappropriately elevating contractual considerations > fiduciary duty; Ps claim: Ds breached a fiduciary duty owed to him as minority s/h to refrain from self-aggrandizing, opportunistic behavior. Ds had no bonafied business-realted reason to fire him and did it for the sole purpose of recapturing his shares at an unfairly low price. a. Facts: P had 8.5% of stock, subject to a mandatory buy-back: if employment ended for any reason before Jan 31, 1985, buy-back price would be book value ($89k). After Jan 31, new formula would be company earnings ($3M). Company fired him without cause 21 days before new buy-back price. b. Holding: No breach of any fiduciary duty owed under plain terms of repurchase agreement. These agreements defined the scope of the relevant fiduciary duty and supply certainty of obligation on each side. They should not be undone simply upon an allegation of unfairness. 2. Problem, p.379

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Fiduciary Duty (ch.10)

7. Fiduciary Duty (Ch.10)

7.1 5 types of Fiduciaries: Partners, LLC Managers, Corp Directors, Corp Officers, and Controlling
Shareholders A. Duty of Care: amount of care exercised by like persons in similar circumstances 1. Duty to be informed prior to making business judgements (focus on process) B. Duty of Loyalty: place the best interests of the corporation over those of self, family, friends, associates, or other businesses in which the director holds an interest 1. Duty of good faith: (oversight liability) focuses on motivation C. Duty to act lawfully D. Duty of Candor: state law duty of disclosure E. Fiduciary duty of Good Faith: a catchall in cases in which revenge or spite rather than greed causes fiduciaries to stray F. Analysis: Ask 1. To whom is he a fiduciary?; 2. What obligations does he owe? 3. How has he failed to discharge those obligations? 4. What are the consequences?

7.2 THE DUTY OF CARE

A. MBCA 8.30: Duty of care: when a director is discharging his duties, he shall act: (1) In good faith; and (2) in a manner the director reasonably believes to be in best interest of the corporation. B. Business Judgement Rule: Whenever director is sued for violation of duty of care, director is entitled to protection of BJR which protects from most negligent acts 1. Basically ct will NOT impose liability for business decisions as long as the director: a. (1) had no conflict of interest, b. (2) gathered a reasonable amount of information before deciding, and c. (3) did not act wholly irrationally 2. Point: ct will focus more on proccess by which director made decision, rather than wisdom of the decision itself C. Brane v Roth, (Ind. App. Ct.), p.382: (standard of care): a director has a duty to inform themselves of all material information reasonably available to make their decisions 1. Facts: S/h action against directors of Grain Corp that incurred significant losses due to failure to hedge against price volatility. hedged only 20k where their total sales were over 7 millD.Ct found directors breached duty by: retaining a manager inexperienced in hedging and failed to supervise him. Failed to attain knowledge of basics of heding in order to direct and supervise his activities; As a result, caused loss of 400k. 2. Standard (statutory): a director shall perform his duties in good faith in the best interest of the corporation and with such care as an ordinarily prudent person in a like position would use in similar circumstnaces. (not a gross neglig standard) 3. Holding: Directors failure to stay informed on what is going in order to provide adequate supervision of managers actions was a breach of duty of care. a. Business Judgement Rule: presumption that directors acted on an informed basis, in good faith and in honest belief that acted in the best interest of co. b. The BJR protects directors from liability only if their decisions were informed ones; rule does not protect directors who have abandoned their functions or absent a conscious decsion, failed to act D. Notes: 1. What is the standard: objective or subjective? You have to look at the particular statute in the state and see how it phrases. Is it negligence or gross negligence or recklessnessdepends on statute and at what point court will say business judgment will not apply. Issue is where is the boundary between negl and gross negligence. a. Objective RPP: care of a reasonable person in like position in similar circumstnaces (tort law std is objective) b. MBCA 8.30(b) (more subjective std): the care that a person in like position would reasonably believe appropriate

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2. Opt-Out (Del code): corporations can opt-out of duty of care money damages liability by its directors, if include provision in AOI; (allowed in all j/d); but may not eliminate liability of duty of loyalty 3. Business Judgement Rule: Gross negligence or Ordinary Care? In most instances where boards undertake some action, including decision not to act, under interaction of the business judgment rule and standard of care, the standard is gross negligence. But in cases where directors do absolutely nothing like in Brane v. Roth, the standard is still is the common denominator negligence standard. 4. Knowledge and Skill after becoming a Director: pretty much are expected to know all the relevant info once you take the seat. There is no grace period during which u may have no liability. So if u cant acquire necessary skills and background resign. 5. Does the Corporation owe Fiduciary Duties? In NY court held no, it does not owe fiduciary duty to stock holders. Otherwise, they can bring derivative suit in the name of the corp against the same corp.

7.3 VIOLATION OF DUTY

A. Francis v. United Jersey Bank, (NJ 1981), p .387: (drunken widow case) Directors are not required to conduct a detailed inspection of day-to-day activities. But, as a general rule, they must at least become familiar with fundamentals of the bsuiness, and must keep informed in a general way about the corporations activities 1. Facts: Mother was director of a reinsurance broker co. She did not care what was going on, she was drunk most of the time and sad because husband has died. Her sons illegally misappropriated millions from trusts accounts held by the co. on behalf of others. Trustees in bankruptcy sue. 2. Issue: whether director was negligent in not noticing what was going on, and whether it was proximate cause of losses? 3. Holding: Her total failure to go through the motions of being a director was a breach of duty of care owed to corp and is thus liable for losses caused by the misapproprations a. (1) Breached. A director should acquire at least a rudimentary understanig of the business. Because directors are bound to exercise ordinary care, cannot set up as a defense lack of the knowledge need to exercise the req care (dummy director) b. (2) Prox. Cause: Although sons wrongdoing was immediate cause of loss, her failure to act was a substantial factor. Had she done even so little as to read the financial statemt would have noticed stealing. Had she noticed this and asked her sons to stop, they probably would have (so her negl was a butfor cause of loss) B. Notes: 1. Duty to Whom? If partnership then duty is to each other. In corporation, officers and directors owe duty to corporation not to any one person. Directors owe no direct duty to shareholders. So s/h bring a derivative action on behalf of the corporation. A derivative suit, means any recovery goes back to the corporation. a. Duty to depositors (a subgroup of creditors) found where institution is like a bank and director has a duty of care and loyalty to depositors. 2. Use of Advisory Board of Directors: some corps expand beyond the original founding directors specialty, i.e., figure head directors, but they dont want to resign. So advisory boards are an option they meet sometimes etc. But still got to act like a director or resign, i.e., can still get u in trouble. Which board is the true board is an issue of fact. 3. Sub duties of the Duty of Care: in the case of a public company, the board's oversight responsibilities include attention to: - MBCA 8.01(c): a. Business performance and plans b. Major risks to which corp may be exposed c. Performance and compensation of senior officers d. Policies and practices to foster the corps compliance w/ law and ethical conduct e. Preparation of the corporation's financial statement; f. The effectiveness of the corporation's internal controls g. Arrangements for providing adequate and timely information to directors 28

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4. Caremark Duties: larger corps have a preventive law system in place which insures that all the corp business comply with the law and which gives off early warning signals where danger of non compliance might exist. 5. Duty to Creditors: In dicta, influential Judge W. Allen posited that fiduciaries of corp owe duty to creditors when they operate on brink of insolvency (zone of insolvency). C. NACEPF v. Gheewalla, (Del. 2007), p.393: (duty to creditors?): Del Sup Court made it clear that fiduciary duties are owed only to the corporation. (bright-line rule). From a practical standpoint, it is necessary to specify an unchanging group of individuals to which the fiduciary duty runs. Otherwise, permitting direct action when corporation is insolvent would permit certain indiviudal creditors to be treated preferably over other creditors or the corporation 1. Holding: (1) Creditors have NO right, as a matter of law, to assert direct claims for breach of fiduciary duty against its directors. (2) However, creditors of an insolvent corp may bring derivative claims on behalf of the corporation. (when corp is insolvent, creditors take the place of s/h as the residual beneficiaries of any increase in value) 2. Reasoning: Unlike s/h, who rely on directors acting as fiduciaries to protect their interest, creditors have protection through contractual agreements, fraud laws, implied covenants of good faith, bankruptcy laws, etc. Adding a new fiduciary duty protection would be to fill gaps that do not exists

7.4 CAREMARK DUTIES (#15: p.398-415; MBCA 8.30-.31, 8.33; CRS Draft Legislation)
A. Duty of Loyalty: includes duty to act in good faith, B. Rule: Directors will have liability for failure of oversight only if they knew that they were not discharging their fiduciary obligations. Unless the directors are conscious that they were not discharging their fiduciary duties, no amount of inattention will be enough. (Stone v. Ritter); So, even gross negligence is not enough 1. Standard (nearly-impossible): directors wont be liable, no matter how grossly negligent they were in failing to notice wrongdoing was occuring, unless plaintiffs can proveDirectors consciously disregarded their duties AND either: a. The directors utterly failed to implement any reporting or information system; or b. consciously failed to monitor such a system once it was installed 2. Graham v. Allis-Chalmers, (Del. 1963) [No duty to detect wrongdoing]: absent cause for suspicion there is no duty upon the directors to install and operate a corporate system of espionage to ferret out wrongdoing which they have no reason to suspect exists. 3. In re Caremark, (Del. Ch. 1996) [Duty to put controls into place]: Even if no red flags, director still has a duty to be informed about the corp, which requires at least a good faith attempt to assure an adequate corporate info and reporting system exists; a. Standard for liability: lack of good faith is a necessary condition for director oversight liabilityonly a sustained or systematic failure of the board to exercise oversight--such as a utter failure to attempt to assure a reasonable information and reporting system exists--will establish such lack of good faith. C. Stone v. Ritter, (Del 2006), p.398: Generally where a claim of directoral liability for corporate loss is predicated upon ignorance of liability creating activities within the corporationonly a sustained or systematic failure of the board to exercise oversight--such as a utter failure to attempt to assure a reasonable information and reporting system exists--will establish the lack of good faith that is a necessary condition to liability. 1. Issue: information was not reaching the board because of ineffective internal controls; Plaintiffs claim directors should be personally liable for the failure to detect that non-director employees were not filing SAR reports. 2. Rule: Where directors fail to act in the face of a known duty to act, thereby deomonstrating conscious disregard for their responsibilities, they breach their duty of loyalty by failing to discharge that fiduciary obligation in good faith. 3. Holding: Plaintiffs failed to prove that directors knew they were not discharing their fiduciary obligations. Factors rebutting claim of bad faith: the board approved policies requiring filing of SARs, and delegated to non-board employees the job of monitoring and reporting back whether policies were being followed; 29

Fiduciary Duty (ch.10)

4. Duty of Good faith: The failure to act in good faith may result in liability because the requirement to act in good faith is a subsidiary element, that is, a condition of the fundamental duty of loyalty a. Bad Faith: failure to act in good faith may be shown where: i. The fiduciary intentionally acts with a purpose other than that of advancing the best interests of the corporation ii. The fiduciary acts with the intent to violate applicable positive law iii. The fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard of his duties b. A showing of bad faith conduct is a necessary condition to establish director oversight liability, but the obligation to act in good faith does not by itself establish an independent fiduciary duty; The actual fiduciary duty violated by that conduct is the duty of loyalty.

7.5 PROXIMATE CAUSATION

A. Barnes v. Andrews, (S.D.N.Y 1924), p.403: No liability if the loss would have happened anyway even had the directors all behaved w/ due care. Plaintiff has burden of showing that the performance of the directors duties would have avoided the loss, and what loss it would have avoidedWhen a business fails from general mismanagement, business incapacity, or bad judgment, is it possible to say that a single director could have made the company successful? 1. Ps burden is cleared in transactional setting where it is easier to show that failure of a director could stopped the illegal loan etc. But it is harder to show proximate causation in general nonfeasance context where there was general mismanagement and corporation failed. Hard to prove that general mismanagement of one specific director caused it. 2. Superceding causes can avert liability of a director if he can show that such cause superceded the proximate cause. B. Requirement of damages: unlike in duty of loyalty cases in which either damage to the corporation or an illicit gain to the officer or director will ground an action, a duty of care case requires director's actions proximately caused damages to the entity

7.6 THE BUSINESS JUDGMENT RULE

A. Business Judgment Rule: Presumption that in making a business decision, the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company. Aronson v. Lewis, (Del 1984); 1. Bursing Bubble Presumption: basically, it's a presumption that reasonable care was in fact exercised. Thus, party attacking a board decision as uninformed must rebut the presumption that its business judgment was an informed one by poking holes in facts (e.g. proving conflict of interest, were woefully under-informed,) 2. Policy of judicial non-review: ct will not review the substantive merits of a boards decision for purposes of deicding whether directors breached their duty of care. 3. Standard of Care for liability under BJR is gross negligence. B. ALI Definition: Prin. Corp. Gov. 4.01(c): A director or officer who makes a business judgment in good faith fulfills the duty of care if the director or officer: 1. Is not interested in the subject (i.e., no conflict of interest or personal stake in outcome); 2. Is informed to extent he reasonably believes to be appropriate under circumstances; and 3. Rationally believes that the decision is in the best interest of the corporation. C. Elements of the Rule: requirements that must be met before director can get protection of BJR: 1. There must have been a decision or judgment a. Must be an independent decision: cant delegate it to someone else; rubber stamping CEOs or controlling shareholders wish will not suffice (Van Gorkom) b. Includes a conscious decision to make no decisions at all; but no protection for mere inaction (Brane v. Roth) c. Modern BJR requires boards to put matters to motion and vote 2. An Informed Decision (some care exercised):

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a. Decision must have been informed but doesnt need to be duly informed or made in the exercise of reasonable care to get protection. b. How much information is enough info is itself a business judgment to be shielded from judicial review if the process demonstrated that board excercised some care c. Gross negligence standard: director would lose benefit of the rule only if he was grossly negligent in the amount of information he gathered. (VanGorkom) 3. Absence of Disabling Conflicts of Interest a. No self-dealing: no protection of BJR if director has an interest in the transaction. So cant be a party to the transaction, or otherwise have some financial stake in its outcome that is adverse to the corporations stake. b. Structural bias (favoring those of same social or economic class) is ok c. But No BJR protection where a critical mass of directors wore second hats as high paid consultants, hired by controling s/h 4. Rational Basis for the decision a. Does not protect totally inexplicable decisions b. Focus more on procedures followed rather than merits of decision 5. Umbrella Requirement of Good Faith (smell test) a. also if decision making process infected by base motives other than greed: revenge, spite, hatred, pride, etc. D. Smith v. VanGorkom, 488 A.2d 858 (Del. 1985), p.404: Must first satisfy the threshold condition of due care and prudence to inform themselves prior to making a business judgment before can apply the protection of the BJR. Under the business judgment rule there is no protection for directors who have made an unintelligent or unadvised judgment." 1. c/a: breach of fiduciary duty of care: Class action brought by s/h of corporation against directors, seeking rescission of cash-out merger of corporation into new corp or alternative award of damages at FMV of stock 2. Facts: Marmon Corp was attempting a leveraged buy-out of TransUnion. TransUnion's CEO, Van Gorkom proposed a price of $55 a share. Turns out, Van Gorkom and CFO didn't bother to do any research to see how much the Co. was actually worth. a. $55 a share was only about 60% of what the company was later appraised at. In Van Gorkom's defense, at the time of the merger, the stock was only selling for $37.25 a share, so $55 seemed like a lot. b. Van Gorkom called an emergency meeting of the board of directors asking them to approve the sale at $55 to his friend Pritzker. He told them Pritzker was demanding an answer within 3 days. Board was not shown the proposed merger agreement and no documents regarding the companys valuation were provided. Board approved buyout based solely on VanGorkoms oral presentation. c. PH: Ct of Chancery held for D-Directors, finding Boards decision was not reckless or imprudent; Del S.Ct reversed. finding was clearly erroneous because it applied the BJR protection without first determining if threshold condition of due care was satsifeid. 3. Holding: Directors breached their duty of care to act in an informed manner: They were grossly negligent in failing to inform themselves adequately about the transaction they were approving. Here, the board was uninformed about the companys intrinsic value and Van Gorkoms role in setting the price and forcing the sale. Yet, still made its entire decision in 2hrs, without prior notice, and without the exigency of a crisis or emergency. a. BJR was not a defense because directors didn't use any "business judgment" when they came to their decision. Basically, the actual merits of the decision (whether $55 was a fair price) is not so important, what the courts will look to is whether there was an adequate decision-making process. b. (note: not duty of loyalty issue here because presumed decision was made in good faith, so motive irrelevant here) 4. Procedural Violation of duty of care: think of the duty of care as imposing procedural requirements for directors actionsthe director must act in good faith, and must get all reasonably needed information before deciding. Once these procedural 31

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requirements are satisfied, the business judgement rule kicks in to protect the substance of the business decision. (which will be upheld as long as it is rational) 5. Take Away: Court basically said that in order to hide behind the business judgment rule, you have to show that you made an informed decision based on some principle of business. If you pull numbers out of thin air or cast votes without doing due diligence, then the courts can overturn your decisions. a. Policy: idea behind the BJR is that people who work in the business have more experience and are better judges of what a corporation should do than a court would be. But when businessmen show that they didn't use any of that experience to make a decision, then there is no reason for the courts to defer to them b. Reverse roadmap case: procedures you should follow listed on p. 414 (basicaly do the opposite of whatever Van Gorkom did) E. Del. 102(b)(7): Right after this decision, Delaware passed a law allowing corporations to amend charter to limit or eliminate directors liability for money damages for breach of the duty of care. 1. But can not reduce liability for breach of the duty of loyalty, or for any acts or omissions not in good faith or which involve intentional misconduct or knowing violation of law F. Policy - why limit directors liability with the BJR?: 1. Risk-taking directors: it is generally in s/hs interest that directors take a certain amount of innovation and risk-taking if businesses are to grow and prosper. 2. Courts are poor judges of business reality: problems of hindsight, lack of training 3. Directors as poor cost spreaders: s/hs can spread the risk of business misjudgements far more easily by diversifying their portfolios than directors can spread this risk by serving on multiple boards

7.7 THE DUTY OF LOYALTY (#16: 415-428)

A. Hayes Oyster Co. v. Keypoint Oyster Co., 391 P2d 979, (Wash. 1964), p.420: lack of disclosure itself is grounds for voiding a contract without regard to fairness (dont need intent to defraud or any actual injury) 1. Facts: Hayes was president of Coast Corp and had an employment contract that prevented him from taking any part in any competitors business. Coast Corp needed money and sold property to Keypoint Oyster Co. Hayes did not disclose to Coast Corp that he had a financial interest in Keypoint Co. 2. Holding: Hayes violated his duty of loyalty. Hayes had duty to divulge his interest because, as president of Coast and shareholder of KP, he might have been put in a position where he would have to choose between the interests of the two companies. 3. Rule: Intention of officer or director to defraud or injure corporation is not necessary to make secret acquisition of interest in corporate property a violation of fiduciary obligation. (means actual injury is not necessary); (Policy: Law aimed at securing the fidelity of the agent, not at preventing actual injury.) B. Notes: 1. Harm to the Principal or Illicit Gain to the Director of Officers? A gain incurred while serving the best interests of a competitor or of one's self may be sufficient to ground for action. The gain need not be secret but it is often the case. 2. Mechanical Rules: old rule: transactions tainted by a duty of loyalty violation were automatically void; now courts find such transactions voidable at the corporations election.. Similarly, if one of the directors on the board had violation of his duty it does not mean entire board is susceptible, instead there is separate inquiry on whether interested director's participation tainted the deliberations 3. Non-Shareholder Statutes: beginning with Penn in 1985, states adopted statutes permitting directors to consider interest of non-s/h constituencies. statutes mention employee interests, suppliers, customers, local communities etc.(in Conn, its mandatory)

7.8 INTERESTED DIRECTOR TRANSACTIONS

A. Self-Dealing Transaction: Classic duty of loyalty case involves some form of self-dealing where the fiduciary is on both sides of the transaction and in a position to receive a benefit 32

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unavailable to other shareholders or the corporation generally. Thus creates a conflict of interest. 1. Key Factors: (1) Key player and corporation on opposite sides; (2) Key player has helped influence corporations decision; (3) Key players personal financial interest has potential to conflict 2. Circumstances in which conflict of interest can occur: a. Property Sale: director sells personal property to corp or buys corporate property. b. Corporation contracts with another coportation in which the fiduciary has a significant financial interest (Hayes Oyster v. Keypoint Oyster) c. Parent corp contracts with subsidiary, and subsidariay has other shareholders. d. Interlocking directors: Two corporations have common directors, but they have no significant finanicial interest in either (some statutes have limited judicial review in these cases) B. Interested Director Statute(Del. 144): transaction will not be void/ voidable solely because of a conflict of interest, or presence of an interested director, if meet one of the statutory tests 1. Test: Not automatically void IF the transaction was: a. Approved by a majority of the disinterested directors after full disclosure of the conflict of interest and the transaction; or b. Specifically approved by shareholder vote after full disclosure; OR c. Was fair to the corporation at the time of approval. 2. Safe Harbor: if dont meet any test, voidable; if meet one of the tests, may still be challenged but burden shifts to plaintiff. a. Process OR Substance: only need to meet one of the req for transaction to come within safe harbor; So, if have approval of either the disinterested board or maj of s/hs, then it doesnt need to be fair; OR if K fair dont need disclosure b. Not Madatory: Statutes provide a safe harbor. However, requirements are not mandatory. If transaction is not approved in one of the specified ways, can rely on common law fairness standard, in which court will look at both the procedure and substance for fairness with burden of proof on defendant 3. Effect of Compliance and judicial reviewThree approaches: a. Weak Form: Compliance with statute does not preclude judicial review or replace common law; Statute merely removes taint of conflict of interest and provides that K will not be void solely because of directors involvement. Thus court may still review transaction for fairness, despite disintered director approval. Fliegler v. Lawrence (Del. 1976), Remillard Brick (Cal. App. 1952) b. Semi-Strict Approach: Compliance with statute shifts burden of proof to plaintiff to prove transaction unfair. (means fairness will always be an issue) c. Strict Approach: Approval of disinterested board limits judicial scrutiny; burden shifts and review under a business judgmt rather than a fairness standard. (ALI) C. MBCA Subshapter F8.608.63 1. 8.61: Judicial Actionprovides a bright line rule limiting judicial review; First, ask: is the transaction covered by the statute; (i.e,.does it fall within narrow statutory definition of a conflicting interest transaction?) a. Non-conflict transactions: if not within definition then not subject to judicial review, thus, not voidable and no damages available on account of any interest director may have; b. Conflict Transactions: Even if a conflicting interest, still wont be voidable as long as: (1) approved by majority of disinterested directors after disclosure (8.62); or (2) majority of shares held by disinterested shareholders ratified it after disclosure (8.63); or (3) transaction is fair to the corporation. i. Dissinterested Shareholder: transaction needs to be approved by majority of qualified shares, which excludes shares held by directors with a conflicting interest or by those related to the director. 33

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2. 8.60: Definitions a. Conflicting Interest Transactions: deals with K between corporation and a director only (so not btwn corp and subsidary); a transaction is a conflicting interest transaction if either of two things: i. director or her close relative is a party; or ii. director or her close relative has a material financial interest known to the director b. Related Person: includes spouse and immediate family members (so NOT cousins); anyone living in same house; a business or nonprofit that director is a director or general partner of, or any trust that director is a beneficiary or fiduciary of; or an employer of the director. c. Required Disclosure: (i) the existence and nature of the directors conflicting interest; and (ii) all facts known to the director that a director free of such conflicting interest would reasonably believe to be material in deciding whether to proceed with the transaction D. Quorum of Directors: used to be that due to a critical mass of interested directors, would have to pass decision onto s/hs; now, easy to achieve (Del 144 says interested directors count for quorum purposes; 8.62 says as long as qualified directors is more than 2) 1. Boards may still refer interested director transactions to s/h for 3 reasons: 1) Policitcal: easier to defend a transaction approved by s/h; 2) Majroity approval may be easier to get; 3) Shareholder approval may result in a more deferential standard of judicial review (burden of proof of waste) E. Note: law forbids duty of loyalty violations, not conflicts of interest. A conflict of interest alone is only a red flag, indicating special treatment or closer review of the transaction may be needed.

7.9 USURPATION OF A CORPORATE OPPORTUNITY (#17: 432-445; 462-66; Broz case, Del on Corp opp)
A. Gen Rule: if an investment opportunity is viewed as belonging to the corporation (i.e., a corporate opportunity), the corporation should be given the chance to invest in it. B. Analysis: 1) Is there a corporate opportunity?; 2) if yes, has the corporation in some way rejected or failed to take the opportunity allowing to the fiduciary to take it instead? C. Legal Tests: 1. Interest or Expectancy Test (narrow): look at corporations specific or unique interest in the investment. Lagarde v. Anniston, (Ala. 1899): corp opportunity involved an interest already existing, or in which it has some expectancy growing out of an existing right; no corp opportunity where it had no contractual right to acquire property) 2. Line of Business Test: focuses on how closely related the opportunity is to the existing business, i.e., would director essentially be competing with the corp?Rule: if there is presented to a corporate officer a business opportunity which the corporation is financially able to undertake and which is in the line of the corps business, and is of practical advantage to it. - Guth v. Loft, Inc., (Del. 1939). a. Broz v. Cellular Info Systems, (Del. Ch. 1996): (layering test): corp director may not take opp for his own IF: (1) corp is financially able to exploit it; (2) it is w/in corps line of business; (3) there is an interest or expectancy; (4) by taking it, director will be placed in a position that is adverse to his fiduciary duties b. So fiduciary can take opportunity if: i. It was presented to her in an individual capacity; ii. Oppportunity is not essential to the corporation; iii. There is no corporate interest or expectancy; and iv. There is not wrongful use of corporate resources 3. Fairness Test: is it fair that the corporate director be required to present the opportunity to the corporation. 4. The ALI Test: Distinguishes between directors and senior executives. A corp opp exists if the opportunity is presented under circumstnaces that either: a. (1) Would reasonably lead them to believe that opp was intended for the corp; or b. (2) would require that they use corp info and it would reasonably be expected to be of interest to the corp 34

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c. (3) If senior exectutive, includes any opportunity that she knows is closely related to the business in which the corporation is or expects to be engaged. 5. Lack of Financial Ability: some courts include lack of wherewithal to show its not an opportunity for a corp; Other courts never accept it as a defense (Irving Trust Co); and some allow it as a defense only if corp is insolvent (Niecholson v. Evans) D. MBCA 8.70: Business Opportunities: a court may not grant relief if a director has received prior board or s/h approval under conflicting interest transaction requirements (8.62-.63); 1. And made prior disclosure of all known material facts concerning business opportunity 2. If did not follow procedure, ct shall not create an inference that an opportunity should have first been presented to the corp or otherwise alter the burden of proof for breach.

7.10 COMPETITION WITH THE CORPORATION

A. ALI, Corporate Governance Project, 5.06General Rule: directors and senior executives may not advance their pecuniary interest by engaging in competition with the corp, unless either: 1. There is no reasonably foreseeable harm to the corporation from such competition; or harm is outweighed by the benefit that the corporation may reasonably be expected to derive from allowing the competition to take place, 2. Competition is authorized in advance by disinterested directors after full disclosure concerning the conflict of interest and the competition, in a manner that satisfied the business judgment rule or 3. Competition is authorized in advance by disinterested shareholders after disclosure and the shareholders' action is not equivalent to a waste of corporate assets. B. Notes: 1. Middle ground test: (permissive phrasing): Under ALI, Director may compete as long as in good faith or engaged in healthy competition; or until additional circumstances show a course of conduct of causing deliberate injury to the business and reputation of the corporation. 2. Alternative phrasing: A corporate director my compete with the corporation on whose board he is sits as long he does not engage in bad faith, or prohibited competition. Bad faith competition includes a. Use of confidential or propriety information but not general experience, knowledge memory and skill. b. Use of customer lists which show not just name and contact but additional information like their preferences, past orders, future plans etc. c. Defamation of the corporation, its products, manner of doing business etc. d. Other tort conduct like interfering w/ prospective or existing business advantage e. Use of more than nominal amounts of corporate assets 3. Relationship to Usurpation of Corporate Opportunities: if director or his family members have been in competition prior to become a director in the corporation he continues only refraining from bad faith acts. 4. Inevitable Disclosure Doctrine: PepsiCo v. Redmond, (7th Cir. 1995): [IP trade secret case]: in absence of covenant not to compete, ct enjoined him from new job on grounds that not the actual but the threatened inevitable disclosure of TS constituted unfair competition

7.11 DIRECTORS AND OFFICERS COMPENSATION (p.438)

A. Basically, director compensation decisions will generally be treated the same as other interested director transactions, thus need vote by disinterested decision-makers with full disclosure (analyze under duty of care, safe harbor statute, and BJR); 1. But if director or officer exercised tangible influence over the decision making process to make board not independent, then reivew under duty of loyalty. B. Ryan v. Gifford, 918 A2d 341, (Del. 2007), p.438: (backdating options): company issues stock options to an executive on one date while providing fraudulent documents asserting the options were actually issued earlier, usually on a date of market lows. violates any stock option plan that requires price to be at least FMV on date option granted. 1. C/A: Shareholder filed derivative action alleging directors breached their duties of due care and loyalty by approving or accepting backdated stock option grants that 35

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violated shareholder-approved stock option and stock incentive plans. Ds Arg: file motion to dismiss claiming that P has not rebutted BJR. (denied) 2. Holding: A director who approves the backdating of options faces at the very least a substantial likelihood of liability, b/c a director may not lie to s/hs and yet satisfy his duty of loyalty. Thus, backdating is so egregious on its face that BJR does not apply. a. Here, directors acted in bad faith thus breach duty of loyalty when intentionally violated s/h aproved stock option plan and made fraudulent disclosures intended to mislead s/h into thinking they complied with the plan. C. In re Tyson Food, Inc., 919 A2d 563 (Del. 2007), p.441: (spring-loaded options): would give share to executives right before the announcement of information which reasonably would drive stock up. Because the board could determine in good faith that springloading is an appropriate form of compensation, thus entitled to BJR protection. Thus, key is proving deception (not just directors are in the money) 1. Holding: Granting spring-loaded options, without explicit authorization from s/h, clearly involves an indirect deception. A directors duty of loyalty includes the duty to deal fairly and honestly with the shareholders for whom he is the fiduciary. D. Notes 1. Statutory Provisions--Directors: it has been traditional to let directors fix their own compensation regardless of conflict of interest. Del. Gen Corp. Law. 141(h) Unless it is restricted by the certificate of incorporation or bylaws. So conflict of interest on its own is not violation of fiduciary duties. 2. Consideration and Stock Options: Stock options result in deferred compensation. So most stock options have limitations like vesting after certain time and continuing services to insure corporation receives benefit. Kerbs and Beard (absence of any requirement for further employment or other performance resulted in an absence of consideration and thus, waste or gifting of corporate assets.) 3. Reasonable Relationship Test: an outdated test requiring compensation to have a reasonable relationship to services rendered. Rogers v. Hill (U.S. 1933) SCt struck large bonus payments based upon profits and uncapped as excessive and not related. 4. Delaware-BJR only: threw out all other tests and only apply BJR. Under current law, gifts are permissible if board observes the property procedural formalities. (Under BJR, Del Ct has upheld options grants with no conditions attached and also for past services.) 5. Sarbanes Oxley Act (2002): Congressional Limitation on Executive Compensations in publicly held corproations: a. Cant loan corporate funds to directors and officers. SOX 402. Excessive perks and other payments on directors behalf must be re-examined to determine if they are actually de facto loans or uses of corporate funds benefit of executives. (MBCA treats it as interested director transactions thus min of two qualified directors have to approve it) b. If have to restate finanical statements because of misconduct, CEO and CFO must forfeit all incentive (performance) based pay for prev 12 mnths. c. Plus other varies limitations which might be not as relevant...hopefully

7.12 ADDITIONAL FIDUCIARY DUTIES (INCOHATE)

A. Duty of Candor (skip) B. Duty of Good Faith 1. Duty of good faith is 1) part of the articulation of the BJR that applies to directors decision-making process and 2) is part of directors oversight responsibility. 2. Potential violations of duty of good faith: a. Intentional or unintentional misconduct b. Reckless behavior given a certain duration or magnitude; c. Conscious disregard of known risks; d. Behavior that cannot rationally be explained e. Acting as if simply dont care about the risks inherent in the transaction (Disney) 3. Issues still unsettled 1) whether reckless behavior can amount to breach and 2) if bad faith can be inferred in the absence of an explicit bad faith intent or motive 4. In re Walt Disney Co, (Del. Ch. 2003)(p.465): Shareholders brought claim for breach of due care in reviewing employment agreement. Director-s moved to dismiss because had an excuplatory provision exempting directors from liabilty for 36

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due care breaches. In denying motion to dismiss, ct reasoned that facts suggest more than a failure to become informed about an issue of material importance (due care) but protrayed a conscious and intentional we don't care about the risks attitude. To get around exculpatory provision for breaches of duty of care, ct recast case as a breach of the duty of good faith Exculpatory provisions do NOT protect actions not taken in good faith. a. At trial, ct found no breach, ordinary negligence alone is insuffiecent for a breach of duty of care. Although CEO made no effort to notify the board of his agreement to hire Ortiz, he did inform himself of all material information reasonably available when making this employment decision, thus exercised good faith. ( but suggested good faith is a separate and independent duty) C. Duty to Act Lawfully 1.

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8. Derivative Litigation (Ch.11)

8.1 Intro (#18: p.46776, 47887; 7.40.46; Demand Flow Chart)
A. The Demand Rule (3 common law Branches): 1. Demand Refused: the board rejects the demand after due deliberation, preceded by investigation of the facts 2. Demand Accepted 3. Demand Excused

8.2 PREREQUISITES FOR A DERIVATIVE SUIT (nutshell)

A. Standing: S/h sues to vindicate the corporation's claimnot her own personal claim. The suit is derivative because the shareholder's right to bring it derives from the corporations right to sue. Derivative plaintiff must have: 1. Contemporaneous Ownership: owned stock when the claim arose or got stock by operation of law from someone who did. (e.g. inheritance or divorce decree; not by purchase). MBCA 7.41(1); AND 2. Adequacey of Representation: must also prove she will adequately represent interest of corp (has proper motivation and stake in the case, an ongoing interest). 7.41(2) B. Demand: shareholder must make a written demand on the board that the corporation bring suit. It must state with reasonable specificity what the claim is and against who it exists. When? 1. Traditional View (Del): P does not have to make a demand if doing so would be futile, i.e. if board is tainted or a board decision so bizarre on its face that it could not possible accord with duty of care, thus not a valid business judgment. a. Aronson v. Lewis, need to raise a reasonable doubt but cant use discovery to ferret out facts, may only use right to inspect corporate books and records) b. If board rejects the demand, decision to not pursue the claim is a business decision thus, is protected by BJR; so upheld unless P can prove boards decision was tainted by self-interest (but if that were true, demand would have been excused as futile in first place) 2. Universal Demand Approach (MBCA 7.42): must always make demand on board, never excused. Make demand then wait 90 days. If board rejects or if waiting will cause irreparable injury to the corp, may sue earlier

8.3 SPECIAL LITIGATION COMMITTEE (SLC) AND THE SCOPE OF JUDICIAL REVIEW
A. SLC Motion to Dismiss: After an objective and throurough investigation, an independent committee, composed of disinterested members, may cause corp to file a motion to dismiss the derivative suit on the basis that suit is not in the best interest of the corp. Motion needs to include a thorough written record of the investigation and its findings and reoomendations. B. ALI Approach (7.10): 1) if a duty of care violation Auerbach approach; 2) if a duty of loyalty violation use Zapata second step approach. C. MBCA 7.44(a): Ct is required to dismiss if following requirements are met: (1) an appropriate group determines (2) in good faith after a reasonable inquiry that (3) the derivative suit is not in the corporations best interest 1. No independent judgement; focus wholly on procedural components of independence and reasonable investigation 2. 7.44(c): If P filed suit after board rejected demand, must allege in detail facts showing either that a majority of the board was tainted or that requirements of 7.44(a) not met 3. 7.44(d): Burden of Proof a. if a majority of board was qualified when rejected demand, Plaintiff must prove 7.44(a) requirements not met; b. But if board tainted, corporation must show that 7.44(a) requirements satisfied D. Zapata Corp v. Maldonado, 430 A2d 779 (Del. 1981) (p.468): Court stated that when demand is excused as futile, the BJR gives too much credence to corporation. Need a balance. Ct came up with two step process when corporation decides to file a motion to end the derivative proceeding due to no interest to corporation; Judicial review of 1) procedure, and 2) substantive merits 1. C/A: shareholder derivative suit against directors for breach of fiduciary duty. Demand excused as futile because all 10 directors were named defendants. Directors 39

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created a committee of 2 independent directors who decided that continuing the lawsuit is not in best interest of corporation and filed a pretrial motion to dismiss. 2. Issue: Can a board, tainted by a majoritys self-interest, legally delegate its authority to a committee of 2 disinterested directors? Should s/h have a right to continue the litigation and what is the appropriate standard to balance the interest of two? 3. Holding: Yes, but the sufficient risk of structural bias requires finding a balancing point between the ability of the stockholder to bring corporate causes of action and the ability of the corporation to rid itself of detrimental litigation. a. Demand Required: A demand, when required and refused (if not wrongful) terminates a s/hs legal ability to initiate a derivative action. Use BJR. b. Demand Excused: But where demand is properly excused as futile, the stockholder does possess the ability to initiate the action on his corporations behalf. Fear of structural bias. Need more than BJR review for balancing point. 4. Two Step Review: Under Del law, in a demand excused case, two step process of review; Ct must assess: a. First Step (procedural): The court should inquire into the independence and good faith of the SLC and the bases supporting its conclusions. Burden on the corporation to prove independence, good faith and a reasonable basis, will not be presumed. Limited discovery may be facilitated for this purposes. If court not satisfied can dismiss motion. b. Second Step (substantive): Ct independently reviews the substance of the SLCs recommendation. Judge applies her own business judgment to determine if case should be dismissed as not in the best interest of the corp. Key to balance: Designed to thwart cases that meet first step but something seems fishy. E. Desigoudar v. Meyercord, (Cal. App. Ct., 2003), p.472: judicial review of the SLC is governed by the BJR. Careful scrutiny of a committees independence and decision-making process strikes an acceptable balance between ligitmate shareholder claims and corporate directors judgment. Court does not consider the merits of the derivative claim or the substance of the SLCs decision. (Ct rejects Zapatas second step of analysis) 1. Rule: If board refuses to pursue the claim, that decision is protected by the BJR and constitutes a defense to a shareholders derivative lawsuit. If SLC members were disinterested and conducted an adequate investigation (in good faith), then the court must dismiss the derivative action. a. The business judgment rule is premised on the notion that management of the corporation is best left to those to whom it has been entrusted. Cts should not interfere so long as there is no fraud or breach of trust or conflict of interest 2. Auerbach analysis (NY) vs. a Straight BJR: board and SLC must put forth evidence that they were in good faith, disinterested, and conducted a diligent investigation; Under a straight BJR context, independence and director care would be presumed.

8.4 WHEN IS DEMAND EXCUSED AS FUTILE?

A. Aronson v. Lewis, 473 A2d 805, (Del. 1984) (p.481): Demand is excused as futile only where 1) facts are alleged with particularity 2) which create a reasonable doubt that directors action was entitled to the protections of the business judgment rule. Mere director approval of a transaction is insufficent to excuse demand (Note: cite this case for business judgement rule purposes (more so than Warshaw v. Calhoun) 1. C/A: waste of corporate assets (see def on p.426): and no valid business purpose amounts paid under employment K are grossly excessive and Fink performed no or little services 2. Facts: shareholder initiated derivative suit without making a prior demand. He alleged that demand would be futile, since all directors were named defendants. Issue arose out of board's decision to pay consultation fees to large stockholder who retired. Sums were pretty hefty and conditions largely benefited the consultant. 3. Issue here is when demand is futile and therefore excused? In another words when BJR kicks in and when it doesnt(issue of demand futility is inextricably bound to issues of the BJR and standards for when it comes into play) 40

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4. Standard: court must decide whether under the particularized facts alleged a reasonable doubt is created that: (1) The directors are disinterested and independent and [sicor] (2) The challenged transaction was otherwise the product of a valid exercise of BJR. a. Mere threat of personal liability for approving a transaction is insufficient b. Stock ownership alone is not sufficent for domination or control, at least when less than a majority 5. Holding: In demand-futile context, plaintiff charging domination or control of a director must allege particularized facts manifesting a direction of corporate conduct in such a way as to comport with the wishes or interests of the persons doing the controlling. Here, Ps claim based on: 1) Finks 47% stock ownership, 2) he hand picked directors. Ct said these allegations were conclusory at best. Needed more factual details showing a causal link between Finks control and approval of the employment agreement B. Rales v. Blasband, 634 A.2d 927, (Del SCt. 1993) (handout): [double derivative suit]: because of a merger, the current board of directors was not the same board as originally made the decision on which the action was based. Where no conscious decision is made by the board, its impossible to apply the Aronson Test (whether the directors have acted in conformity with the business judgment rule in approving the challenged transaction); Rather the proper test is whether the board on who demand is made, can make an independent judgement on corps behalf, specifically looking at each individual director one-by-one to see if they can impartially consider the merits without being influenced, such that each can exercise independnent and disinterested business judgment with respect to the underlying claim. 1. Which test? Aronson test for futility (BJR) does not apply if the board considering the demand did not make a business decision which is being challenged in the derivative suit. Situation would arise in 3 scenarios: a. (1) a business decision was made, but a majority of the directors making the decision have been replaced; b. (2) subject of derivative suit is not a business decision of the board; c. (3) and where the decision being challenged was made by the board of a different corporation. C. Note on Strike Suit Era Reforms (#19: p.494505; Rales v. Blasband)

8.5 UNIVERSAL DEMAND (p.498): In re Guidant, 841 NE2d 571 (Ind 2006) (p.498) 8.6 AVOIDING DERIVATIVE CHARACTERIZATIONDIRECT VERSUS DERIVATIVE
A. derivative vs. direct claim: 1. Who suffered the alleged harm (the corporation or the suing stockholders, individually); and 2. Who would receive the benefit of any recovery or other remedy (the corp or the stockholders, individually)? B. Tooley v. Donaldson, L&J Inc., 845 A2d 1031 (Del SCt. 2004), p.501: SH alleged that members of BOD breached their fiduciary duties by agreeing to a 22 day delay in closing a proposed merger. Ps contend that the delay harmed them due to the lost time value of the cash paid for their shares.) 1. Here, delay affects all SH equally, so not a special injury to P, so action is derivative, at most. this standard gets dropped in Tooley 2. Court must look to nature of wrong and to whom relief should go. a. SHs claimed direct injury must be independent of any alleged injury to the corp. Must demonstrate that duty breached was owed to the Stockhodler and that he can prevail without showing an injury to the Corp. C. Problem on p.505

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Securities Litigation (ch.12) and Insider Traiding (ch.13)

9. 10(b) Of The Securities Exchange Act (#20: 517-531; 551-558)

9.1 RULE 10b-5 AND WHO CAN ENFORCE IT
A. Rule 10b-5 provides: it is unlawful for any person, directly or indirectly, by any instrumentality of interstate commerce, or any national securities exchange to: 1. (a) employ any device, scheme, or artifice to defraud; 2. (b) to (1) make any untrue statement of a material fact or (2) omit a material fact that would be necessary, given the circumstances, to make the statements not misleading, 3. (c) to engage in any act or practice that would operate as a fraud/deceit on any person 4. in connection with the purchase or sale of any security. B. Who can be sued?: Rule forbids any person from doing the things proscribed. Includes individuals and entities. Rule applies to any business (partnerships, CHC, public, etc.) 1. Defendant not required to have bought/sold stock C. The SEC can enforce it by seeking civil penalties or injunctions, it can also refer cases to the DOJ for criminal prosecution; The Rule does not expressly provide a private cause of action, however the courts have inferred a civil claim

9.2 ELEMENTS OF A 10b5 CLAIM

A. Note: key element will be that the defendant committed one of the types of fraudulent behavior prohibited by 10b5, which may involve a misrepresentation or omission B. (1) Jurisdictional Hook - use of instrumentality of interstate commerce. Transaction does not have to cross state lines, intrastate phone calls are covered. Fraudulent behavior doesnt need to involve the instrumentality, as long as used at some point in the deal 1. exclusive fed j/d. cannot bring claim in state court (usually class actions) 2. Basically, only transaction that would not satisfy the interstate nexus is a face-to-face meeting in which buyer pays cash and seller endorses the certificates. C. (2) Standing: Purchaser or Seller - can sue for damages only if bought or sold securities because of some bad act by the defendant. Iow, if she neither bought nor sold, she cannot sue. 1. A Direct suit and Punitive damages are not recoverable D. (3) Manipulation or Deception - and not merely breach of fiduciary duty (Santa Fe) 1. In private actions, aiders and abettors not liable. (but SEC can enforce against them) E. (4) Materiality - misstatement or nondisclosure of a material fact. A fact is material if there is a substantial likelihood that a reasonable investor would consider it important in deciding how to invest. (Basic Inc v. Levinson) 1. Dont need to show that had the fact been accurately disclosed, it would have changed a reasonable investors mind. Only need to show that it would have assumed actual significance in the deliberations. 2. Issues: when statements are about something that may (not necessarily will) happen. (e.g., mergers). Use a sliding scale probability/magnatude test that balances: (1) the probability that the event will occur and (2) the magnitude of the possible event F. (5) Scienter - defendant acted with knowing intent to deceive, manipulate, or defraud. Rule 10b-5 cases can NOT be based upon neglignce. 1. Must plead with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind. A strong inference of scienter is more than merely plausible or reasonable. It must be cogent and at least as compelling as any inference of non-fraudulent intent. (Tellabs v. Makor) G. (6) Reliance - plaintiff relied on the misstatement made by defendant and such reliance was reasonable (i.e., plaintiff exercised due diligence) 1. In cases of misrepresentation, indirect reliance is sufficent 2. Mass misrepresentation (class actions), fraud on the market theory, applicable in public corporations (Basic, Inc. v. Levinson) H. (7) Causation - between defendants wrongful conduct and plaintiffs loss. two types: 1. But-For causation: plaintiff must show that she did what she did (buy or sell securities) because the defendant engaged in fraudulent behavior. 2. Loss Causation: the defendant's fraudulent behavior actually caused the loss about which plaintiff complains. (ex. if decrease in stock value has nothing to do with defendants lie (like a downturn in market) then P cant prove loss causation I. (8) In connection with the purchase or sale of any security: generally, the proscribed conduct must be integral to the purchase or sale of the security. J. (9) Duty to disclose: if an omission, then the primary violator must have had a duty to disclose K. Statute of Limitations: 2 years after the violation was, or should have been, discovered by the plaintiff and no more than 5 years after the violation. 43

Securities Litigation (ch.12) and Insider Traiding (ch.13)

9.3 The Deception Or Manipulation Requirement

A. Santa Fe Industries, Inc. v. Green, 430 US 462 (1977), p.521:

9.4 Materiality 9.5 The Reliance Requirement

A. Basic, Inc. v. Levinson, 485 Us 224 (1988), p.526:

10. Insider Traiding

10.1 INTRODUCTION
A. Overview B. Meaning of Material and Nonpublic Information: under certain conditions, fed securities laws prohibit the trading of securities (or tipping) when such person uses material nonpublic information. SEC v. Mayhew, 121 F3d 44 (2nd Cir. 1997)(p.553): 1. Non-public Information Requirement: trading based on public information does not violate 10(b) or 14(e): a. Public: info becomes public when (1) disclosed to achieve a broad dissemination to the investing public generally and without favoring any special person or group; or (2) although known only by a few persons, their trading on it has caused the info to be fully impounded into the price of the particular stock b. Non-Public: to be non-public info must be specific and more private than general rumor (can still be non-public even if don't reveal all the details of a particular event or tender offer) i. Confirmation of information on which the press had speculated can satisfy the non-public requirement. 2. Materiality Requirement: (same as above): in merger context, balance probability and magnitude a. No violation if the disclosed information is so general that the recipient is still undertaking a substantial economic risk that wont occur b. But info regarding a merger can become material at an earlier stage than other transactions; Factors for materiality: (1) if orginiates from an insider, the info, even if not detailed, takes on an added charge just because it is inside info. (2) the importance attached to it by those who knew about it C. Boudreaux on Insider Traiding: lj

10.2 DUTY THEORY (#21: 558-569; 574-583; 584-587; Boudreaux on Insider Trading)
A. Chiarella v. U.S., 445 US 222, (1980), p.558: imposition of liability under 10(b) and Rule 10b-5 for trading on material non-public information must be premised upon a duty to disclose

10.3 TIPPER-TIPPEE LIABILITY

A. Dirks v. SEC, 463 US 646, (1983), p.565: duty of tippers-tippees to disclose or abstain from traiding depends on whether the insider personally will benefit directily or indirectly from disclosure (e.g. by reciept of pecuniary gain or reputaitonal enhancement that will translate into future earnings). Absent some personal gain, there has been no breach of duty to stockholders. And absent a breach by insider, no derivative breach by tippee.

10.4 MISAPPROPRIATION THEORY

A. U.S. v. OHagan, 521 US 642, (1997), p.574: Sup ct upheld the vailidity of: (1) the misappropriation theory under 10(b) and (2) SEC Rule 14e-3. Held that a person violates 10(b) if he engages in securities trading using confidential material information in breach of a fiduciary duty owed to the source of the information. B. Note on Family and Other Personal RelationshipsSEC Rule 10b5-2 10.5 POSSESSION VS. USE 10.6 DAMAGES AND PENALTIES A. Damages10(b) Actions B. Penalties C. Contemporaneous and Option Traders

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Securities Litigation (ch.12) and Insider Traiding (ch.13)

11. The Regulation of Securities Offerings (ch5: #22: p.165-187)

11.1 WHAT IS A SECURITY
A. B. C. D. Wartzman v. Hightower Productions, Ltd. Stock Notes Investment Contracts 1. SEC v. W.J. Howey Co.

11.2 THE EXEMPTION-REGISTRATION QUERY 11.3 EXEMPTIONS FROM REGISTRATION

A. The Statutory Private Offering Exemption4(2) 1. SEC v. Ralston Purina Co. B. Rule 506 of Regulation D C. The Limited Offering Exemptions 1. Section 4(6) Exemption 2. Section 3(b) Exemptions D. Intrastate Offerings

11.4 OVERVIEW OF THE REGISTRATION PROCESS 11.5 GOING PUBLICPROS AND CONS 11.6 A BRIEF LOK AT THE PROCESS OF A PUBLIC OFFERING 11.7 STATE BLUE SKY LAW 11.8 THE REGISTERED OFFERINGFRAMEWORK OF SECTION 11
A. Escott v. Barchris Construction Corp.

11.9 THE SARBANES-OXLEY ACT

A. B. C. D. E. F. G. H. I. CEO and CFO Certifications Audit Committee Forfeiture of Bonuses and Profits Officer and Director Bars Prohibition of Loans to Directors and Officers Management Assessment of Internal Controls Real-Time Disclosure Accounting Oversight Board

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Basic Corporate Changes (ch.15) and Change of Control of the Corporation (ch.16)

12. Basic Corporate Changes (ch15: #23: 605-625)

12.1 INTRODUCTION
A. Types of corporate changes 1. Charter and bylaw amendments 2. Statutory business combination transactions like mergers, consolidations, share exchange transactions, and dispositions of all or substantially all of a corporations assets 3. Dissolutions B. Directors serve an advisory role in recommending basic corporate changes (typically board approval followed by shareholder approval) 1. However, because the right to initiate amendments lies solely with the board, shareholders cannot implement these basic corporate changes on their own 2. Shareholders are limited to voting to approve a decisions already made and recommended by the board C. Because of the importance of fundamental changes to the corporate form, the board as a whole must approve and recommend to shareholders instead of a board committee (MBCA 8.25 and DGCL 141(c))

12.2 CHARTER AND BYLAW AMENDMENTS

A. Introduction 1. The charter and bylaws are the two key corporate organizational documents a. Corp charter = its constitution: establishes the corp as an entity and sets forth its basic corporate structure (w/o a charter, there is no corporation) b. ByLaws: certain rules for corps ongoing operation as an entity 2. As a general matter, state corporation laws require both director and shareholder approval for charter amendments a. Bylaw amendments always may be made by shareholders, but sometimes may be made by the directors B. Charter Amendments 1. Farahpour v. DCX, Inc., 635 A2d 894 (Del. 1994), p.609: Otherwise legally valid changes made to charters and bylaws may be invalidated if directors breach their fiduciary duties in approving the changes a. Facts: ITOA was a for-profit corporation. In 1928, it amended its charter to convert the corporation to a nonprofit, nonstick corporation. In 1989, ITOA changed its name to DCX and converted to a for-profit stock corporation b. Issues: (1) Can a corporation make fundamental changes to its structure and purposes through amendment of its articles of incorporation? i. (2) Can the changes be made without notification to the corporations nonvoting members, without a dissolution of the predecessor nonprofit corporation, without a merger or consolidation, and without the corporation providing anything of value to the members whose rights have been extinguished? c. Decision: Yes and Yes, a corporation may make fundamental changes to its structure and purpose through amendments to its certificate of incorporation i. A proposed amendment to the certificate of incorporation must be submitted to a vote of the corporations stockholders entitled to vote (DGCL 242(b)(1)); Two exceptions: 1. Where a corp has yet to receive payment for its shares, the board may amend the certificate by board action alone 2. Where a corp has no capital stock, the governing body may approve a certificate amendment in a two step process a. Adopting a resolution setting forth the amendment proposed and declaring its advisability b. Approving the amend by maj vote of the members of the governing body at a subsequent meeting C. ByLaw Amendments 47

Basic Corporate Changes (ch.15) and Change of Control of the Corporation (ch.16)

12.3 STATUTORY BUSINESS COMBINATIONS

A. Statutory Mergers and Consolidations 1. classic merger is a stock-for-stock transaction in which two similarly-sized corporations combine. The shareholders of the disappearing corporation give up their stock in that company and get stock of the surviving corporation. B. Statutory Share Exchanges 1. The name is misleadingit is not an exchange of shares, but a device that compels a sale of stock. In other words, it forces the shareholders of a target company (T Co.) to sell their stock to the acquiring company (A Co.). The result is that A Co. gets all the stock of T Co., and the T Co. shareholders end up with cash or other property. (is essentially a substitute for the reverse triangular merger). C. Dispositions of All or Substantially All of a Corporations Assets (4/19: #24: p.625-648) 1. Unlike a stock purchase, buyer in an asset transaction will acquire only the assets described in the acquisition agreement and, so, they must be described with specificity a. Con: more transaction costs in the form of addl drafting and documentation; b. Pro: flexibility of choosing the assets and liabilities it actually wants to acquire 2. It is often in the buyers best interest to purchase assets; but in the sellers best interest to sell stock or merge 3. When to use an asset purchase acquisition a. a non-corporate seller is involved b. buyer is only interested in purchasing a portion of the companys assets or assuming only certain of its liabilities (note: may still be liable under tort doctrine of successor liability) c. If the stock is of a company that is widely held or it is likely that one or more of the shareholders will not consent, a sale of stock may be impractical 4. State Regulation: asset dispositions are generally standard commerical transactions that can occur absent statutory authorization; but when corp disposes of all or substantially all of its assets, state law may require shareholder approval and in some j/d appraisal rights to dissenting s/hs: a. DEL 271: need approval of holders of a majority of the outstanding stock entitled to vote; board must approve before s/hs get to vote b. MBCA 12.01: asset sales outside the usual and regular course of corporations business, need s/h approval at a meeting at which a quorum is present, if corp would be left without a significant continuing business activity (25%) i. Appraisal rts available to dissenting s/hs in MBCA 13.02 but not Del 5. Katz v. Bregman, 431 A2d 1274 (Del. Ch. 1981), p.627: proposed sale of Canadian subsidary corporation was substantially all of the parent corps assets under Del 271; ct looked to quantitiative measures (attributable asset value, sales revenue, and pre-tax net operating income, contribution to overall profit of parent) and also if sale of subsidary was extraodinary for parent and what its overall effects are. a. c/a: s/h sought prelim injunction prohibiting sale of corps Canadian assets. b. Facts: Katz is a shareholder in Plant Industries. Bregman, as CEO of Plant, has disposed of several unprofitable subsidiaries of the company. He is attempting to dispose of Plants entire Canadian operation, which has been the only profitable facility for the corporation. Katz wants the matter put to a shareholder vote c. Issue: is this a sale of substantially all of corporations property and assets under Del 271, and thus need shareholders to vote? d. Holding: injunction granted. proposed sale would constitute sale of substantially all of corporation's assets, where Canadian assets constituted over 51% of corporation's total assets and generated approximately 45% of net sales, and corporation proposed, after sale, to radically depart from its historically successful line of business i. If the sale of assets is quantitatively vital to the operation of the corp and is out of the ordinary and substantially affects the 48

Basic Corporate Changes (ch.15) and Change of Control of the Corporation (ch.16)

existence and purpose of the corporation then it is beyond the power of the board (Gimbel) ii. The critical factor in determining the character of the sale of assets is generally considered not the amount of property sold but whether the sale is in fact an unusual transaction or one made in the regular course of business of the seller (Philadelphia Nat. Bank) 1. Here, the principal business was manufacturing steel drums, not buying and selling industrial facilities D. Appraisal Rights 1. Siegel, Back to the Future: Appraisal Rights in the 21 st Century E. De Facto Mergers 1. Hariton v. Arco Electronics, Inc.

12.4 DISSOLUTIONS

13. Change of Control of the Corporation (ch.16: #25: p649-70)

13.1 OVERVIEW
A. B. C. D. E. F. A. B. C. D. Shareholder Primacy Director Primacy Managerialism Resulting Theoretical Confusion Market for Corporate Control A Birds-Eye View of Change-of-Control Transactions Charter Amendments and Business Combinations Proxy Contests (aka Proxy Fights) and Other Changes in Control of the Board Tender Offers and Other Share Purchases Going Private Transactions 1. State Law Regulation a. Winberger v. UOP 2. Federal Law Regulation

13.2 TYPES AND REGULATION OF CHANGE OF CONTROL TRANSACTIONS

E.

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