Types of business associations - overview:

Standard/traditional forms: Sole propr., Partnership, Corporation, Limited pp, Close corp.
New/hybrid forms: LLC limited liability company (Explosive growth!), LLP limited liability
partnership
Law of unincorporated entities/Corporate law:
Scope: limited
Practice: litigation or transactional
Relevant sources of law:
Restatements: Agency 2nd and 3rd
Statutes:
Federal: Securities Exchange Act of 1934, Sarbanes- Oxley (SOX), Dodd-Frank
State/Model Acts: UPA, RUPA, ULPA, RULPA, re-RULPA, LLP statutes, LLC statutes
Re: corporations: Delaware, Revised Model Business Corporation Act, Others
Common issues for all business forms:
1) Klein & Coffees 4 bargain elements/deal points:
1) the risk of loss (who pays debts if the business fails?);
2) the return (salaries, interest, other fixed claims and shares of the residual the profit);
3) control (who gets to make the various decisions affecting the business?); and
4) duration (how long will the relationship last and how can it be terminated?).
2) Essential elements of business organizations:
Each business firm must address 5 basic questions:
1) Duration: When does the investment begin and end?
2) Profit: What is the likely return on the investment?
3) Control: Who manages the investment who has control?
4) Exit: How can the investors get out?
5) Duties and liability: What are the investors responsibilities to others?
Underlying Tensions:
Conflicting normative views of corporate balance of power: Shareholder primacy vs. director
primacy
Nature and effectiveness of corporate law: Contractarian vs. regulatory vs. norm-based
views
Federalization and the changing role of Delaware
The roles of the various actors: courts/counsel
Some major issues in the news today:
Governance system
Shareholder voting
Fiduciary duties
Executive compensation reform & say on pay
The plaintiffs bar and the rise in M & A litigation
Insider trading
Corporations as political actors post-Citizens United

Rules for new business forms

International business rules in global commerce environment

I.

AGENCY

Sect. 1 : THE SOLE PROPRIETORSHIP

Most rudimentary form of business organization.
Firm owned by a single individual
Not created by filing a statute
Have a degree of psychological and social identity separate from identity : will only dedicate
a part of his asset to the agency.
But as a matter of law, a sole proprietorship has no separate identity from its owner :
unlimited personal liability for oligations incurred in the conduct of the proprietorships
business.
Typically, the sole proprietorship does not conduct the business by himself.

Rules relating to representational relationships

Foundational to all business relationships
Source of law: Common law and Restatements of Agency 2nd and 3rd
Basic problem: agency costs. So:
1) how can we reduce agency costs enough to optimize use of agents?
2) who should bear agency costs and when?

Sect. 2 : THE AUTHORITY OF AN AGENT

Definition volitional (= de volont), hierarchical relationship
Person who by mutual assent acts on behalf of another (Principal) and subject to the others
(Principal) control.
1) Manifestation from P to A,
2) consent by A,
3) with A acting for the benefit of P and under his/her control
Nature of the agency relationship: consensual
3rd RS: agency is the fiduciary rel. arising when one person manifests assent to another person that
s/he will act on the principals behalf and subject to his control, and the agent manifests assent or
otherwise consents to so act.
Agency law governs relationships between:
Agent and Principal
Agent and Third Party
Principal and Third Party
Principal can be :
disclosed
partially disclosed
unindentified
We look at . . .
Agency formation (agency relationship or something else? E.g., lender/creditor)
Principals liability (for acts of agent, authorized or unauthorized)

Duties inter se (fiduciary duties)

Agents and non-agents

Hypo: Lawyers and stockbrokers vs. plumbers and paperboys
Agency as legal conclusion:
Ramseyer: many of the legal distinctions make more sense backward.
Key elements of agency formation:
Manifestation
Consent
Principals behalf & control
Relevant Restatement provisions:
RS 2nd: 1, 13, 14, 15, 26
RS 3rd: 1.01, 1.02, 1.03
Agency creation RS 3rd
What counts as a manifestation?
RS 3rd: A person manifests assent or intention through written or spoken words or other
conduct.
How about silence?
How about conduct that carries a meaning at odds with words expressed previously or
simultaneously?
Whose is the relevant state of mind? The one speaking or the one(s) hearing?
Creating an agency relation
Do the parties have to know theyve created agency relationship? No
E.g., you let someone use your car and s/he kills someone

Can you be an agent for some purposes and not for others?

Do the parties have to have a contract to have created an agency relationship? Written?
Oral?
Morris Oil v. Rainbow Oilfield Trucking: Undisclosed agency
Facts: Dawn was the holder of a certificate of public convenience and necessity and was engaged
in the oilfield trucking business in the Farmington area.
Rainbow, a New Mexico company was operating in the Hobbs.
Dawn allowed Rainbow to use its certificate to operate in the Hobbs retaining the control and
supervision of operation.
Dawn was collecting all charges due for transportation clerical fee (1000 USD/month) +
pourcentage off gross receipts and was remetting the balance to Rainbow .
They further agreed that Rainbow would not function as Dawns agent, and that Rainbow was not
authorized to incur debt in Dawns name outside the ordinary course of business. In the course of
its operations, Rainbow agreed to purchase diesel fuel from Morris Oil Company (Morris) (plaintiff).
Morris installed a bulk dispenser. Rainbow did not disclose its relationship with Dawn to Morris.
Rainbows business then failed and it declared bankruptcy, still owing Morris $25,000. At that time
Dawn still held $73,000 which it had collected from Rainbows operations. When Morris discovered
Dawns involvement, Dawn assured Morris that it would pay the debt but later declined to do so.
Morris sued Rainbow and Dawn to collect the debt. The trial court found against both defendants,
holding that Dawn was vicariously liable because Rainbow acted as Dawns agent. Dawn appealed.

Issue: Did the district court err in finding liability based on a principal-agent relationship between
the defendants?
Reasoning : i. Liability to Morris was incurred in the ordinary course of operating the trucking
business and their agreement specifically states that Rainbow may create liabilities of Dawn in this
course.
ii. Also, recitation of the parties in their contractual documents need not bind third parties who are
ignorant of these instructions.
iii. This case is about an undisclosed agency because Rainbow contracted in its own name and not
the name of Dawn. An agent for an undisclosed principal subjects the principal to liability for acts
done on his account if they are usual or necessary in such transactions. This is true even if the
Principal has previously forbidden the agent to incur such debts.
iv. Moreover, Dawn ratified the account by learning of its existence when Morris contacted Dawn
regarding payments and Dawn never disputed legitimacy of funds but rather assured Morris
payment would be forthcoming. Therefore, Dawn may be held liable regardless. A principal may be
held liable for the unauthorized acts of his agent if the principal ratifies the transaction after
acquiring knowledge of the material facts concerning the transaction. Where a principal retains the
benefits or proceeds of its business relations with an agent with knowledge of the material facts, the
principal is deemed to have ratified the methods employed by the agent in generating the proceeds.
Holding: Yes. Principals are liable for their agents contracts, even unauthorized ones, unless the
third parties contracting with them knew they were unauthorized.
What if their contract specifically disclaims agency?

Why isnt the disclaimer language in contract sufficient?

Contract language: is relative to terminal management = in the ordinary course of

business of operating the terminal?

What if contract didnt have the ordinary course of business words and simply
disclaimed agency more clearly?
Morris Oil

What else did the court focus on to show agency?

Why does control seem to be important?
Why should it matter if Dawn maintained the right to control, if it didnt exercise control?
What was the behavior of the parties regardless of what was written in the contract?

Why isnt Dawn actually the agent and Rainbow the principal?

Is an alternative account of the deal available?

Does the outcome of the case make sense from a policy standpoint?

How do you weigh contending factual variables in assessing whether an agency was
created?
Agents authority

Key question re: authority = to what can agents can bind principals?

Remember: agency costs

Under the law of agency, a principal is liable to a third person on a contract entered into by an agent
on the principals behalf if the agent had:
actual
apparent

 or inherent authority
to act on the principals behalf in the way that he did, or the principal ratified the act or transaction.
Authority: 4 types
1.

Actual: 2.01 RS 3rd

The Principals word or conduct would lead a reasonable person in the agents position to believe
that the principal wishes the agent to act.
Scope of actual authority: It depends on agents reasonable understanding of Ps
manifestations P A
But remember: issues arise when there are changed circumstances

Can be written or oral

The actual authority can be:
Express
Implied (incidental authority): To do incidental acts that are reasonably necessary to
accomplish an actually authorized transaction or that usually accompany a transaction of
that type
Most actual authority is created by implication.
Q: can A reasonably infer from Ps instructions that P has acquiesced to a certain action?
Illustration: 1. P gives A a power of attorney authorizing A to sell a piece of property owned
by P. P subsequently says to A, "Don't sell the property. Lease it instead." After P's
statement, does A have actual authority to sell?
The presence of actual authority requires that an agent's belief be reasonable at the time the agent
acts. It is also necessary that the agent in fact believes that the principal desires the action taken by
the agent.
Actual authority Changed circumstances

Question to ask: would Ps words or conduct lead a reasonable person in As position to

believe that P had authorized him/her to so act.

It is the agents duty to interpret the principals instructions reasonably to further the
purposes of the principal that the agent knows or should know, in light of the facts the agent
knows or should know when he acts.

Illustrations: 2. Same facts as Illustration 1, except that A overhears P say to a third party
that P no longer wishes to sell the property and wishes A to lease it. A has actual authority
only to lease because A knows P does not wish the property to be sold.

Actual authority review

Most straightforward category: actual express authority
Is Ts belief as to As authority relevant in actual authority contexts?
T can enforce K against P even when T didnt know A had been acting on behalf of P.
Actual authority by mistake:
Remember also that P can give actual authority to A through unintended conduct that A reasonably
believes to constitute an expression of Ps intentions.

2.

Illustrations: 3. Same facts as Illustration 1, except that, after telling A to lease the
property instead of selling it, P tells F that P regrets making this statement and wishes that
the property be sold. A is unaware of P's statement to F. A sells the property to T, showing T
the power of attorney. T is unaware of P's oral statements to A and F. Did A have actual
authority to sell the property?
5. P drafts and executes a power of attorney authorizing A to sell a piece of property.
Following a change of mind, P drafts and executes a second power authorizing A only to
lease the property. P inadvertently sends the first power to A and does not otherwise
communicate with A regarding the nature of A's authority. Does A have actual authority to
sell the property?
6. Same facts as Illustration 5, except that after A receives the power of attorney from P,
P sends A a letter asking for a status report on A's efforts to lease the property. The letter
also states that P is glad the property will not be sold. After receiving P's letter, does A have
actual authority to sell the property?

Apparent: RS 3rd
If manifestation of the Principal to the Third Party would lead a reasonable person in the Third Party
position to believe that the Principal had authorized the agent to act.

2.03 Apparent Authority: the power held by an agent to affect a principal's legal
relations with third parties when a third party reasonably believes the actor has authority to
act on behalf of the principal and that belief is traceable to the principal's manifestations.

Manifestations from P T

Why should Ps be held to As contracts on the basis of apparent authority?

Illustration: I hire an agent to buy a house from X. I meet with X and the agent and I tell X that my
agent has full authority to negotiate the deal for me and close it. The agent makes the deal for
$35,000, but I had secretly told him that I wasn't willing to pay more than $30,000. Can the third
party hold me to the deal?
Apparent authority

Whats authority when P doesnt make direct representations to T?

E.g., A tells T about his authority in Ps presence and P doesnt object
E.g., Parties behavior in prior transactions
E.g., P gives A a signed blank check which she shows T
E.g., power of position
Apparent authority via agents own representations re: authority to T

Can an agent create her own apparent authority by representing it to T?

What happens if her authority changes is reduced after she first represents it
(accurately at the time) to T?
Morris Oil

Why wasnt there apparent authority in Morris Oil?

3.

Inherent agency power (2nd RS) or estoppel of undisclosed principal (3rd RS)
2 RS Section 161 concerns the inherent authority of a disclosed or partially disclosed Principal.
May bind the principal even if the agent has neither actual nor apparent authority even if the
Principal has forbidden the agent to do the act if:
the act usually accompanies or is incidental to transactions that the agent is authorized to
conduct,
nd

and if the Third party reasonably believes the agent is authorized to do the act.

Policy decision : totally policy based concept

Rationales for inherent agency power:
1. Fairness/causation: P put A in position of dealing with T and controls A
2. Economic efficiency: Need to have rules that make agency more efficient, and P is
the better risk-bearer. Proper allocation of resources is promoted by requiring the
enterprise to include in the price of its goods the costs of accidents closely associated
with its operations. More equitable to place responsibility on the principal (greater
chance for T to be paid)

Underlying Q: What can reasonably be expected of a third party in assuring himself that
the person with whom hes dealing has the authority to make the deal that the agent
offered?
When do you say that the T was not reasonable in believing in the agents authority?

Rest 2nd Section 194 concerns the inherent authority of agents of undisclosed Principal.
A general Agent for an undisclosed Principal authorized to conduct transactions subjects his
Principal to liability for acts done on his account, if usual or necessary in such transactions although
forbidden by the principal to do them.
Inherent agency power Restatement Second of Agency

Principal held even though no actual authority or classic apparent authority

Particularly good example: undisclosed principals

Limitations: what is customary for the enterprise?

Inherent Agency Power

Found in 2nd RS, eliminated as such in 3rd RS

2nd RS 8a: the power to bind a principal arising not from authority, apparent authority
or estoppel, but solely from the agency relation and that the power exists for the protection
of persons harmed by dealing with an agent.
Good example: The undisclosed principal problem

Under 2nd RS, if P undisclosed and there is no actual authority and no apparent authority
(by definition), inherent agency power is the only basis for Ps liability.

3rd RS deals with this as an estoppel matter.

Why should a creditor have access to the undisclosed principals deep pocket if he only
knew of and relied on the agent?
Are there any limits to the liability of the undisclosed principal?
Watteau v. Fenwick
Facts : Defendant owned a hotel-pub that employed Humble to manage the establishment. Humble
was the exclusive face of the business; Humbles name was on the bar and the license of the pub.
Defendant explicitly instructed Humble not to make any purchases outside of bottled ales and
mineral waters, but Humble still entered into an agreement with Plaintiff for the purchase of cigars.
Plaintiff discovered that Defendant was the actual owner and brought an action to collect from
Defendant.
Issue : The issue is whether Defendant is liable for damages resulting from an agreement between
Plaintiff and Humble, who is knowingly acting outside his actual authority as an agent for Defendant.

Held : Defendant is liable for damages. Humble was acting with an authority that was inherently
reasonable for an agent in that position. The situation is analogous to a partnership wherein one
partner is silent but is still liable for actions of the partnership as a whole.
The Court that it was not about actual authority nor apparent authority but inherent authority.
Synopsis of Rule of Law : An undisclosed principal can be held liable for the actions of an agent
who is acting with an authority that is reasonable for a person in the agents position regardless of
whether the agent has the actual authority to do so.
Customs : Kids v. Edison (record company)
Defines custom business in a case about a new industry. Proceeded by analogy.
Inherent Agency Power
Policy decision
Rationales for inherent agency power:
1. Fairness/causation: P put A in position of dealing with T and controls A
2. Economic efficiency: Need to have rules that make agency more efficient, and P
is the better risk-bearer.
Underlying Q: What can reasonably be expected of a third party in assuring himself that
the person with whom hes dealing has the authority to make the deal that the agent
offered?
When do you say that the T was not reasonable in believing in the agents authority?
Dreier
Facts: Dreier represented Gardi in negotiating a settlement with Jana. Gardi agreed to provision
binding both parties while Jana wanted unilateral provision. Dreier forged the signature of Gardi on
the settlement containing unilateral provision. Jana paid 6.3 M and Dreier embezzled the money.
Gardi sued Jana to reopen the dispute arguing not to be bound.
Holding: An agent forges the principals name on an agreement with a third party while acting
within the scope of the agents apparent authority binds the Principal to the third party.
Reasoning: The third party reasonably believed the signature to be Dreiers.
4.

By Acquiescence
If an agent does similar unauthorized acts over a period of time and the principal knows about them
and doesnt object, hell be deemed to have acquiesced in them for the future under similar
conditions.
How can we tell whether the circumstances are sufficiently similar that the principal should be
deemed to have acquiesced?

5.

By Ratification
Even if an Agent has neither actual, apparent or inherent authority, the Principal will be bound to the
Third person of the agent purported to act on the principals behalf and the principal, with
knowledge of the material facts, either:
affirmed the agents conduct by manifesting an intention to treat the agents past conduct
as authorized
or engage in conduct that is justifiable only if he has such intention.
Similar to actual authority
Retroactive approval (express or implied)
Can happen through inaction and by accepting or retaining benefits while knowing
that they result from an unauthorized act.

 See Morris Oil: whats an argument that Dawn didnt ratify in Morris?
Ps Liability for As unauthorized acts:
Apparent authority
Estoppel
Inherent authority
Justification for liability: actual authority
Ps would have been liable themselves
Ps have clearly consented to be bound
Does actual implied authority doctrine place the incentives on the right party?
Yes creates incentive to draft good instructions. If P wants A to do X in an
idiosyncratic manner, P needs to draft its authorization carefully.
Overview questions
Can you have actual authority without apparent authority?
Can you have apparent authority without actual authority?
6.

Estoppel
1. acts or omissions by the principal, whether negligent or intentional, which create the
appearance of agency and authority;
2. acts by the third party reasonably in reliance on the principals conduct; and
3. detrimental change of position by the third party in reliance on the appearance of
agency or authority
Lower court decision in Morris Oil relied on estoppel theory
Agency: Authority Wrap-up
P liable when: actual authority, acquiescence, ratification, apparent authority, estoppel,
inherent agency power (2nd RS) or estoppel/expanded manifestation/expanded apparent
authority (3rd RS)
Look at manifestations
P A re: actual authority
P T re: apparent authority
Inherent agency power Should Fenwick have access to Watteaus deep pocket if he only
contracted with and relied on Humble?
Windfall to T?
Or appropriate incentives for P?
Fairness?
Or about whos the better risk-bearer?
How can we tell? Is it always P?
Are there any limits to the liability of the undisclosed principal?
What justifies limit of customary?
What do you do about new industries with no established customs, or w/ multiple
customs?
Are there valid business reasons for allowing undisclosed principals?
When are principals likely to be undisclosed?

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When agent forgets to mention s/hes representing another. Common in rapid, timepressured deals.
When P wants privacy. Common in art auctions.
When P fears strategic hold-outs by T in multi-T transactions. Common in real estate
deals.
When P knows T doesnt want to deal with him.

Critique of IAP rules: indeterminacy

1. Common rationales dont support inherent agency power:
a) fairness could be argued other way;
b) economic efficiency/risk bearer argument will depend on circumstances.
(True that P could have trained A better, but T could have asked a question or two also,
given the importance of the K.)
2. Notion of custom is manipulable/indeterminate.
3. Courts are confused by the concept and use apparent authority in inherent agency
situations.
Critiques of inherent agency power
4. Uncertainty increases transactions costs of using agents, harming everyone
concerned.
5. In most cases of agency, there is no substantive difference between inherent agency
power and apparent authority.
6. the expansion of tort law and contract law has filled the gap previously occupied by
inherent agency power
What do you think of the forseeability standard for inherent authority?
Traditional approach: focus on what is customary.
Eisenbergs alternative:
Would a reasonable person in P's position have foreseen that, despite his
instructions, there was a significant likelihood that the agent would act as he did?
Focuses not on what T reasonably believes, but on what P reasonably could foresee.
Restatement Third of Agency
Eliminates inherent agency power language
Attempts to achieve the same results by:
Expansive meaning of manifestation
Expansive meaning of apparent authority
Specific estoppel provision
Undisclosed principal liability under Restatement Third
2.06 Liability Of Undisclosed Principal
(1) An undisclosed principal is subject to liability to a third party who is justifiably induced
to make a detrimental change in position by an agent acting on the principal's behalf and
without actual authority if the principal, having notice of the agent's conduct and that it
might induce others to change their positions, did not take reasonable steps to notify
them of the facts.

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(2) An undisclosed principal may not rely on instructions given an agent that qualify or
reduce the agent's authority to less than the authority a third party would reasonably
believe the agent to have under the same circumstances if the principal had been
disclosed.

Illustrations from Restatement Third:

1. P buys a medical-supplies business owned and run for many years by A as a sole
proprietor. P employs A as general manager, telling A to keep P's ownership a secret. P
tells A to sell no supplies at a discount except with P's prior approval. As is customary in
the trade, A offers a standard discount in exchange for a large order to T Hospital, a
long-standing customer. T Hospital accepts the offer made by A. P is bound to sell to T
Hospital on the terms to which A agreed. Had T known that A acted as an agent on
behalf of a principal, T would reasonably believe that an agent in A's position had
authority to offer the standard discount.
2. Same facts as Illustration 1, except that A offers T Hospital a requirements contract at
fixed prices, terms unprecedented in the industry. T Hospital accepts the offer made by
A. P is not bound to sell to T Hospital on the terms offered by A. A's offer was
extraordinary, and had T known that A acted as an agent on behalf of a principal, T's
belief in A's authority to offer such terms would not be reasonable.
3. A owns and operates a carpet-cleaning business doing business under the name "A's
Cleaner Carpets." A purchases cleaning supplies each week from T on terms standard in
the trade that require payment in cash within 30 days. A sells the business to P, who
employs A to manage it. P continues to do business under the name "A's Cleaner
Carpets." T is unaware that A no longer owns the business.
4. Same facts as Illustration 3, except that A enters into a contract to sell A's Cleaner
Carpets to T. P is not subject to liability to T on the contract. A lacked actual authority to
make the contract. A lacked apparent authority because P's existence was undisclosed.
Had T known that A acted as an agent for P, it would not have been reasonable for T to
believe that A had authority as manager to contract to sell P's business. T is not entitled
to restitution under 2.07 because P did not benefit from the contract.
5. P, who owns Blackacre, coinhabits it with A, who manages Blackacre on P's behalf. T,
who wishes to purchase Blackacre, mistakenly believes that A has authority to sell it on
the basis of A's representation that A has such authority. P is aware of T's error and
could easily inform T of the facts. P is subject to liability to T if T justifiably makes a
detrimental change in position as a consequence of A's conduct.
For what have critics faulted the Restatement Third approach?
Restatement Third affects substantive change to law, which is not what Restatements
are supposed to do.
Restatement Third will harm innocent third parties currently protected under the Second
Restatement.
Liability of Agent to Third Party
Disclosed Principal: If the Principal was disclosed and the Principal is bound because
the Agent has actual, apparent or inherent authority, or the act has been ratified, the
general rule is that the Agent is not bound to the third Person.
Undisclosed Principal: The Agent is bound even if the Principal is bound.
Partially disclosed Principal the third party knows that the Agent is acting on the behalf
on someone but does not his identity): Both Principal and Agent are bound.

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If the principal is not bound because the Agent had no authority, the Agent is liable to the
Third Party.
Should A be discharged, even if he has deep pockets, if P is found liable but is
insolvent?

Agents as fiduciaries:
Agents considered fiduciaries under both 2nd and 3rd Restatements
What is the consequence of calling them fiduciaries?
RS 2nd 13 defines a fiduciary as "a person having a duty, created by his
undertaking, to act primarily for the benefit of another in matters connected with is
undertaking."
Not absolutely prohibited:
unlike trusts, P can consent to As self-interested
action/competition
Preconditions of consent: good faith, full disclosure under both Restatements.
Possible fiduciary duty rule options
1. no k out: no contracting out of fiduciary duties under any circumstances see trusts;
2. k out possible: generally requiring agent loyalty but permitting the parties to contract
out of it;
3. court review: generally requiring agent loyalty but permitting interested transactions if
a court thinks they are not harmful; or
4. k in: the principal must specifically contract in for the agent's loyalty
Fiduciary duty - Third Restatement
8.02 Material Benefit Arising Out Of Position
An agent has a duty not to acquire a material benefit from a third party in connection
with transactions conducted or other actions taken on behalf of the principal or
otherwise through the agent's use of the agent's position.
8.03 Acting As Or On Behalf Of An Adverse Party
An agent has a duty not to deal with the principal as or on behalf of an adverse party
in a transaction connected with the agency relationship.
8.04 Competition
Throughout the duration of an agency relationship, an agent has a duty to refrain
from competing with the principal and from taking action on behalf of or otherwise
assisting the principal's competitors. During that time, an agent may take action, not
otherwise wrongful, to prepare for competition following termination of the agency
relationship.
8.05 Use Of Principal's Property; Use Of Confidential Information
An agent has a duty
(1) not to use property of the principal for the agent's own purposes or those of a third
party; and
(2) not to use or communicate confidential information of the principal for the agent's
own purposes or those of a third party.
Consent provisions 3rd Restatement - Section 8.06
8.06 Principal's Consent

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Conduct by an agent that would otherwise constitute a breach of duty as stated in 8.01,
8.02, 8.03, 8.04, and 8.05 does not constitute a breach of duty if the principal consents to
the conduct, provided that
(a) in obtaining the principal's consent, the agent
(i) acts in good faith,
(ii) discloses all material facts that the agent knows, has reason to know, or should know
would reasonably affect the principal's judgment unless the principal has manifested that
such facts are already known by the principal or that the principal does not wish to know
them, and
(iii) otherwise deals fairly with the principal; and
(b) the principal's consent concerns either a specific act or transaction, or acts or
transactions of a specified type that could reasonably be expected to occur in the ordinary
course of the agency relationship.

(2) An agent who acts for more than one principal in a transaction between or among them has a
duty
(a) to deal in good faith with each principal,
(b) to disclose to each principal
(i) the fact that the agent acts for the other principal or principals, and
(ii) all other facts that the agent knows, has reason to know, or should know would
reasonably affect the principal's judgment unless the principal has manifested that such
facts are already known by the principal or that the principal does not wish to know them,
and
(c) otherwise to deal fairly with each principal.
Secret profits
Must be disgorged even if P not harmed
Why?
Characterized as punitive rule designed to deter
Can it be characterized as a compensatory rule in cases like Tarnowski?
But what about Reading? Could the principal have benefited from the agents secret profit
there? What was wrong with what Reading did?
What about off-duty police officers who stand guard at Walgreens in their uniforms?
Does the $ have to go to the Police Dept?
Fiduciary duties
What about forfeiture of compensation? Rash v. JV

Why only applied to clear and serious breaches of loyalty?

Wouldnt that be the best way of deterring disloyalty in all circumstances?
Sect.3 : The agents duty of loyalty
Tarnowski v. Resop
Facts: Tarnowski (plaintiff) retained Resop (defendant) as his agent for the purpose of exploring a
potential investment in a jukebox business. The defendant got a secret $2000 commission from the
seller to report back that there were over 75 locations, each with machines less than six months old,
and that the overall gross income was over $3,000 per month. In reality, the agent had only
investigated five of the locations, some machines were up to seven years old, and the gross income

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was substantially less than $3,000. On the strength of Resops report, Tarnowski agreed to
purchase the business from the sellers and made a downpayment of $11,000. Tarnowski later
discovered that Resops statements had been false and rescinded the sale. When the sellers
refused to refund the downpayment, Tarnowski sued them and was awarded $10,000 at trial.
Tarnowski then sued Resop, alleging that Resop was secretly paid by the sellers to inflate the value
of the business. Tarnowski sought to recover the secret commission as well as a variety of
incidental and consequential damages he incurred as a result of Resops misrepresentations,
including attorneys fees from the trial against the sellers.
The trial court found in favor of Tarnowski.
Resop appealed contended that the purchaser's recovery in an action against the sellers was a bar
to the actions against the agent.
Holding : The court held that the purchaser had an absolute right to any commission received by
the agent, irrespective of any recovery resulting from the action against the sellers for rescission.
Reasoning :The recovering from the seller does not bar the plaintiff from suing defendant agent for
business losses and attorney fees. The contract-related suit regarding the seller does not preclude
recovering tort-related losses from the agent; the attorney fees and expenses were directly
traceable to the harm caused by the defendant's wrongful act. Moreover, many of the damages
sought from the agent were not available in the suit against the seller.
RULES: All profits made by an agent in the course of an agency belong to the principal.
-Dont want the agent to be tempted by own private interests and disregard those of the principal.
Reading v. Attorney General
Facts: The applicant had been a sergeant in the army. He had misused army property and his
uniform to assist in smuggling operations. After serving his sentence he now sought repayment of
the money he had earned.
Holding: His claim failed.
Reasoning: The money had been earned by his misuse of his official position, and therefore his
employer was entitled to keep the money even though it had been earned unlawfully. The soldier
owed a fiduciary duty to the Crown, which was an additional ground on which he lost his claim.
Bergquist v. Kreidler
Facts : Plaintiffs engaged an agent to purchase real estate. Agent told the plaintiffs the real estate
will be free starting from August 1,1920. When the plaintiffs entered in possession they discovered
that a tenant was occupying the premises with a lease runnin to August 11, 1922 on a rental much
lower than the actual value of the premises. The Agent conceded to refund the loss in rent but not
the attorney fees testing the validity of the lease.
The Court granted Plaintiff considering that there was a iolation of duty of loyalty.
Rash v. J.V. Intermediate Ltd
Facts:Rash was a manager at one of JV Intermediates industrial plants. JV claims that Rash
actively participated in and owned at least four other businesses, none of which were ever
disclosed to JV. One of those businesses was Total Industrial Plant Services, Inc. (TIPS), a
scaffolding business.

15

TIPS bid on projects for JV, and with Rash as its manager, often selected TIPS as subcontractor.
Between 2001 to 2004, JV paid over $1 million to TIPS.
At some point during Rashs tenure, JV started its own scaffolding business. Rash resigned and
then sued JV for breach of contract and fraud.
V
He claimed the company purposely understated the net profits and equity of the Tulsa branch
and therefore did not properly pay him the net profit and equity bonuses.
JV countered that Rash (1) materially breached his employment agreement,(2) breached his duty of
loyalty, and(3) breached his fiduciary duty.
The District Court held that Rash was not a fiduciary.
V

Issues:(1) The existence and scope of a fiduciary duty between an agent and a principal.(2) The
propriety of the equitable remedy of forfeiture for breach of a fiduciary duty.
Holding:(1) Rashs agency relationship with JV created a fiduciary obligation, and he breached that
duty.(2) Fee forfeiture is a proper equitable remedy in response to a breach of contract claim.
Case reversed and remanded.
Reasoning:

V
1

(1) Rashs agency relationship with JV created a fiduciary obligation, and he

breached that duty.
1 Agency: Rash was an agent contractually, and also because he ran the shop
and was responsible for generating business for the Tulsa upstart.

Breach: Restatement (Second) of Agency 387: Unless otherwise agreed, an agent is subject
to a duty to his principal to act solely for the benefit of the principal in all matters connected with his
agency.
Restatement (Second) of Agency 13:The employee has a duty to deal openly with the employer
and to fully disclose to the employer information about matters affecting the companys business.
(2) Fee forfeiture is a proper equitable remedy in response to a breach of
contract claim.
Forfeiture is based on two propositions:
(i) the principal is considered not to have received what he bargained for if the agent breaches his
fiduciary duties while representing the principal and
(ii) fee forfeiture is designed to discourage agents from being disloyal to their principal or to protect
relationships of trust by discouraging agents disloyalty.
Restatement Third 8.01 - 8.05
1. An agent acts solely for the benefit of his principal.
2. An agent who makes a profit is under a duty to give such a profit to the principal.
Agency Costs
The monitoring expenditures by the principal, the bonding expenditures by the agent, plus the
residual loss.
Liability of Principal to Agent : If an agent has acted within his actual authority, the Principal isunder
a duty to indemnify the Agent for payments the Agent made that were necessary in executing the
Principals affairs.
Liability of Agent to Principal : If the Agent overides the power and the Principal is nevertheless
bound, the Agent is liable to the principal for any resulting damages.

16

FINANCIAL STATEMENTS
Intro. to financial accounting
Intro. to valuation
Why this material?
Important for lawyers to understand the business deals their clients undertake
Some basic accounting and finance principles will make it easier for you to understand the
deals behind some of the cases.
If you dont want to take advanced classes in accounting for lawyers or corporate finance,
youll get a very quick introduction
The Fundamental Equation

Assets = Liabilities + Owners Equity

Left and right sides of equation must be balanced -- equal

Purpose of bookkeeping

To provide clear and accurate picture of how a business is doing.

And yet notice the degree of discretion and judgment required, particularly for some
kinds of accounting activities.
E.g., the illustrations in Chapter 2 involving depreciable assets and inventory
What are the basic kinds of financial statements you should be aware of?
Balance sheet: the parallel listing of assets and their sources, which must always be equal
Balance sheet is a snapshot at one instant in time
Income Statement: covers a period of time between successive balance sheet dates and
tells the reader the extent to which business activities have caused an entitys equity, or net
worth, to increase or decrease over a period of time
These are the ones the book talks about, but you should be aware of another common one
the cash flow statement.
Methods of accounting
Cash basis method: most basic method, used predominantly by service-providing
companies.
Accrual basis method: revenues are reported in the fiscal period in which they are earned,
and expenses are reported when they are incurred.
Recognition of revenue is guided by the realization principle, and the reporting of expenses is
determined according to the matching principle
revenue must be realized before it can be recognized: before you can record a sale or
professional income on the income statement, there must be a shipment of the goods
purchased or a rendition of the services for which revenue is to be recorded.
Conventions of accounting

Accounting reports use metrics referred to as the GAAP generally accepted

accounting principles.

Source of GAAP: FASB (Financial Accounting Standards Board). Most

authoritative.

17

When no explicit FASB rule, then GAAP established by American Institute of Certified Public
Accountants + generally followed conventions

Factors designed to enhance independence in standard-setting

Change to FASB funding/decoupling funding from accounting profession
Regulation of auditors:
Audit procedures under the control of the Public Company Accounting Oversight Board
(PCAOB) designed to promote objectivity

Important distinctions between accounting and valuation

Goal of accounting: to assess the financial condition and performance of the firm. Focuses
on the past and present activities, performance, and condition of a business.
Goal of valuation: judging what a business is worth in order to determine whether to buy it.
This requires looking not only at current health, but at the future. How much will the
business be worth in a week, a year, a decade? How much are the future earnings of the
business worth today?
When is valuation important?
Business valuations are made in various circumstances, including:

One company acquires another

One company is prospectively assessing another firm for acquisition

The board wishes to reorganize a companys capital structure

A company splits up

A company enters bankruptcy

Valuation Calculating Present Value
The value of money depends on three dimensions: amount, time, and risk.
Why would you prefer $5 today rather than in a year?
What would be a reasonable compensation for delaying getting the money?

1) youre forsaking current consumption, including the opportunity costs of other

investments the bank might pay 3% annually

2) risk of non-payment

3) erosion of the purchasing power of a dollar as a result of inflation.

These factors yield the discount rate the amount by which the future payment is
reduced to yield the present value of the future payment.
Present Value Equation
P = 1.05
(1 + r)n
n = number of years before the payment is received
T = terminal value
r = annual rate of interest
Note that compounding tables and present value tables can reduce complexity in
calculation
Stock valuation models
There are many sophisticated models for pricing equity securities.
Classic model: capitalization of earnings
Determine a stocks present value by:

18

Estimating the average yearly earnings per share, then

Capitalizing the estimated earnings per share at an appropriate capitalization rate see p. 45

Risk and diversification

Risk = the degree of dispersion or variation of possible outcomes.
Risk can be mathematically measured.
One investment is riskier than another if the dispersion of potential outcomes is greater (aka
volatility risk).
The reason its important in valuing future payments to know their risks is that it will help you
adjust for the uncertainty of receiving the future payment.
As between investment A and B, you can assess which is a better investment by seeing
whether its return is high enough to compensate you for the risk of its acquisition. These
are matters of judgment, so they raise the question of who should decide.
Empirical observations:
Empirical studies show strong relationship between risk and return.
Aside from return, what seems related to risk is firm size, with smaller firms being riskier
than larger ones (maybe because big firms are likley to be more diversified in their products
and revenue streams)
How to reduce risk?
Risk is driven by both market-wide events (systemic risk) and firm-specific developments
(unsystemic risk)
Diversification can reduce risk associated with a particular investment, but
Obviously, doesnt help with respect to market risk or systemic risk (that relates to
general market conditions)
Capital asset pricing model (CAPM): what insights does it provide?
Capital asset pricing model is a tool widely used to isolate developments that influence the
return of an individual firm and remove market-wide effects on the return.
CAPM predicts the relationship between risk and return for all risky investment opportunities.
See p. 53
Says that the expected return for any security is the combination of the risk free rate (short
term US government Treasury bills) plus a premium for risk.
CAPM makes important assumptions.
Market efficiency: hypothesis and qualifications
Hypothesis of efficient markets: based on statisticians observation that stock price shifts
over a period of time were random
Depending on whether youre talking about the strong or weak version of the EMH,
the notion that you cant outperform the market
Currently under challenge for a variety of reasons, including the irrational behavior of
investors

19

II. PARTNERSHIP
Statutory, regulate by statute in every jurisdiction.
State law
Partnership Relevant Law
Uniform Partnership Act (UPA) 1914
Revised Uniform Partnership Act (RUPA) 1992 and 1994.
Florida adopted RUPA in 1995 (5th state to do so). UPA still operative in other states.
Key conceptual difference: entity or aggregate status.
RUPA and UPA are both default rules: parties can K around most but not all aspects.
(on limits, see RUPA 103)
Creation of PP
Why are many partnerships operated informally, w/o a contract?
UPA 6: association of two or more persons carrying on as co-owners a business for profit.
RUPA 201: explicit characterization as entity (if one of the partners dies, the entity does
not collapse, its still exist)
No filing necessary under UPA or RUPA, though RUPA allows filing in some circumstances
under 303, 704, 805, 907

UPA 7
Share in profits is indicia of partnership, but not when in connection w/ 5 categories
RUPA 202 (FRUPA 620.8202) effectively melds 6 and 7 w/out substantive changes

What about the 4-element test: agreement to share profits, losses, a mutual right of control or
management, and a community of interest in the venture?
What does this mean?
Should the elements be conclusive or just evidentiary?
Why should loss-sharing have to be shown if profit-sharing is?
V

Partners may share profits and losses in any way they agree, and they may agree to share
losses in a different way than they share profits.
V
- In absence of an agreement the UPA/RUPA default rule is that partners share profits equally,
and that losses are shared in the same proportion as profits are shared.
V
- A personal creditor of a partner cannot attach or seize partnership assets.
V
- Any partner may be called on by a creditor at any time to pay a specific partnership debt.
Section 1. What constitutes a general partnership
Hilco Property Sces Inc. v. U.S.
Whether a partnership exists is determined by the conduct of the parties and the circumstances
surrounding their relationship and transactions when there is not a written agreement.
It is a question of intent.
Martin v. Peyton
Facts. Hall was a friend of Respondents, and Halls brokerage business was suffering.
Respondents discussed helping Hall and his business, but they needed to ensure that Halls
business would discontinue their speculative, unwise investments. Respondents agreed to loan Hall

20

$2.5 million in securities for Hall to secure $2 million in loans. In return, Respondents received Halls
more speculative collateral and would receive a percentage of Halls profits. Respondents acquired
the ability to review Halls books and veto certain investments.
Issue. The issue is whether the conditions of the agreements between Respondents and Hall
constituted a partnership between the two parties.
Held. The agreements did not establish a partnership. Although Respondents ensured that they had
some control over the operations of Halls business, the controls they bargained for were to ensure
that their investment was secure. Immediately prior to Respondents investment, Halls business
was doing poorly due to bad decision-making and Respondents needed to prevent further bad
decisions. Hall still was able to control the day-to-day affairs, and Respondents never had control to
initiate their own ideas
The particular set of rights and control put in the agreement are consistent with what a lender would
have done.
The Court is engaging in a social policy, in a context where there was no bankruptcy law.
Hall was not an agent because PPF had a right of inspection but no control on his decisions.
Pro-PP arguments

Martin v. Peyton universally characterized as a close case.

Pro-PP arguments:

high share in profits;

Hall as manager,

right to be kept advised, consulted on important matters,

right to inspect books and get information,

right to veto business they think is speculative or injurious,

no loan to partners permitted,

fixed draw,

partners assign their interests in partnership to trustees,

profits to be realized quickly,

other partners resignation letters on file.

Martin v. Peyton: Pro-loan/contra-PP arguments

1. Documents carefully drafted to indicate loan (unlike Rainbow Trucking).
2. Sharing of profits described as compensation for loan and limited in range from $
100,000 to $ 500,000.
3. Given risky nature of transaction, negative controls not excessive.
Martin v. Peyton
Case often justified by reference to social policy of promoting life-saving loans to business

Are there contrary public policy arguments available?

MM vs. OPM?
Lupien v. Malsbenden
Facts : Stephen Cragin, doing business as York Motor Mart, entered into a contract with Robert
Lupien (plaintiff) to build a special-order automobile. Lupien paid in full but the car was never
produced. Cragin disappeared soon after the contract was signed. Frederick Malsbenden
(defendant) also had some involvement with York Motor Mart. He made expenditures for the

21

business totaling $85,000, purchasing equipment and supplies and paying wages. He was to be
reimbursed from the proceeds of car sales. After Cragins disappearance, Malsbenden had physical
control of the place of business, and interacted with Lupien there personally on numerous
occasions. Lupien sued Malsbenden for breach of contract, asserting that Malsbenden was a
partner in York Motor Mart. Malsbenden claimed that he was simply a financial backer of the
business. The trial court found that Malsbenden was a partner and held him liable on the contract.
Malsbenden appealed.
Holding : The court affirmed the judgment.
Reasoning : The court reasoned that: (1) the customer often dealt with the individual in inquiring
about the status of his car; (2) the individual's alleged loan carried no interest or fixed payments, but
was paid back from business profits; and (3) the individual took part in the business' day-to-day
operations for several years after its alleged sole proprietor disappeared.
Rule : -If the arrangement between the parties otherwise qualifies as a partnership, it does not
matter that parties did not agree expressly to form a partnership or did not intend to.
-D had a financial interest (called it a loan), unlike a banker, D had right to participate in control, and
did so on day to day basis.

Why different result than in Martin v. Peyton?

The Court searchs for sharing of profit and level of control.
No sharing of profits
But no interest on loan
No fixed repayment date
Control over day-to-day business operations way beyond his investment.
Why isnt that true of high-level managers too?

The Court seems to think that there was a collusion with Cragin who disappeared

What factors weigh heavily in reality?

Courts seem to look at:

what they take to be the economic realities of the situation among the particular parties
concerned, and

(2) the social and business effects of coming out one way rather than another
(although multiple policy arguments are often plausible).

Fact-specific inquiry.
Sect 2: The ongoing operation of Partnerships
A. Partnership operation: Management
Note RUPA 103 list of non-waivable provisions (most of them concern liability to T)
Relevant re: management are UPA 18(a), (e), (g), (h), 19, 20; RUPA 401
UPA: ordinary business decisions by majority of partners; matters in contravention of
agreement to be decided by unanimous vote. Extraordinary matters interpreted to require
unanimity too.

Absent an agreement to the contrary, partners in a partnership have equal rights to

participate in the management of the business.
The default rule is that if there is a vote taken on specific matters, each partner has one
vote and the majority decision controls in the absence of an agreement to the contrary.

22

The partnership agreement may create classes of partners with different voting and
financial rights.
Partners have apparent and actual authority to bind the partnership to obligations
relating to the business of the partnership. Thus, a partner may bind the partnership on
obligations he or she was not authorized to create.

Effect of majority vote presumption

Hypo: A contributes 90% of the capital, gets 90% of the profits, is responsible for 90% of the
losses. B and C each contribute 5% of the capital, are entitled to 5% of the profits and are
responsible for 5% of the losses. Agreement is silent on how decisions will be made. If A
votes one way and B and C vote another on an ordinary partnership matter, who prevails?
Issues raised by UPA/RUPA presumptions

1) Is the majority vote approach a desirable one why make that assumption for matters
in the ordinary course?

2) what do you do about any of this when you have a 2 person partnership? and

3) What are ordinary business decisions of the partnership?

Effect of course of dealing on UPA 18(h) assumption

What should control when you have a course of dealing where in fact one partner really
acts as the managing partner?

What should it take to demonstrate such an implicit understanding?

Summers v. Dooley: garbage case
Facts. Plaintiff and Defendant agreed to operate a trash-collecting business. They decided to
perform the work themselves, and if either was unable to perform then that partner was responsible
for paying a third party to work on his behalf. Plaintiff was unable to perform his duties and
suggested that the business hire an employee. Defendant objected but Plaintiff hired another
person anyway, personally costing Plaintiff $11,000. Plaintiff wanted to be reimbursed for half of the
costs.
Issue. The issue is whether the partnership should be held responsible for the costs of the
employee hired by Plaintiff over the objections of Defendant.
Held. The Plaintiff should not be compensated by the partnership for the cost of the additional
employee. The additional employee was brought on for the personal benefit of Plaintiff and not the
partnership. Defendant repeatedly rejected the hiring. A decision to change the status quo would
also require a majority approval, and Plaintiffs one vote did not constitute a majority.
Discussion. The facts are very similar to National Biscuit Company v. Stroud with a different result.
However, in this case the partners decision was for his own benefit, and the decision was contrary
to the status quo.

Is Summers right?

Usually taught as a bookend with National biscuit v. Stroud (bread case)

Facts. Stroud and Freeman decided to dissolve their business February 25, 1956. Several months
prior to February 25, Stroud informed Plaintiff that he was not going to be held liable for any
deliveries made by Plaintiff. Plaintiff still made deliveries to the business through Freemans

23

consent. After the business dissolved, Stroud agreed to liquidate the business assets and
discharge the debts, and Stroud ended up losing his own personal money in the process. Stroud
disputed the money owed to Plaintiff because he specifically requested that Plaintiff not make any
deliveries or else he would not be liable.
Issue. The issue is whether Stroud can be held liable for the deliveries that Freeman consented to
but Stroud declined.
Held. Stroud can be held liable for the deliveries. Partners are jointly and severally liable for the
actions of the partnership. Freemans conduct in allowing the deliveries was within the scope of the
business and he has a right to make these decisions unless a majority of the partners vote to deny
him of these rights. Since Stroud is only one half of the partnership, and not a majority, he is unable
to prevent Freeman from exercising his rights.

How to reconcile Summers and National Biscuit?

Beyond UPA 18(h): Should failure to agree lead to finding of fiduciary breach

Sanchez v. Saylor
Facts: Sanchez and Saylor were partners. A third party was considering lending money to the
partnership under the condition that Sanchez provided a personal financial statement. Sanchez
refused. Saylor sued him on the ground that Sanchezs refusal to provide his financial statement
was a violation of his fiduciary duty.
Holding: Business differences must be decided by a majority, not by one of two equal partners
when the other objects. If the two partners cannot agree and do not want to continue their
partnership, the remedy is dissolution.
Reasoning: All partners have equal rights in the management and conduct of the business of the
partnership
Neither partner has the right to impose his will or decision concerning the operation of the
partnership business upon the other
Voting in UPA vs. RUPA (p. 77)

UPA 18(h): Majority vote for ordinary matters connected with the partnership &
unanimity for acts in contravention of any agreement

RUPA 401(j): Majority vote for matters in the ordinary course of business, but
unanimity for acts outside the ordinary course of business and an amendment to the
partnership agreement.

Changes in the way the partnership is actually conducted may constitute amendments to
the PP agreement

Management - equal participation

UPA 18(e): All partners have equal rights in the management and conduct of the PP
business. (note: same under RUPA, 401(f))

What does this mean?

Continuing right to participate in the management of the PP and to be informed
about the PP business, even if that partners assent is not required for the PP to act.
PP management majority rule

18(h): Any difference arising as to ordinary matters connected with the PP business
may be decided by a majority of the PP; but no act in contravention of any agreement
between the Ps may be done rightfully w/o the consent of all the Ps. (note: see RUPA

24

401(j) makes clear that unanimity is required when act outside the ordinary course of
business or an amendment to the PP agreement).
What does UPA 18(e) add to 18(h)?

Governing law

UPA = no choice of law provision

RUPA 106 = internal affairs of general partnership are governed by law of state in
which the PP has its chief executive office.
Indemnification and contribution
Partners are individually liable to partnership creditors for partnership obligations.
Between partners, each partner is only liable for his share of partnership obligations. Thus if one
partner pays in full, he is entitled to indemnification from the partnership for the difference between
his share of the obligation and the amount he paid.
Indemnification of the partner is a partnership liability (when a partner pays in full the debt of the
partnership to a third party).
Contribution is a partners liability toward the partnership for example to pay partnership creditors
and equalize capital losses.
PP Money issues sharing of profits and loss

Partners capital account = Ps contribution, minus liabilities, plus his/her share of the
profits of the partnership

At termination of solvent PP, P gets his/her contribution and equal share of the profit
after all liabilities are satisfied, including those to Ps, unless otherwise agreed. UPA 18(a)

RUPA 401(b): same approach

How are losses shared?

In the same way as profits.

So, if agreement says profits to be shared 20/30/40, then losses follow the same
breakdown.

If no agreement, UPA 18(a) controls, and losses follow profits.

Same w/ RUPA 401(b)

UPA hard case: services only partner

Hypo: Fred and Ginger form PP to run dancing school. No PP agreement. Ginger
contributes $250,000 and does not work in the business. Fred works there full time, but
gets no salary and contributes no capital. The partnership ends after a year, having lost
$250,000. After bills are paid, nothing left over for the partners to share. What happens
under 18(a)? Fred has to pay to Ginger 125.000 USD.
UPA 18(a) in services-only P situations

Is the result fair when the services-only partner is not compensated?

What if s/he is compensated?

What is a common judicial resolution (not mandated by the UPA)?

Assessing value of contributions

How do the statutes value Ps initial contribution, assuming it has greatly increased in
value?
Compensation: The draw (= dividends = cash distribution to the partners)

How is the draw decided? Majority

25

Does it have to be of all profits? No

Where does it come from? May be more or less than the profit.

Compensation UPA (18f); RUPA 401(h)

No partner acting in the PP business (except surviving partner) is entitled to

compensation.

Why? Why exempt surviving partner?

How about compensation by court order?

Sect. 3: Authority & Liability for PP Obligations:
UPA 3(1), 4(3), 9, 13, 14,15;
(F)RUPA (620.8)301, 303, 304, 305, 306

UPA 9(1) = every partner is an agent of the partnership for the purpose of its business
and can bind the partnership by any act for apparently carrying on in the usual way the
business of the partnership unless the P has no authority and T has knowledge of the fact
that P has no such authority.
RUPA 301

Each partner is an agent of the partnership for the purpose of its business. An act of a
partner, incl. the exec. of an instrument in the PP name, for apparently carrying on in the
ordinary course the partnership business or business of the kind carried on by the PP binds
the PP, unless the P had no authority to act for the PP in the particular matter and the
person with whom the P was dealing knew or had received notification that the P lacked
authority.
Authority of partners
Exceptions UPA: 1) Unless the other party has knowledge of the fact that he has no authority to so
act. (knowledge = actual knowledge or knowledge of such other facts as in the circumstances
shows bad faith) in the 2) UPA 9(3) sets forth the sorts of things that less than all the partners
have no authority to do.

Exceptions RUPA: T had notice (=actually knew or had received notification) that P
lacked authority. 2) No list like UPA 9(3).
UPA vs. RUPA on knowledge

Hypo: Partner enters into a huge deal with a third party. Hes really shifty, tells the third
party not to say anything about it to the other partners because theyre jealous of him and he
wants to surprise them, drinks constantly and is grandiose [add other suspicious
circumstances as you wish.] Different result under UPA and RUPA? See Comment.
RNR Investments Limited Partnership v. Peoples First Community Bank
Facts : RNR Investments Limited Partnership (RNR) (defendant) was created to purchase and
develop a parcel of land. RNRs written partnership agreement restricted general partner Bernard
Roegers capacity to commit the partnership to expenses beyond what was approved in the budget.
Specifically, Roeger was prohibited from exceeding the budget by more than ten percent for any line
item, without the prior written consent of the limited partners. Roeger obtained the oral approval of
the limited partners to seek $650,000 in financing for construction. Without consulting the limited
partners, Roeger entered into a construction loan agreement and mortgage with Peoples First
Community Bank (Bank) (plaintiff) in the amount of $990,000. Bank had no knowledge of the

26

partnership agreements restrictions. RNR defaulted on the loan, and Bank sued RNR in
foreclosure. The trial court granted summary judgment to Bank, rejecting RNRs arguments that
Bank had a duty to discover the limitations on Roegers authority.
Issue: Is a partnership bound by the unauthorized acts of a partner when the third party neither
knew nor should have known of the restrictions on the partners authority?
Holding:Yes. Under the Revised Uniform Partnership Act, a general partners authority to act on
behalf of the partnership in the ordinary course of partnership business is established,
notwithstanding any limitation on the general partners actual authority, if a third party did not know
or have reason to know that the general partner in fact lacked authority to bind the partnership.
Rules: -A general partners authority to act on behalf of the partnership in the ordinary course of
partnership business is established, notwithstanding any limitation on the general partners actual
authority, if a third party did not know or have reason to know that the general partner in fact lacked
authority to bind the partnership.
-Each partner is an agent of the partnership for the purpose of its business.
-An act of a partner, including the execution of an instrument in the partnership name, for apparently
carrying on in the ordinary scope of partnership business or business of the kind carried on by the
partnership, in the geographic area in which the partnership operates, binds the partnership unless
the partner had no authority to act for the partnership in the particular manner and the person with
whom the partner was dealing knew or had received notification that the partner lacked authority.
-Thus, even if a general partner's actual authority is restricted by the terms of the partnership
agreement, the general partner possesses the apparent authority to bind the partnership in the
ordinary course of partnership business or in the business of the kind carried on by the partnership,
unless the third party knew or had received a notification that the partner lacked authority.
Analysis: Although a third party has no duty to inspect the partnership agreement to detect any
limitations on a general partners authority, the partnership may file a statement of partnership
authority to restrict a partners authority (because it is real estate).
Partnership authority
RNR Investments v. Peoples First Community Bank (p. 85):
Attempt by partners to limit authority
Why unsuccessful?
What does knowledge mean under FRUPA?
Why protect bank sophisticated plaintiff that could have asked to see partnership
agreement?
See RUPA 301 and 303
Does filing a limitation of authority operate as constructive knowledge of a partners lack
of authority with respect to non-real property transactions? It has to be filed and
delivered to the third part to limit the partners authority(will not be effective until the third
party knows of the limitation) except in real estate it has to be filed in the real-property
recording office.
Northmon v. Milford Plaza:
Facts: Milford Plaza Associates (Milford) (plaintiff) and Northmon Investment Company (Northmon)
(defendant) were partners in a partnership which owned a parcel of real property and no other
assets. Milford sought to commit the partnership to a 99-year lease of the property. Northmon
objected but Milford was intent on proceeding. The partnership agreement set a partnership
termination date of 2075, years before the proposed 99-year lease would end. Northmon sued

27

Milford to block Milford from entering into the lease, arguing that Milford lacked the authority to do
so. The trial court found Northmons favor, and Milford appealed.

why impose liability when you could say the deal was in the ordinary course of business?
Remember the dispute here is between partners

What is apparently in the usual course?

UPA 9 and RUPA 301
The basic default rule governing a partners actual authority under the UPA is that each partner is
an agent of the partnership for the purpose of business.
However, under the UPA, a partner has authority to bind the partnership by an act for apparently
carrying on in the usual way of the business of the partnership of which he is a member.
Ambigous: is it the usual way the partners firm carries on its business or the way other firms in the
same locality engaged in the same general line of business?
Sect.4: Liability of nominal partners:
Davis v. Loftus: income vs. equity partners in law firm
Facts:- The client retained the attorneys to represent him in a large real estate transaction.
-The party with whom he participated in a joint venture never paid the client the amounts due, and,
allegedly because of the attorneys' mistakes in drafting the joint venture documents, there was
some doubt as to whether the client would ever be able to collect the amounts.
-The client sued the attorneys, their firm, and every lawyer in it for malpractice and breach of
contract.
Holding:The income partners did not qualify as partners. They had no rights to vote on
management or conduct in business. Plus, their wages were set.
Analysis: Since those lawyers who were designated as income partners were paid flat salaries and
had no role in managing the law firm, they were not liable for any judgment that might be entered
against the partnership.
-In the case of several partners who claimed income partner status, however, the record was
inadequate to determine whether that was in fact their status.
Partners authority re: atypical business (this business or this kind of business?)
UPA not clear, but RUPA is. In some jurisdictions, significant difference
RUPA 301 focuses on the act of a partner for apparently carrying on in the ordinary
course of the partnerships business or business of the kind carried on by the
partnership [emphasis supplied].
Does not focus on this particular PPs operation
Is the apparent rule change pro- or anti-third party?
Joint vs. joint and several liability: UPA vs. RUPA
UPA 15(a): partners are jointly and severally liable for wrongful acts and omissions of
the partnership such as torts, and breaches of trust. (joint liability for contracts and no
entity to sue)
Partners are only jointly liable for all other debts and obligations of the partnership. If
one partner not joined in 15(b) contact case, whole action against all the others could
be dismissed as a result.

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RUPA 305-307: PP can sue and be sued as an entity. Partner liability is joint and
several, but creditors must exhaust partnership assets first before going after partners
personal assets (different from traditional joint and several liability model).

Sect.5: Partnership interests and partnership property

PP property: UPA 8, 18, 24, 25, 26, 17, 28
Distinguishing partnership = important re: 1) is the gain or loss on disposition of the
property, or income from it, to be shared by the partners?; 2) who gets it on dissolution of the
firm or death or withdrawal of a partner?; 3) who may convey or devise it?; 4) are
partnership or individual creditors entitled to priority against it in satisfying their claims?.
UPA 8
8(1): All property originally brought into the PP stock or subsequently acquired by purchase
or otherwise, on account of the PP, is PP property.
8(2): Unless contrary intention appears, property acquired with PP funds is PP property.
RUPA 203 & 204
203: Property acquired by a PP is property of the PP and not property of the Ps
individually.
204: Property is PP prop. if acquired in the name of the PP. It is presumed to be PP prop.
if purchased w/ PP assets, even if not acquired in the PP name. If prop. Is acquired in the
name of a P w/o use of PP assets and indication of transfer to PP is presumed to be
separate property, even if used for PP purposes.
Interpretation: Intent of the parties
Intent of the parties key under both UPA and RUPA.
Who owns PP property?
UPA 24-26
What partners really own: partnership interest
PP property under RUPA
Sec. 501states: A partner is not a co-owner of partnership property and has no interest in
partnership property which can be transferred, either voluntarily or involuntarily. This
abolishes the UPA 25(1) concept of tenants in partnership and reflects the adoption of the
entity theory.
Section 502 states: The only transferable interest of a partner in the partnership is the
partners interest in distributions. The interest is personal property.
Adding partners
UPA 18(g) and RUPA 401(i) unanimity required
- Why?
Assignment of PP interest
Interpreting transfer of interest as limited: Rapaport v. 55 Perry Co.
Facts: The Rapaports (plaintiffs) joined with the Parnes (defendants) to form a partnership.
Paragraph 12 of the partnership agreement states that partners do not have authority to assign or
sell partnership property, or to enter into an agreement that grants another person an interest in the
firm without the written consent of a majority of the partners. Immediate family members of partners,
however, could be granted an interest without consent. Paragraph 15 provides that when a partner

29

dies, her heir steps into her shoes and is granted the same rights and obligations that the partner
had. Without consulting other partners, Simon and Genia Rapoport assigned 10 percent of their
partnership share to their two adult children and attempted to make them partners. The Parnes
objected. The Rapoports sued the Parnes seeking a declaratory judgment that the partnership
agreement permitted them to unilaterally add their adult children as full partners. Both sides moved
for summary judgment. The trial court denied both motions.
Holding: On appeal, the court held that the agreement was not ambiguous, and that, pursuant to
the terms of the agreement and of the Partnership Law, consent of the other partners was required
in order to admit the others to the partnership.
Analysis : The court stated that a reading of the agreement indicated that the parties intended to
observe the differences between assignees of a partnership interest and the admission into the
partnership itself of new partners.
-The court held that N.Y. Partnership Law 40(7) provided that no person could become a member
of a partnership without the consent of all the partners, that the partnership agreement was
intended to limit a partner with respect to his right to assign a partnership interest, and that plaintiffs'
children had interests as assignees.
Rules: An assignee of an interest in the partnership is not entitled to interfere in
management/administration of partnership, but is merely entitled to receive the profits to which the
assigning partner would otherwise be entitled. No management rights wome with the assignment of
interests.
Property Rights of Partner:
(a) His rights in specific partnership property,
(b) his interest in the partnership, and
(c) his rights to participate in management.
-An assignee is excluded in the absence of an agreement from interfering in the arrangement of
the partnership and access to the partnership books and information re: transactions.
-A person can NOT become member of partnership without consent of ALL partners.
-An assignment of a partnership interest may be made w/o consent but assignee is only entitled to
receive the profits of the assigning partner.
See also RUPA 502, 503
Bauer v. Blomfield: What duties do partners have to assignees?
Facts: Bauer, assignee of a partnership interest, sued the partnership and the individual partners,
claiming that partnership profits were wrongfully withheld from him.
Bauer loaned 800.000 $ to the Holden. To secure the loan, the Holdens assigned to Bauer all of
their right, title and interest in a partnership (Blomfield Company/Holden Joint Venture). The other
members consented to the assignment. For a time, Bauer received the monthly share of
partnership income to which the Holdens would have been entitled. However, the partners soon
ceased making income distributions, deciding instead to use income to pay a commission of
877.000$ to Chuck Blomfield. The fee arose from a unanimous agreement of the partners that
predated the Holdens assignment. Bauer sued the partnership and all the partners except the
Holdens, claiming that his right to partnership income had been violated. The trial court granted
summary judgment in favor of all the defendants, and Bauer appealed.
Reasoning: The assignment of rights does not make the assignee a member of the partnership.
Therefore, he is not entitled to complain about a decision made with the consent of all the partners.
He cannot interfere in the management or administrationof the partnership business or affairs or
require any information or account of partnership transactions or to inspect the partnership books.

30

He is only entitled to receive the profitd the Holdens would have received. He was due nothing
because no profits were distributed.
(Dissent: the court should have relied on good faith: did the partners owe a duty of good faith and
fair dealing to assignees of a partners interest? Whether the decision to pay the commission in lieu
of making a distribution was made in good faith?).
Tha majority did not want to give a second guess to the management decision bBut according to
UPA, an assignee has the right to petition a court for dissolution of the partnership (but in this case
because of an error while copying the UPA, the Alaska partnership act does not permit the assignee
to ask for dissolution).
Partnership is very personal
When a creditor cannot protect his interest, a fiduciary duty is imposed on partners.
The assignee can in lastrestort terminate the partnership asking the court to disolute the
partnership.
Property that is used by partnership may be either partnership property or property of a partner that
is loaned by the partner to the partnership. It is important:
for purposes of determining who has the power to transfer the property.
if creditors of the partnership are competing with creditors of an individual partner.
If the partnership is dissolved.
UPA8 recognizes the concept of partnership property and explicitly permits real property to be
held in the partnerships name.
But all the incindents of ownership are vested in the partnership so that the tenancy in partnership
rule of the UPA has no real-world significance: for ex: when a partner dies his right in specific
property does not devolve on his heirs or legatees
RUPA203 provides that property acquired by a partnership is property of the partnership and not
the partners individually.
The partners interest in the partnership: The partnership owns the partnership property and the
partner owns her interest in the partnership.
Assignment: A partnership interest is assignable, but a partner cannot assign her partnership
interest in a way that would substitute the transferee as a partner because there is a rule than no
person can become a partner without the consent of all partners.
It is a transfer to secure a debt that the partner-assignor owes to the creditor-assignee. The
assignee does not become a partner. But as long as the partnership continues its existence, the
assignee does have a right to receive the distributions to which the assigning partner would have
otherwise be entitled and on dissolution the assignee has the right to receive the assigning
partners financial interest.
Partnership creditor: A partners separate creditor is in a position somewhat comparable to the
assignee of a partnership interest. Under UPA 28; RUPA 504, if such a creditor obtains a
judgment, he can get a charging order on the partners partnership interest. It gives the creditor the
right to be paid the partnership distributions to which the partner-debtor would otherwise be entitled.
The creditor can foreclose on the partnership interes and cause its sale.
Assignment of PP interest
Interpreting transfer of interest as limited: Rapaport v. 55 Perry Co.

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See also RUPA 502, 503

Bauer v. Blomfield: What duties do partners have to assignees?
Individual P creditors and the charging order procedure: UPA 28; RUPA 504

SECTION 6 : FIDUCIARY DUTY DUTY OF LOYALTY

PP Duty of loyalty UPA and caselaw

Duty of loyalty among partners come out of common law and different cases not from
statutes.
No clear specific rule in UPA but the courts read it as a genral provision for this duty as
implicit. Key source: caselaw.
Meinhard v. Salmon: classic statement of fiduciary duty of partners/joint venturers
Broad, hortatory language: behavior must go beyond the morals of the marketplace and
display a punctilio of an honor the most sensitive. But what does it really require?

Meinhard v. Salmon
Facts: Salmon (defendant) executed a 20-year lease (Bristol Lease) for the Bristol Hotel which he
intended to convert into a retail building. Concurrent with his execution of the Bristol Lease, Salmon
formed a joint venture with Meinhard (plaintiff). The joint ventures terms provided that Meinhard
would pay Salmon half the amount required to manage and operate the property, and Salmon
would pay Meinhard 40 percent of the net profits for the first five years, and 50 percent thereafter.
Both parties agreed to bear any losses equally. The joint venture lost money during the early years,
but eventually became very profitable.
During the course of the Bristol Lease another lessor(Elbridge) acquired rights to it. The new lessor,
who also owned tracts of nearby property, wanted to lease all of that land to someone who would
raze the existing buildings and construct new ones. When the Bristol Lease had four months
remaining, the new lessor approached Salmon about the plan. Salmon executed a 20-year lease
(Midpoint Lease) for all of new lessors property through Salmons company, the Midpoint Realty
Company. Salmon did not inform Meinhard about the transaction. Approximately one month after
the Midpoint Lease was executed, Meinhard found out about Salmons Midpoint Lease, and
demanded that it be held in trust as an asset of the joint venture. Salmon refused, and Meinhard
filed suit. The referee entered judgment for Meinhard, giving Meinhard a 25 percent interest in the
Midpoint Lease. On appeal, the appellate division affirmed, and upped Meinhards interest in the
Midpoint Lease to 50%.
Issue : When a partner appropriates the benefit of the partnership without making any disclosure to
the other partner, will that act be a breach of loyalty?
Holding : Yes.Joint adventurers owe to one another the duty of the finest loyalty, while the
enterprise continues.The cort required Salmon to give to Meinhard the ability to compete by
dislaiming the opportunity. If he had revealed this fact to Gerry, Gerry would have laid before both of
them his plans of a new lease.
Salmon because ofh his position as a manager was the oe with opprotunity to know about it, he had
to disclaim it.
Joint adventurers, like copartners, owe to one another, while the enterprise continues, the duty of
the finest loyalty.
A trustee is held to something stricter than the morals of the market place.

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Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of
behavior.
Uncompromising rigidity has been the attitude of courts of equity when petitioned to undermine the
rule of undivided loyalty
There was no general partnership, merely a joint venture for a limited object, to end at a fixed
time.
The new lease, covering additional property, containing many new and unusual terms and
conditions, with a possible duration of 80 years, was more nearly the purchase of the reversion than
the ordinary renewal with which the authorities are concerned.
Conclusion: Partners in a joint venture owe each other fiduciary duties, including the duty to
present new opportunities to their partners should they arise during the course of the partnership.
Dissent. The issue here is whether the transaction was unfair and inequitable. There was no
general partnership, merely a joint venture for a limited object, to end at a fixed time. The design
was to exploit a particular lease. The interest terminated when the joint adventure terminated.
This case became the case in all fiduciary contract.
PP duty of loyalty contd
From Latta v. Kilbourn 19th C.
Broader conception of duty of loyalty.
One partner cannot directly or indirectly use partnerhip assets for his own benefit, carry on another
business in competition...
To Enea v. Superior Court RUPA
Enea (plaintiff) sued William and Claudia Daniels (defendants), his former partners, for breaching
their fiduciary duties by renting the partnerships sole asset, an office building, to themselves at less
than fair market value. The trial court granted the Daniels motion for summary judgment. The trial
court found that California law authorized such conduct, that the Daniels had no duty to collect fair
market value rent in the absence of a contract requiring them to do so, and that the primary purpose
of the partnership was to hold the property for later sale as opposed to collecting market value rent.
-The court held that the trial court erred in granting the real parties' motion for summary adjudication
because they were not categorically entitled to lease partnership property at less than it could yield
in the open market.
Issue: Are Ds able to lease partnership property to selves or anyone else at less than fair market
value?
Holding : NO. The partnership is a fiduciary relationship, and partners may not take advantages for
themselves at the expense of the partnership.
-The cost to the partnership was the additional rent rendered unavailable for collection from an
independent tenant willing to pay the propertys full value.
Reasoning : -The court rejected the real parties' argument that Corp. Code, 16404, provided the
exclusive statement of a partner's obligation to the partnership and to other partners.
-In adopting the Revised Uniform Partnership Act, the California legislature left the articulation of the
duty of loyalty to traditional common law processes.
-Further, even if the statutory enumeration of duties were exclusive, it would not entitle the real
parties to rent partnership property to themselves at below-market rates. Section 16404, subd. (e),
did not empower the real parties to occupy partnership property for their own exclusive benefit at

33

partnership expense, in effect converting partnership assets to their own and appropriating the
value it would otherwise have realized as distributable profits.

Californias RUPA statute

RUPA 404 Fiduciary duty

Major changes attempt to narrow scope of fiduciary duty
Approval of partner self-interest: A partner does not violate a duty or obligation under this Act
or under the partnership agreement merely because the partners conduct furthers the
partners own interests.
Narrow interpretation: evidentiary rule, the fact alone is not sufficient.
Broad interpretation: the only limit is section 404(b) duty of loyalty, not to violate obligation of
good faith and fair dealing.
The only fiduciary duties a P owes to the PP and the other Ps are the duty of loyalty and the
duty of care set forth in subsections (b) and (c)..Read details carefully.
Controversial provision critiqued by all sides!
See Californias reservation to the uniform law (Enea)!
RUPA on Fiduciary Duty
Section 403: Partners rights and duties with respect to information (access to books,
records and information)
Section 404: General standards of partners conduct
(a): the only fiduciary duties a partner owes are the duty of loyalty and the duty of care
set forth in subsections (b) and (c).
(b): duty of loyalty is limited to: (1) account to the PP and hold in trust any property, profit
or benefit derived by the P in the conduct and winding up of PP; (2) to refrain from
dealing with the PP as or on behalf of a party having an interest adverse to the PP; (3) to
refrain from competing with the PP before dissolution.
(c): Ps duty of care is limited to refraining from engaging in grossly negligent or reckless
conduct, intentional misconduct, or a knowing violation of law.
(d): P shall exercise any rights consistently with the obligation of good faith and fair
dealing
(e): A P does not violate a duty or obligation merely because the partners conduct
furthers the partners own interest.
(f): A P may lend money to and transact other business with the PP and the Ps rights
and obligations are the same as those of a person who isnt a P
RUPA on fiduciary duty
How do these provisions compare with fiduciary duty under agency law? Under the
Meinhard v. Salmon description of duty of loyalty?
Section 103 Non-waivable provisions
PP agreement may not:
unreasonably restrict access to books and records under 403(b)
eliminate the duty of loyalty under section 404(b) or 603(b)(3), but
The PP agreement may identify specific types or categories of activities that do not violate
the duty of loyalty, if not manifestly unreasonable
All the partners or a % specified in the PP agreement may authorize or ratify, after full
disclosure, a specific act or transaction that otherwise would violate the duty of loyalty
Unreasonably reduce the duty of care under section 404(c) or 603(b)(3)
Limits on inter se agreements under RUPA

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No agreement can totally remove fiduciary duties partners owe to one another.
The more fundamental the waiver provision, the more scrutiny.
For example, very strict
judicial scrutiny of agreed-upon restrictions on partners right to information.
Probably partners have non-delegable right to consent to fundamental changes in the
agreement.
Right to withdraw at any time (even if wrongful).
Apparent authority provisions as protections for third parties.
RUPA: Sets out non-waivable provisions in section 103. Corresponding rights and liabilities
under section 405

Section 7. THE END OF THE PARTNERSHIP: DISSOLUTION

The end of the partnership
UPA provisions re: dissolution
Dissolution, winding up, termination
RUPA provisions re: dissociation
Dissociation plus fork in the road: termination or buyout/continuation
DISSOLUTION UNDER THE UPA
Complicated provisions (due to aggregate theory in the statute)
Dissolution = term of art: "the change in the relation of the partners caused by any partner
ceasing to be associated in the carrying on of the business" (UPA 29).
E.g., mutual agreement, a unilateral act like retirement, or an unwilled act like death.
Dissolution is not the end of the partnership. Rather, start of the process of termination.
Post-dissolution possibilities under UPA
After dissolution, 2 possibilities:
winding up and
continuation
Businesses have:
Going concern value
Book value
Liquidation value
Goodwill = going concern value book value
Winding up under UPA
1) winding up (UPA 33-40 & 43) and actually terminating the partnerships business.
This includes: completion of transactions undertaken prior to dissolution, selling the assets,
paying the debts and settling the accounts among members.
If the business is wound up rather than continued, the partnership will be terminated after
winding up is complete, creditors paid and the remaining assets, if any, distributed to the
partners as their interests appear.
Continuation under UPA
2) the business of the partnership may be continued (by agreement or in circumstances laid
out in UPA 38(2), 41, 42 and 43.)
UPA dissolution categories:
The UPA sets forth four categories of dissolution in 31 and 32: dissolution by rightful
election under circumstances set forth in the statue; dissolution in contravention of the

35

agreement or wrongful dissolution; automatic dissolution not covered by those two

categories; and dissolution decreed by a court under enumerated circumstances.
Rightful dissolution:
Dissolution is rightfully and automatically caused when:

i. The definite term of a partnership for a definite term ends

ii. In a partnership at will (not for a definite term), whenever any partner elects to withdraw;
iii. When all the partners decide to dissolve (whether the partnership is at will or for a
definite term); and
iv. When a partner is expelled pursuant to the partnership agreement.

Wrongful dissolution:
UPA 31(2): Dissolution is wrongfully caused by the express will of any partner at any time
when it doesn't satisfy the conditions for rightful dissolution or when found by court decree.
Automatic dissolution UPA 31(3)
i. when it becomes unlawful for the business to be carried on;
ii. by death;
iii. by bankruptcy of any partner or the partnership; and
iv. by court decree.
Dissolution by court decree UPA 32:
i. a partner becomes incapable of performing his part of the partnership contract;
ii. a partner has been guilty of conduct "as tends to affect prejudicially the carrying on of the
business";
iii. a partner willfully or persistently commits a breach of the partnership agreement or otherwise so
conducts himself that it is not reasonably practicable to carry on the partnership business with him;
iv. the partnership business can only be carried on at a loss;
v. other circumstances render a dissolution equitable; and
vii. at the application of an assignee or creditor with a charging order either at termination of a
definite term partnership or at any time if it's an at-will partnership.
Dissolution by rightful election
Girard Bank: no good faith requirement
Facts: Anna Reid entered into a partnership with Haley and others to lease real property for profit.
Before dying, Mrs Reid sent a letter to the partners terminating the partnership.
Issue : Whether the letter or the death is termination.
If the termination is upon the letter : the partners had to wind-up or buy-out but did not have the
money. If the termination was death, the surviving partners had 10 years to pay Mrs Reids
interests.
The chancellor concluded that the partnership was terminated by Reids death, and the remaining
partners were entitled to the option to purchase Reids interests under the terms of the partnership
agreement.
The Court of Appeal decided the termination is upon the letter because it is an at-will partnership,
therfeor it can be terminated at any time without need of justification.
Distributions on dissolution
When rightful/automatic:
Cash or in kind? In cash requirement in the statute (possible collusion, difficulties of
valuation of the partnership).

36

Certain Courts have found the requirement unfair when there are no creditors.

Dreifuerst v. Dreifuerst
Facts :The Dreifuerst brothers formed a partnership for the purpose of operating two feed mills. The
partnership is not governed by a written partnership agreement. One of the brothers (plaintiffs)
brought an action for dissolution and wind-up of the partnership after serving the remaining brother
(defendant) with notice. The defendant asked the court to permit a sale pursuant to Uniform
Partnership Act (UPA) 38(1), at which the partners could bid on the property, thus allowing the
plaintiffs to continue running the business and the defendants partnership equity to be satisfied in
cash (obtaning a less property value). Dreifuerst (D) argued that he could obtain better fair share of
the assets in cash upon dissolution when could continue to run the business under a new
partnership The trial court denied the defendants request and instead divided the partnership
assets in kind, granting the physical assets of one of the feed mills to the plaintiffs, and the physical
assets of the other feed mill to the defendant in according valuation presented by Dreifuerst (P).
Defendant appeals the trial courts in-kind division of the partnerships assets.The Court of Appeal
reversed and remanded.
Reasoning : In this case, The Dreifurst (P) want to dissolve the partnership. This partnership at will
can rightfully dissolve by express will or without consent of any partner at any time. Here the
Dreifuerst (P) never claimed that Dreifuerst (D) has violated any partnership agreement, therefore
there is not exist a wrongful dissolution of the partnership. And the partners who has not wrongfully
dissolve a partnership has the right to wind up the partnership. This is a lawful dissolution that gives
each partner the right to liquidate his business and his share of surplus be paid by cash.
The Court held that the district court erred in ordering a in-kind distribution of the assets of the
partnership. That the sale is the best means of determining the true fair market value of the assets.
Therefore the Court reversed and remanded.
Definitely the term Disolution is the termination of the association through the completion of the
winding up process.
If cash, is public judicial sale necessary? (Note UPA vs. RUPA approaches)
Lot of cases interpreted the stature 38 as requiring a public judicial sale but then came cases like
creel v. Lily.
Creel v. Lilly
Facts : Joseph Creel (plaintiff), Arnold Lily (defendant), and Roy Altizer (defendant) formed a
partnership to operate a NASCAR memorabilia business called Joes Racing Collectibles. Joseph
Creel died in 1995. The partnership agreement did not provide for the continuation of the
partnership after a partners death. Upon death of a partner, the parnership was automatically
dissolved. The surviving partners were required to wind up. They conducted an inventory of the
business and hired an accountant to compute the business value. Anne Creel made no attempt to
calculate her own estimate. Lilly and Altizer then continued to operate the business under a new
name: Good Ole Boys Racing (defendant). Anne Creel sued Lilly, Altizer, and Good Ole Boys
Racing, requesting an accounting and a declaratory judgment that Lilly and Altizer were not
permitted to continue the partnership over her objections. The trial court found that Lilly and Altizer
were not required to liquidate the business assets but only to pay Creels estate the appropriate
percentage share of the business value. The intermediate appellate court affirmed.
Holding : Where the surviving partners have in good faith wound up the business and the
deceased partners estate is provided with an accurate accounting allowing for payment of a
proportionate share of business, then a forced sale of all partnerships assets is unwarranted.
The court accepted the buy-out at least because RUPA has been just adopted.
Disotell v. Stiltner

37

Same issue as Creel, the court came the same way.Alaska statutes does not compel liquidation and
forbids a buyout.
A buyout guaranteed Disostell a fair value for his partnership interest. Liquidation exposed Disostell
to the risk that no buyer would offer to pay a fair market value for the property.
McCormick v. Brevig
Facts: Joan McCormick (plaintiff) and Clark Brevig (defendant) were 50/50 partners in a ranching
partnership. Their relationship deteriorated over time, and it ultimately became impossible for them
to cooperate on business matters. McCormick sued Brevig, alleging he had taken partnership
property for his own use, and seeking an accounting. McCormick also requested an order
mandating the dissolution and winding up of the partnership business. The trial court ordered that
the partnership be dissolved and wound up. It determined McCormicks share in the partnership to
be worth $1,107,672, and ordered Brevig to pay McCormick that amount. Brevig tend to Mac
Cormick this amount for the purchase of her interest. McCormick refused to accept the payment
and appealed the order, arguing that the partnership assets must be sold and the proceeds
distributed.
Issue: After ordering dissolution, did the District Court err by failing to order liquidation of the
assets, and instead granting Clark the right to purchase Joans partnership?
Holding : Yes.
Reasoning : The Court found that the UPA requires liquidation of partnership assets and
distribution of the net surplus in cash to the partners upon dissolution. RUPA provides two separate
tracks, one applying to dissociation (buy-out) and the other to dissolution (winding up).
The District Court dissolved the partnership but reasoned that liquidation had a variety of meanings
and that a buy-out was an acceptable alternative to liquidation of the partnership assets through a
compelled sale. The SC of Montana decided that the common and plain meaning, however, is to
reduce assets to cash, pay creditors, and distribute to partners.
Hee because the partnerships dissolution is court ordered, the partnerships asstes necessarily
must be reduced to cash in order to satisfy the obligations of the partnership and distribute any net
surplus in cash to the remaining partners in accordance with their respective interests.
Schymanski v. Conventz
The general rule is that in the absence of an agreement to such effect, a partner contributing only
personal services is ordinarily not entitled to any share of partnership capital pursuant to
dissolution, nevertheless personal services may qualify as capital ccontributions to a partnership
where an express or implied agreement to such effect exists.
The court distinguish cases from a day-to-day basis contribution to cases when the skill and labor
of the partner are his contribution to the capital assets of the partnership.
Kovacik v. Reed
One partner contributes in money, the other in skill and labor. By their agreements to share equally
in profis, agreed that the calues of their contributions (the money and the labor) were likewise
equal.
If a services-only partner has been fully compensated for his service, he should be required to
contribute toward making up a capital loss. But if he has not been compensated for his services, the
partners should normally be deemed to have impliedly agreed that she need not contribute to a
capital partners capital loss.

38

Expulsion under UPA

Courts seem to promote expulsion usually for economic reasons. When the Partnership agreement
says that under special circumstances a partner shall be expelled.
Bona fide exercise of the provision is required.
Courts focuse on:
Is there an economic tension? If business flourishing financially, wont order expulsion
unless extreme circumstances.)
The expulsion of a partner without good cause prior to the end of the partnership term is ordinarily a
wrongful violation of the partnership agreement, and a wrongfully expelled partner ordinarily has a
right to have the partnership dissolved and liquidated.
A partnership agreement may lawfully provide that a partner can be expelled without cause upon a
designated vote of the remaining partners.
The expulsion must be bona fide.
Winston & Stawn v. Nosal
Facts: Nosal was expelled for a law firm after he requested information about actions of Fairchild a
manager partner and threat to sue if he does not obtain the documents. The partnership agreement
did not place a restriction upon the expulsion of a partner other than approval by the requisite
majority. The PA granted access to the books and records of the partnership.
Reasoning: a fiduciary relationship exists between partners and each partner is bound to exercise
the utmost good faith and honesty in all matters relating to the partnership business.
Nosal was expelled solely because he persisted in invoking rights belonging to him under the
partnership agreement and that the reasons advanced by the firm was pretextual.
Crutcher v. Smith
Facts: A partner failed to replace a 500$ bad check he gave to another partner and used 110$ of
partnership funds.
He was expelled by failing to fulfill his duties as partner
Holding: the Debtors alleged wrongful act against the partner were insufficient to trigger a
dissolution of the partnership.
Reasoning: The misuse of 110$ was technically a misconduct (sum at issue was minimal) and the
bad check was a personal wrongful act against another partner rather than an act against the
business.
When is dissolution rightful or wrongful?
Sometimes seen as hard question. Page v. Page. Drashner v. Sorensen.

Should agreement to pay debt be considered a term?

Page v. Page: Paying back was not considered to be a term
Drashner v. Sorense: Paying back a loan to the partnership is a term.
At will: the term was not a specific term but an accomplishment of an act, you can walk away with it
but it has to be in good faith.
Page v. Page
Under UPA a partnership may be dissolved by the express will of any partner when no definite term
or particular undertaking is specified.
Facts: Page P. (plaintiff ) and Page D. (defendant) entered into an oral partnership agreement to
run a linen supply business. Page P. and Page D. did not discuss a specific term for the partnership,
but agreed that the partnership should stay in existence long enough to make a profit and pay its
debts. The business was unprofitable for the first nine years, but then their fortunes turned when an
Air Force base opened nearby. In spite of the partnerships profitability, Page P. sought to dissolve

39

it. Defendant asserts that he and Plaintiff have run other businesses together and they always
stipulated that the partnership should continue until the parties could recoup the money they
invested. Defendant also believes that Plaintiff is using his superior financial position to push out
Defendant so Plaintiff can acquire the whole business and receive 100% of the profits.
The trial court found that the parties intention was that their partnership should last only until it was
profitable enough to pay all debts and operational expenses. Hence, the trial court ruled in favor of
Page D., holding that the partnership had a specific term and was not a partnership-at-will.
Issue : The issue is whether the partnership is for a term (in this case as long as it takes to recoup
their investments) or whether it is a partnership at will.
Holding : A partnership can be dissolved by the express will of any partner providing that the
partner making a good faith judgment.
Reasoning : Although factors may exist that would indicate that the parties meant to have a
partnership for a certain term, those factors did not exist in this case. Defendant Failed to prove any
facts from which an agreement to continue the partnership for a term may be implied.
Even though UPA provides that a partnership a twill may be dissolved by the express, this power
like any other power held by a fiduciary, must be exercised in godd faith. &Plaintiff could not
dissolve the partnership in order to enrich himself at the expense of the partnership.
Discussion: This case follows the Uniform Partnership Act which allows for a dissolution at will
unless stipulated in the agreement. This holding would seemingly be in contrast to the holding in
Collins v. Lewis. However, a partners obligation to operate in good faith overrides their freedom to
dissolve the partnership.
Partnership breakup under the UPA:
The first phase consists of an event (decided by one or more partners or by a court) that set the
termination in motion.
Under UPA: dissolution, a change in the relation of the partners caused by a partner ceasing to be
associating in the carry on of the business (change in the legal status). The business continues until
the termination of the winding up.
Second phase consists of the process of actually terminating the partnerships business (change in
the economic status).
Under UPA: it is reffered as the winding up.
Under RUPA: it launches the process of actually terminating the partnerships business.
The final phase = the completion of the winding-up referred as termination.
Consequences among the partners: under the UPA, partnership must sell its assets for cash and
distribute the proceeds of the sale among the partners. Under some cases, instead of a cash
payment, an in-kind distribution.
UPA 38(2)(b): if a partner wrongfully causes dissolution although the partnership is dissolved, the
remaining partners can continue the partnerships business. Must pay to the partner the value of his
partnership interest minus the good will and any damages caused by the wrongful dissolution.
Effect between the partnership and the third parties.
Under UPA because of the dissolution, the partnership that continues is a new partnership. The
contracts must be transferred.

40

RUPA adds the term dissociation: 602(a): continues the rule of the UPA that every partner has the
right to withdraw (dissociate) from the partnership at any time, rightfully or wrongfully, by express
will.
Consequences of Dissociation:
Under UPA: if the partnership status of one or more partners is terminated, the partnership is
dissolved but the remaining partners can continue the business as a new partnership.
Under RUPA: the dissociation of a partner does not necessarily cause dissolution.
Two forks : - winding up (under article 8). Under 801, only upon the occurrence of one
of the events listed under 801, the partnership is dissolved.
or mandatory buy-out (under article 7) if none of the occurrence in section 801 justifies
the dissociations.
Wrongful dissolver under UPA
Drashner v. Sorensen: loss of good will
Facts: C.H. Drashner (plaintiff), A.D. Sorenson (defendant), and Jacob Deis (defendant) formed a
partnership to operate a real estate, loan, and insurance business. Sorenson and Deis fronted
$7,500 to purchase the business from its original owner. The parties had no written partnership
agreement but orally agreed that the $7,500 would be repaid to Sorenson and Deis from
partnership earnings. They also agreed on percentages which each partner would receive in
commissions from their respective sales. Disagreements soon arose. Drashner neglected his
duties, and also requested additional cash distributions from the partnership, which Sorenson and
Deis refused to grant. In order to cash out his share of the partnership, Drashner sued Sorenson
and Deis, seeking an accounting and the dissolution of the partnership. At the time of filing,
Sorenson and Deis had only recouped $3,000 of their $7,500 loan. The trial court granted the
dissolution, but found that it was in contravention of the partnership agreement. The court further
found that Drashner was entitled to a distribution based only on the value of partnership property
and not including the good-will value of the business. Since the assets were valued at less than the
amount still owed to Sorenson and Deis, the court held that Drashner had no interest in the
business and was entitled to nothing at dissolution. Drashner appealed.
Facts: Drashner (plaintiff), Sorenson (defendant), and Jacob Deis (defendant 2) formed a
partnership to operate a real estate, loan, and insurance business. Sorenson and Deis fronted
$7,500 to purchase the business from its original owner. The parties had no written partnership
agreement but orally agreed that the $7,500 would be repaid to Sorenson and Deis from
partnership earnings. They also agreed on percentages which each partner would receive in
commissions from their respective sales. Disagreements soon arose. Drashner neglected his duties
(spending time at bars), and also requested additional cash distributions from the partnership,
which Sorenson and Deis refused to grant. In order to cash out his share of the partnership,
Drashner sued Sorenson and Deis, seeking an accounting and the dissolution of the partnership. At
the time of filing, Sorenson and Deis had only recouped $3,000 of their $7,500 loan.The trial court
granted the dissolution, but found that it was in contravention of the partnership agreement. The
court further found that Drashner was entitled to a distribution based only on the value of
partnership property and not including the good-will value of the business. Since the assets were
valued at less than the amount still owed to Sorenson and Deis, the court held that Drashner had
no interest in the business and was entitled to nothing at dissolution. Drashner appealed.
Holding: In affirming the judgment, the court held that the evidence supported the findings that
plaintiff spent most of his time in bars, had been convicted of reckless driving and jailed, and had
wrongfully caused the dissolution.

41

Reasoning:-The trial court did not err in placing a value on the partnership that was less than the
amounts remaining to be paid to defendants for their capital contribution, thus providing for no
distribution to plaintiff.
-While the pending real estate listings of the business represented going concern value, not good
will that was excludable from the valuation of the partnership per S.D. Codified Laws 49.0610(2)
(c), the trial court appropriately accounted for the value of these listings and then excluded some of
it on the assumption that many of these listings would follow the plaintiff to his new business.
Rules:-UPA allows in the avent of a wrongful dissolution, that the other partners may continue the
partnership if they pay the dissolving partner the value of his interest in the property.
-Damages from the wrongful dissolution minus any good will.
-Do not award good will to a wrongful dissolving partner.
Defendants got thriving (prospre) business for nothing, because court held it was for a term
What was the term?
Could this have been interpreted differently?
No goodwill rule: Draconian result for businesses whose value is principally good will
Is this a good rule?
Wrongfully withdrawing P when business continued under UPA
The continuing partners may continue to use the partnership property and need not pay the
withdrawing one the amount to which he is entitled until the end of the agreed-upon term
(assuming this is a partnership for a term). They have to post a bond to guarantee ultimate
payment to the withdrawing partner and to protect him from the claims of creditors for predissolution obligations. The partner does not get paid until the term arrives.
Liability of withdrawing partner under UPA
UPA 36(1): dissolution of itself does not discharge the existing liability of any partner.
What does? 36: an agreement to that effect between himself, the continuing partners and
creditors.
Easy or hard to infer? 36(2) - such an agreement may be inferred form the course of
dealing between the creditor having knowledge of the dissolution and the continuing
partners.
Post-dissolution power to bind under UPA
UPA 33, 34, 35
apparent authority may continue as to persons subsequently dealing with a partner who
previously knew of the partnership but do not know of its dissolution.
Note: that is not the case when the third party is dealing with the partner who is himself
bankrupt, because he is bound to know the status of the person with whom he deals.
best option to avoid huge post-dissolution liability = advertise dissolution in a newspaper
of general circulation in the locality or localities where the partnership operates.
Any undesirable practical effects of this?
DISSOCIATION UNDER RUPA
Events causing Ps dissociation: 601
Notice of express will to withdraw, agreed-to event, expulsion by agreement, unanimous
vote to expel under enumerated circumstances, P thats a PP is dissolved and winding
up, on application to court, insolvency, death
Wrongful dissociation: 602

42

Effect of Ps dissociation: 603

Dissociation under RUPA

RUPA change: dissolution to dissociation.
10 Events causing Ps dissociation: 601

Notice of express will to withdraw, agreed-to event, expulsion by agreement,

unanimous vote to expel under enumerated circumstances, P thats a PP is
dissolved and winding up, on application to court, insolvency, death
Dissociation is rightful unless it fits into wrongful category.

RUPA 602
602(a): P has power to dissociate at any time, rightly or wrongly, by express will.
602(b): Ps dissociation is only wrongful if its in breach of express provision of PP
agreement, or withdrawal/expulsion/bankruptcy during term
602 (c): Wrongfully dissociating P = liable for damages caused + cant wind up if
business terminated.
But UPA preclusion of goodwill is eliminated
Effect of Ps dissociation under RUPA
Section 603 provides the statutory road-map
Dissociation + Winding up Article 8 applies
Business continuation Article 7 applies
Note: continuation preference in the statute
Article 8: When PP business dissolved and wound up under RUPA
801: Events causing dissolution and winding up of PP business include
a partnership at will having notice of a partner's express will to withdraw,
the expiration of the term in a term partnership;
events agreed to as resulting in liquidation
judicial dissolutions.
Agreement to continue after dissociation under Article 8
After dissociation, the partners may agree to continue the partnership (if all the partners
waive the right to have the business wound up as indicated in 802(b).)
On continuation: Partners dissoc. when business not wound up/RUPA
Article 7: If the dissociation doesnt fit into the Section 801 winding up categories, then
section 701 requires a mandatory buyout of the withdrawing partner. Designed to
promote partnership stability
RUPA Buyout formula
701(b) buyout formula: Buyout price of a dissociated partners interest is the amount that would
have been distributable to him if, on the dissociation date, the assets of the partnership were sold at
a price equal to the greater of the liquidation value or the value based on a sale of the entire
business as a going concern, without the dissociated partner, and the partnership was wound up as
of that date.
Wrongfully dissociating partners under RUPA

43

no right to immediate payment for his or her interest unless s/he establishes that an earlier
payment wouldnt cause undue hardship to the business of the partnership. (section
701(h)). (under UPA, the wrongful dissolver has no right to good will RUPA changed that).
As noted, his/her partnership share is reduced by damages caused by wrongful dissociation.

Corales v. Corales (Exam)

Be careful not to assume that the buy out provision in RUPA will apply.
Under 701: buy-out but under 801(at-will): wind-up no buy-out option!
Agency power after dissociation under RUPA
RUPA deals with post-dissociation agency power differently depending on whether there is a
buyout or winding up.
Either way, RUPA seeks to cut off partners lingering agency power more quickly than under
UPA.

E.g., in a buyout situation:

RUPA imposes a reliance requirement on third parties;

deems third parties to have conclusive notice of a partner's dissociation ninety

days after filing of a statement of dissociation;

and limits a dissociating partner's agency power and personal liability to a

maximum period of two years following dissociation, regardless of a third party's notice
or reliance, even if no statement of dissociation is filed.
Even less in Florida -- look at FRUPA.

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III. CORPORATIONS
Sect.1: Corporate characteristics
Limited liability up to their contributions
Free transferability of stock
Continuity of existence (unless a shorter term is specified in the certificate of incorporation)
Centralized management (board of directors)
Entity status (can sue or be sued)
Centralization of management:
Shareholders:

No apparent authority

No strict fiduciary duty inter sese

No right to participate in profits (except dividends)

No right to participate in day-to-day operations

What consequences? All they own are negative rights: Wall Street walk (you
sell), vote.
Sect.2: Architecture of corporate law
State statutory law (enables corporations to be organized).
State judge-made law (states the level of care required for officers and directors, regulate
traditional conflicts of interests, ang gives content to remedial structures to protect SH rights
and resolve SH claims).
Federal law regulates certain traditional conflicts directly through rules on insider training
and regulates positional conflicts of interest indirectly (proxy voting system and flow of
information concerning management).
Private ordering
Sect.3: Which states law governs a corporations internal affairs?
The normal rule is: the state of incorporation
VantagePoint Venture Partners 1996 v. Examen, Inc.
Facts: Vantage Point Venture Partners 1996 (VantagePoint) (plaintiff) held 83 percent of the
preferred stock and no common stock in Examen, Inc. (Examen) (defendant). Examen was a
Delaware corporation with ties to California (did the majority of its business in Ca). Examen entered
into a merger agreement with another corporation (Reed Elsevier). VantagePoint opposed the
merger.
Under Delaware law, the merger would require the approval of Examens shareholders voting as a
single class (both common stock and preferred stocks holders), and VantagePoint would lack the
votes to block the merger.
If California law applied, the preferred shareholders would be entitled to a class vote; since
VantagePoint controlled the preferred shareholder class, it could defeat the merger. A California
statute ( 2115) purports to apply California law to foreign corporations if the corporation has
sufficient ties to California.
Examen filed suit in Delaware, seeking a declaratory judgment that Delaware law applied in spite of
2115 and that VantagePoint was not entitled to a class vote. The trial court in Delaware granted
Examens motion for judgment on the pleadings. VantagePoint appealed.
Issue: Does the DE Internal Affairs Doctrine or the CA rule apply?
Holding : The DE Supreme Court affirmed with the trial court that the DE Internal Affairs Doctrine
should apply. The issue about voting and mergers involves the relationship between a corporation

45

and its shareholders. Therefore it is an 'internal affair.

Reasoning : -Court states that the Internal Affairs Doctrine was designed to meet the
constitutionality of the Commerce Clause (prohibits States from regulating subjects that are in their
nature national, or admit only one uniform system : the internal affairs of a corporation are subjects
that require one uniform system of regulation). This made it so that the DE law was constitutional
while the CA law was not.
Friese v. Superior Court
About power
Facts: Robert Friese (plaintiff) is the trustee of the successor entity to Peregrine Systems, Inc.
(Peregrine), a Delaware corporation that was based in California. Friese alleges that a group of
former directors and managers (defendants) engaged in illegal insider trading in 1999 when they
sold stock knowing that Peregrines public statements had deliberately exaggerated the companys
profit margins. Californias securities laws ( 25402 and 25502.5) prohibit directors and other
insiders from trading in the state on information that is not publicly available. Another statute,
2116, codifies the internal affairs doctrine. Friese sued the defendants for violating 25502.5,
among other charges. The defendants moved to dismiss the insider trading charges, arguing that
2116 requires the court to apply Delaware law, which lacks a comparable insider trading ban. The
trial court granted the defendants motion to dismiss. Friese petitioned the appellate court for a writ
of mandate to set aside the trial courts ruling. The appellate court agreed to consider the matter.
Reasoning: Conflict of law: The local law of the ate of incorporation will be applied to determne the
existence and extent of a directors or officers liability to the corporation, its creditors and SH,
except where with respect to the particular issue somme other state has a more significant
relationship.
Public interests are much broader than protection of a corporaions SH. trading of public shares
affects more than internal corp: affects public (deterioration in confidence in market.)
Sect.4: Selecting a state of incorporation
Small corps (usually incorporate locally) vs. larger, publicly held corps (in Delaware)
Relevant concerns
Race to the bottom/race to the top: Delaware (friendly management- high quality Bar
specialized in corporate law) wants to attract coroporations because they will impose tax
upon them. To attract then by essentially becoming prostitutes
Race to the top: Market has information, if Delaware passes too many statutes too friendly
to management SH will not buy stock of the corportaions. Delawara has to find a perfect rule
of incorporation to balance both interests.
Race to the top and to the bottom are irrelevant today because he wants corporate law to
become completely federalized.
Sect.5: Organizing a corporation
DGCL 101, 102, 103, 106, 107, 108, 109
RMBCA 2.01, 2.02, 2.03, 2.05, 2.06
Form of minutes of organization meeting
Form of by-laws
Form of stock certificate
Procedure of incorporation:
- Articles of incorporation must be filed wuth the states (corporate name, purpose, powers,
duration)
- Issuance of the stock. However the power to issue stock is normally vested in the board, the
board in turn is normally elected by SH, but until stock is issued there are no SH.

46

Bylaws: May contain any lawful provision or the management of the corporation or the
regulation of its affairs that is not inconcistsent with the articles of incorporation. When there is a
conflict the articles of incorporation control.
Organizational meeting: Under the law of Delaware, the initial directors and be named in the
corporations certificate of incorporation.
In the states, the incorporators have the powers of directors until directors are elected and the
powers of SH until stock is issued.
After the initial directors are named, they will hold an organization meeting.

Sect.6: Basic modes of corp. finance

Equity:
- common stock (all shares have the same rights, privileges as other shares, normally
carries the right to vote in the election of the BD and dividends are paid at the discretion
of the BD), often reffered as residual ownership. Common SH are often thought as the
owners of the firm as the holders of the equity interest in the firm. Many states limit
convertibility and redeemability of common stock.
preferred stock (sort of a hybrid of debt and equity): two types of owners emerge. Typically,
preferred stock carries a dividend that is payable periodically. The corporation if decides to
distribute the dividends, must first pay the preferred stocks. Typically, preferred is given a
rght to vote on the election of the BD.

As an economic matter:
Has some functional attributes of debt
Preference over common in payment of dividends and in assets of corp. on liquidation.
Traditionally dont exercise control no voting rights
Often convertible
Virtually always cumulative

As a strategic matter:
Preferred shares issued with complex voting rights as part of anti-takeover devices
Debt
Corporate earnings
Usually combination of all three
Corporate planners described as chefs cooking a meal!
Vocabulary
Dividends
Liquidation rights
Conversion rights
Redemption rights
Sect.7: The seductive qualities of debt
Debt
Advantages of debt financing/leverage: In a world with taxation of corporate earnings in
which interest is a deductible business expense and dividends are not deductible, the value
of the firm is increased by the introduction of debt to its capital structure.
Tax shield of debt: corporations pay a tax on its profit and SH on the dividends. Many SH are
not taxable entities because they are charitable institutions. Small entities enjoy passthrough treatment so that business itself is only a reporting entity but not a tax payer.

47

Sect. 8: Equitable subordination of Shareholder

Equitable subordination: When a corporation is in bankruptcy, debt claims that a controlling SH has
against the corporation may be subordinated to the claims of other persons, including the claims of
preferred SH.
Gannett Co v. Larry
Gannett Co was in the newspaper-publishing business. Berwin paper was also in the business of
publishing a newspaper. To ensure a supplu of newsprint in view of a threatened shortage, Gannett
purchased all the stock of Berwin and converted Berwin from a publisher to a newsprint supplier.
Gannett lent substantial sums to Berwin. Berwin was operating at loss and became insolvent. The
Court subordinated the sums that Gannett ha sloaned to the claims of other creditors. The losses
suffered by Berwin were suffered not to make the subsidiary profitable but to turn it into a souce of
newsprint, of no interest to the other creditors, unless financially profitable.
Piercing: Denying to a SH his privileged of limited liability. The equitable remedy of subordination is
less dradtic.
Undercapitalization: Arnold formed a brewery company with capital stock of 50.000 $, paid for in
cash. He then lent the brewery 75000 so that it would have enough to start operations. The
brewery went into bankruptcy. A mortgage held by Arnold to secure his loans was held invalid on the
ground of inedaquate capitalization.
The two series of advance were treated differently: Those made before the enterprise was launched
were really capital. Although the charter provided for no more capital than $50,000, what it took to
build the plant and equip it was a permanent investment, in its nature capital. There was no security
asked or given. Arnold saw that he could not proceed with his enterprise unless he enlarged the
capital. There can be little doubt that what he contributed to the plant was actually intended to be
capital, notwithstanding the charter was not amended and demand notes were taken. The district
court was justified in concluding as a matter of fact that the advances during the first year were
capital, a sort of interest-bearing redeemable stock; and that as a matter of law these contributions
could not, as against corporate creditors, either precedent or subsequent, be turned into secured
debts by afterwards taking and recording a trust deed to secure them. There was no debt to be
secured.
Benjamin v. Diamond
3 conditions must be satisfied before exercise of the power of the equitable subordination is
appropriate:
the claimant (owner, director or officer of the bankrupt corporation) must have engage in some
type of inequitable conduct
the misconduct must have resulted in injury to the creditors or conferred an unfair advantage on
the claimant
equitable subordination must not be inconsistent with the provisions of Bankruptcy Act.
Sect.9: Requisite for a valid action by the board
A single director normally has no power to either act for the corporation or to cause the corporation
to act. Directors normally act as a body.
Organizing theme: SH/Board Power
Requisites for valid action by the board
DGCL 141(b), (f), (i), 229
RMBCA 8.20, 8.21, 8.22, 8.23, 8.24

48

Board action Governing rules

Meetings. Why require?
Notice: Not required for a regularly scheduled board meeting but required for a special
meeting nd must state the purpose of the meeting unless the certificate of incorporation or
the bylaws otherwise provide.
Quorum: Majority of the full board (not only those who attend the meeting!). Most statutes
permit the certificate of incorporation or bylaws to require a greater number. Dealaware
allows a lower number but usually no less than one third of the full board.
Voting: Affirmative vote of a majority of those present not simply a majority pf those voting is
required for action. Most statutes provide that the articles or bylaws can require a super
majority vote for board action.
Formalities of board action
Quorum usually majority of full board
What happens when theres no quorum? Usually renders the decision ineffective.
RMBCA vs. DGCL on voting
RMBCA 7.25 (c)
DGCL 216
Treatment of abstentions
Can be outcome-determinative
Fogel v. U.S. Energy
Facts: U.S. Energy is a publicly traded Delaware corporation. Fogel (Plaintiff) was hired to become
CEO and joined the BD.
At a June 14 meeting, the board scheduled another meeting for the morning of June 29 to hire a
financial advisor or restructuring officer. Before the meeting, the three independent directors agreed
to fire the CEO, the only other director on the board. They arrived at the designated time and place
and one of the directors announced the decision to the CEO. Thereafter, the CEO called for a
special meeting for the purpose of voting on the removal of the other directors and election of
replacements.
Issue : whether the CEO had been properly dismissed, thereby depriving him of the authority to call
the special meeting.
Holding : the Delaware Chancery Court decided that a confrontation between the CEO and
directors was not a meeting under section 141 of Delawares General Corporation Law.
Reasoning : The mere fact that directors are gathered together does not a meeting make. There
was no formal call, no vote so ever. Simply polling board members does not constitute a valid
meeting or effective corporate action. No free exchange of ideas. If a meeting occured it is void.
Before a corporation may held a special meeting of its board of directors, each director must
receive notice as prescribed by the bylaws. Where a director is tricked or deceived about the true
purpose of a board meeting, any action purportedly taken there is invalid and void.
Because the meeting of June 29 is void, it cannot be ratified by the July 1 resolution. Mr Fogel was
entitled to call for a special meeting.
Ignoring the fact that the meeting had been noticed and that all of the directors were present, the
court concluded that no meeting had occurred, rendering the dismissal ineffective.
Why wasnt the meeting in Fogel considered a meeting for purposes of the DGCL?
What kind (and extent) of notice is required?
o Why didnt the circumstances put Fogel on notice?
o What would the consequences be if Fogel had come out the other way?
What would Fogel have been able to do if he had adequate notice?

49

Delegation
Board committees: Boards of publicly held corporations often delegate significant authority
to comittees.
Note impact on SH voting rights
Board Committees
E.g.: audit, nominating, compensation committees

Arguments pro: specialization, expertise, reduced management influence

Federal law impact on structure:
SOX especially on audit committees

Principally re: independence and expertise

Sect.10: Requisites for valid action by shareholders
DGCL 211, 213, 214, 216, 222, 228
RMBCA 7.01, 7.02, 7.03-7.07, 7.21, 7.25-7.28
Shareholder action
Meetings
- Annual meeting is compulsory.
Action to court to call for the annual meeting
Election for board members.
Calling special meetings
Notice issues

Quorum: majority of the shares entitled to vote unless the certificate of incorporation sets
a higher or lower figure (not lower than 1/3)

Voting

Ordinary matters: majority of the shares represent (in person or by proxy), under some
statutes only the affirmative vote of a majority of those voting (an absentation counts as a
negative vote).

Cumulative voting
Sect.11: Election of directors
Special voting rules may apply in the election of directors
Staggered boards
Board that is divided in two or more classes, each of which is elected separately for staggered
terms. The rationale is to ensure continuity, came to be seen as a defense against takeover
because a multi-year process was required to oust an incumbent majority of directors.
Acting by executive committee
Permitting board vacancies to be filled by remaining board members
Cumulative voting
In straight vote, a SH can cast for each open directorship a number of votes equal to the number of
her shares.
In cumulative votes, the SH can distribute among her nominees in a way she pleases a
number of votes equal to the number of her shares time the number of directors to be
elected, so that minority SH can cumulate his/her votes and thereby elect director(s)
Goal: to permit minority SH representation on the board
Only applies to director elections
Formula for CV is tricky you need to make your voted count
CV was popular pre-1950s (even in some state constitutions); popularity reduced thereafter.

50

Legal mechanisms for shareholder voice:

1) structural control over the corporation

a) right to elect board of directors and right to vote on certain types of major
corporate action;

b) in order for the shareholders to be able to exercise their franchise, state law
provides for the inspection of corporate books and records;

c) with respect to many publicly held corporations, there is a system of disclosure

and monitoring by the SEC
2) litigation:

a) the right to wage a derivative action against management on behalf of the

corporation, or a direct action for harm to individual shs;

b) state law provides for the appraisal remedy;

c) state law fraud actions and federal securities regulations are designed to keep
the markets honest.

3) Wall Street walk (=sell)

What do the following do to the effectiveness of cumulative voting?
Staggered boards: An issue raised by CV is whether, when CV is required either by state law or by
a corporations certificate of incorporation, a corporation can have a staggered board. If a board is
classified, a minority must hold more stock to elect a single director than if a board of the same size
is unclassified, because the number of directors to be elected each year is only a fraction of the full
board.
Delaware: ebay Domestic Holdings Inc v. Newmark
Craig Newmark founded Craiglist and became the most popular classifieds website in the U.S.
3 shareholders together, Craig and Jim held 72% of Craiglists stock. The 3 SH was members of the
board.
Philipp sold his shares to ebay and one of ebay representative replaced Philip on the board.
Subsequently ebay launched its own online classifieds website. Craig and Jim made an agreement
allowing ebay to compete but unhappy Jim and Craig adopted several measures to keep Ebay out
of the boardroom and to limit its ability to buy shares. One of the amendment was the
implementation of a staggered board. The craiglist certificate of incorporation provided a cumulative
voting but was not meaningful if only one director was up for election each year. The staggered
board cut off ebays ability to place a director on the craiglist board.
The court held the amendment valid because Delaware law does not require that minority SH have
board representation. Delaware corporations have the express power to implement staggered
board and do not have to adopt cumulative voting for the benefit of minority stockholders.
What is the impact of the following on shareholder rights?
Plurality voting (= the nomine who receive the most votes is elected even if does not have
the majority): the director receives the highest number of votes even if cast less than the
majority, decrease SH power
Short slates (= listes courtes usually less than the majority of directors to be elected do not
create a change in control) increases the effectiveness power of SH.
New developments attempting to enhance shareholder voting rights:
Majority voting

Delaware DGCL has not changed its statutes but amendments permit the change
from plurality voting to majority

Voluntarily adopted by many large corporations

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Note: effectiveness of majority voting depends on the corporations holdover policies (an
incumbent titulaire nominee who fails to get the required vote remain in place until his
successor is elected but must tender his resignation) (Intel: board committee decides within
90 days to accept or reject the resignation).

Proxy access : 3% or more of SH can choose a candidate.

SEC proxy access rule struck down by DC Circuit in Business Roundtable v.

SEC

But, pursuant to this strike down, SEC rule changes that took effect in September
2011, shareholders are now permitted to submit and vote on proxy access proposals,
which give shareholders the right to include director nominees in the companys proxy
materials. 14a-8(i)(8)
But see 14a-8(i)(9) [if the company submits its own conflicting proxy access proposal at the
same meeting and wants to raise proxy access from 3% to 15% for example].
14a-8(i)(9) can manipulate (8): what is given by 8 can be taken away by 9.
Election of directors: exercising voting rights

Pro-bd/mgmt

Staggered boards

Plurality voting

Management slates

Quorum requirements

Super-majority voting requirements

Pro-SH

Cumulative voting

Majority voting

Proxy access

Removal rights (sometimes)

Sect. 12: Removal of directors
Common law: Removal of director for cause
Directors may be removed:
By shareholders for cause even in the absence of a statute that so provides, but without
cause only if a specific authority provides it (certificate of incorporation, bylaws or statute).

RMBCA 8.08 (Florida 607.0808) without cause; DGCL 141(k) with or

without cause except a classified (10%)
By the board itself

Generally no unless a statute provides it.

By courts for cause

Statutorily permitted by DGCL amendment to 225(c)

Equitable power narrowly read in Shocking Technologies v. Michael (Del. Ch.

2012)

Remember the need to call special shareholder meeting in order to remove directors.

Whether you can exercise your removal right depends on the rules regarding
shareholder ability to call special meetings
Delaware
Florida
Issue: 10% SH can call, but pays
Contract
What is cause: criminal offense, financial motive but it can be more precise.

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for cause has required to fill a due process, but SH cannot vote to remove a member of the
board they can only vote by proxy access. Because they cannot be present during the
meeting, it is hard to justify a due-process.
Removal can be hard to exercise: there are not that many for cause jurisdictions, Pb of
due-process and need to call for a special meeting (10% of SH can call but have to pay
unless charter says otherwise).

Sect.13: Requisites for valid action by corporate officers

Typically authority of corporate officers come up in the context of a transaction between the
corporation and a third person in which an officer rather than the board acted on the corporations
behalf.
DGCL 142
RMBCA 8.40, 8.41
President
Various cases deciding that the president has apparent authority by virtue of his position but the
modern rule is that the president has apparent authority to bind the corporation to contracts that are
made in the usual and regular course of business but does not have apparent authority to bind the
corporation to contracts of extraordinary nature.
Depends on the context in which the business transaction arises (extent of risk, sale of assets).
2 situations: get out of a deal the officer got in or internal disputes.
C.E.O. : Second in hand in a publicly held corporation. Often chairman of the board.
Officers
Appointed by the board

Can they be fired?

Are significant powers delegated?
Authority

President, CEO, COO, CFO, V-Ps, Secretary, Treasurer,

officers in closely held corporations,

ratification
Schoonejongen v. Curtiss Wright Corp.
Beyond the board of directors, the corporation may validly act through its officers as authorized
corporate agents. Express authority is usually manifested through a statute, the certificate of
incorporation, the by-laws or a board or SH action.
Implied actual authority may be found through evidence as to the manner in which the business
was operated in the past. If it is reasonably and proper to effectuate the purpose of the office or the
main authority conferred.
Sect. 15: OBJECTIVE AND CONDUCT OF THE CORPORATION
Classical ultra vires doctrine
Transactions outside the sphere of activities of the corporation were characterized by the courts as
ultra vires and unenforceable against the corporation because beyond the corporations powers and
unenforceable by the corporation on the ground of lack of mutuality.
Two questions: whether a corporation had acted beyond its purpose and whether the
corporation had exercised a power not specified in its certificate.
Effectively eliminated

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Evolution in views of the proper goals of corporations

From public to private
Objectives of corporations : Maximization of Shareholder wealth
Corporation is to be primarly run for the pecuniary benefit of its shareholders.
Interests other than maximization of SH wealth
Dodge v. Ford
Facts: Henry Ford owned 58% of Ford Motors stock and controlled the board. Two Dodge brothers
owned 10%. In 1916, Ford decided a new policy of the company that would be not to pay any
special dividends but to put back into the business all the earnings other than the regular 1.2 M
(from 1908 and 1911 special dividends amounted to 41 M). At one point, the cars were sold for
$900, but the price was slowly lowered to $440 and finally, Defendant lowered the price to $360.
The head of Defendant corporation, Henry Ford, admitted that the price negatively impacted shortterm profits, but Ford defends his decision altruistically, saying that his ambition is to spread the
benefits of the industrialized society with as many people as possible. Further, he contends that he
has paid out substantial dividends to the shareholders ensuring that they have made a considerable
profit, and should be happy with whatever return they get from this point forward. Instead of using
the money to pay dividends, Ford decided to put the money into expanding the corporation.
Issue : The issue is whether Plaintiff shareholders can force Defendant to increase the cost of the
product and limit the money invested into expansion in order to pay out a larger dividend.
Holding : Plaintiffs are entitled to a more equitable-sized dividend, but the court will not interfere
with Defendants business judgments regarding the price set on the manufactured products or the
decision to expand the business. The purpose of the corporation is to make money for the
shareholders, and Defendant is arbitrarily withholding money that could go to the shareholders.
Notably, Ford did not deny himself a large salary for his position with the company in order to
achieve his ambitions. However, the court will not question whether the company is better off with a
higher price per vehicle, or if the expansion is wise, because those decisions are covered under the
business judgment rule.
Fords vision
My ambition is to employ still more men, to spread the benefits of this industrial system to the
greatest possible number, to help them build up their lives and their homes. To do this we are
putting the greatest share of the profits back in the business.
Dodge v. Ford on Dividend policy
A business corporation is organized and carried on primarily for the profit of the stockholders. The
powers of the directors are to be employed for that end. The discretion of directors is to be
exercised in the choice of means to attain that end, and does not extend to a change in the end
itself, to the reduction of profits, or to the nondistribution of profits among stockholders in order to
devote them to other purposes."
Dodge v. Ford on vertical integration
"We are not, however, persuaded that we should interfere with the proposed expansion of the
business of the Ford Motor Company. ... The judges are not business experts. It is recognized that
plans must often be made for a long future, for expected competition, for a continuing as well as an

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immediately profitable venture. The experience of the Ford Motor Company is evidence of capable
management of its affairs.
AP Smith v. Barlow Princeton gift case
Facts: AP Smith, Plaintiff corporation, had a history of donating minor sums of money to various
charities and institutions. Board of directors voted to give $1,500 to Princeton University. Plaintiff
instituted a declaratory judgment action after Defendant stockholders questioned the proposed gift.
Although a state statute allows corporations to contribute to charities, Defendants assert that the
corporations certificate of incorporation does not allow the gift, and the corporation was
incorporated prior to the statute that authorizes the gift-giving.
Issue: Whether Plaintiff can donate money to a charity without authorization from stockholders or
through the certificate of incorporation.
What justifications for charity? General social responsibility, profit maximization, long term
investment you have to get Princeton kids to come to work for you), you have to give money
to a privte school because of the communist threat (Cold War opinion).
Note who testified and what they said! President of the cie, chairman of the board of
Standard Oil (biggest trust), former chairman of the US steel corporation: good will in the
community and public responsibilities, higher learning.
Holding : Plaintiff can give money to charities providing that it was not made in furtherance of
personal rather than corporate ends, it was modest in amount and well within the limitations
imposed by the statutory enactments and with the reasonable bief that it would aid the ublic welfare.
Note on the conduct of the corporation
Donations should be reasonable in amount in the light of the corporations financial condition, bear
some reasonable relation to the corporations interest and not be so remote and fanciful as to
excite the opposition of SH whose property is being used.
What justifies profit maximization norm?
Before ENRON. Corporations are citizens and have obligations. Directors have at least conscience
that the corporation has a purpose open to the outside not only towards the SH but the creditore..
protecting the investor, who invested to get a return
protecting the value of the stock.
hard to say where the line is to be drawn otherwise.
risk of waste of corporate assets for undesirable purposes.

How does anyone know how much voluntarism is appropriate? Who decides?
non-profit maximizing goals = plutocracy in disguise.
why rely on voluntarism? If society worried, deal with harm collectively/legislatively.
In a free-enterprise, private-propety system, a corporate executive is an employee of the owners of
the business. His responsibility toward his employers (SH) is to conduct the business in accordance
with their desires, which generally will be to make as much money as possible while conforming to
the basic rules of the society.
Counter-arguments
Focus on long term profit max., not short term price hikes
External governmental regulation of corps = not effective way of correcting market failures.
Purely profit maximizing norms can create significant externalities that the rest of society has
to pay for.

55

Strictly profit maximizing corporations could distort the political mechanism for deciding
collectively about the size and nature of redistributive programs, thus further emasculating
the possibility of market and government constraints.
SHs as lenders of capital: If corporations = entities separate from SHs, why shouldn't they
keep whatever is left over after giving shareholders the expected return?
Not all shareholders are the same, with the same economic interests.

Differing interests
Shareholders inter sese: Primarily short vs. long term interests

Different types of institutional shareholders

Shareholders vs. corp: risk tolerance different b/c of sh diversification
Plus ca change
See Concurring Opinions, Feb. 15, 2013 Dave Hoffman post Dodge v. Wholefoods? -- on
Whole Foods CEO John Mackeys recent statement: we [the Whole Foods company] dont
exist primarily to maximize profits.
Remind you of anything? Dodge v. Ford, perhaps?
Other constituencies (groupes dintrt)
Statutes
Case-law (e.g., Delaware): Cases that took into account the interests of groups, other than
the shareholders that are affected by corporate decisions, such as labor and the community.
It occurred in takeover cases and have address the boards power to take an action in favor
of other constituencies, whose effect is to block a takeover: corporate directors have a
fiduciary duty to act in the best interests of the coporations SH.
An aspect of the review of a board action to block a tender offer is the element of balance. A
defensive measure must be reasonable in relation to the threat posed. This entails an analysis by
the directors of the nature of the takeover bid and its effect on the corporate enterprise.
Unocal, Revlon, Paramount, ebay
How do other constituency statutes fit with the shareholder profit maximization version of corporate
goals?
Unocal: While concern for various corporate constituencies is proper when addressing a takeover
threat, that principle is limited by the requirement that there be some rationally related benefit
accruing the stockholders.
Revlon: The Revlon board argued that it acted in good faith protecting the holders because Unocal
permits consideration of other corporate constituencies. They are nevertheless limits. The board
may have regard of various constituencies in discharging its responsibilities, provided there are
rationally related benefits accruing SH.
Paramount: A board can act against threats to corporate policy or corporate policy and
effectiveness, as an autonomous goal independent of the concept of maximizing SH interests.
In Paramount the board was interested to preserve Times Culture.
Ebay: The issue of preserving a corporations culture was revisited. Craig and Jim two of ebays SH
wanted to prevent the third SH from being able to name one of Ebays directors or purchase any
more Ebay stock. To this end, Jim and Craig adopted defensive measures.

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Under Unocal, the board could adopt this kind of defensive measure if it was a reasonable
response to a threat to the corporations policy and effectiveness.
Craiglist operated its business largely as a community service, nearly all classified advertisments
were placed free of charge and was not selling advertising space. Its revenue stream consisted
solely of fess for online job postings in certain cities and for apartment listings in NY. These fees
were more than enough to meet craiglists operating and capital needs. They try to justify the
defensive measures against Ebay that they perceived as a threat to craiglists policy and
effectiveness (not to monetize its site). The court rejected the defense:
On the unique facts of a particular case- Paramount v. Time- this court and the Delaware SC
accepted defensive action by the directors of a corporation as a good faith effort to protect a specific
corporate culture. Time involved a journalistic independence of an iconic American institution.
More importantly, Time did not hold that corporate culture standing alone, is worthy of protection as
an end in itself. It must lead at somepoint to value for SH.
When the director decisions are reviewed under the business judgment rule, the court will not
question rational judgments about how promoting non-SH interests (paying to employees higher
salaries, charitable contributions) ultimately promote stockholder value. Under the Unocal standard
however, the directors must act within the range of reasonableness.
In Ebay, defendants failed to prove that craiglist possesses a palpable, distinctive and
advantageous culture rejecting an attempt to monetarize the site sufficiently promotes SH value to
support the indefinite implementation of a poison pill. Giving away services to attract business is a
sales tactic not a corporate culture.
Having chosen a for-profit corporate form, the craiglist directors are bound by the fiduciary duties
and standard that accompany that form (acting to promote the value of the corporation for the
benefit of its SH). Jim and Craigs actions affect others besides themselves (the SH).
Unocal
Mesa Petroleum Co. (Mesa) (plaintiff) owned 13 percent of Unocal Corporations (Unocal)
(defendant) stock. Mesa submitted a two-tier cash tender offer for an additional 37 percent of
Unocal stock at a price of $54 per share. The securities that Mesa offered on the back end of the
two-tiered tender offer were highly subordinated junk bonds. With the assistance of outside
financial experts, the Unocal board of directors determined that the Mesa offer was completely
inadequate as the value of Unocal stock on the front end of such a sale should have been at least
$60 per share, and the junk bonds on the back end were worth far less than $54 per share. To
oppose the Mesa offer and provide an alternative to Unocals shareholders, Unocal adopted a
selective exchange offer, whereby Unocal would self-tender its own shares to its stockholders for
$72 per share. The Unocal board also determined that Mesa would be excluded from the offer. The
board approved this exclusion because if Mesa was able to tender the Unocal shares, Unocal
would effectively subsidize Mesas attempts to buy Unocal stock at $54 per share. In sum, the
Unocal boards goal was either to win out over Mesas $54 per share tender offer, or, if the Mesa
offer was still successful despite the exchange offer, to provide the Unocal shareholders that
remained with an adequate alternative to accepting the junk bonds from Mesa on the back end.
Mesa brought suit, challenging Unocals exchange offer and its exclusion of Mesa. The Delaware
Court of Chancery granted a preliminary injunction to Mesa, enjoining Unocals exchange offer.
Unocal appealed.
Issues : 1. Was the minority shareholder's two-tier "front loaded" cash tender offer for 37% of the
corporation's stock at a price of $54/share fair?
2. Can D exclude P from participating in D's self tender?
Holding : 1. No, the Supreme Court held that board of directors, having acted in good faith and,
after reasonable investigation, found that minority shareholder's two-tier front loaded cash tender

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offer for approximately 37% of corporation's outstanding stock at a price of $54 per share was both
inadequate and coercive, was vested with both power and duty to oppose same and, hence, to
effect a self-tender by corporation for its own shares which excluded particular stockholder's
participation and which operated either to defeat inadequate tender offer or, in event offer still
succeeded, to provide 49% of shareholders, who would otherwise be forced to accept junk bonds,
with $72 worth of senior debt.
2. Yes, D could exclude P from the repurchase of its own shares. The directors for D corporation
have a duty to protect the shareholders and the corporations, and one of the harms that can befall a
company is a takeover by a shareholder who is offering an inadequate offer. The directors decision
to prevent an offer such as the one at issue should be subject to heightened scrutiny since there is
a natural conflict when directors are excluding a party from acquiring a majority control. Here the
directors met their burden. Evidence existed to support that the company was in reasonable
danger: the outside directors approved of their self-tender, the offer by Plaintiff included the junk
bonds, the value of each share was more than the proposed $54 per share, and Plaintiff was wellknown as a corporate raider.
Rules : -Directors have a duty to protect the corporation from third party/shareholder injury, which
grants directors the power to exclude some shareholders from a stock repurchase.
-A court will not substitute its judgment for that of the board of directors of a corporation if the
judgment can be attributed to any rational business purpose.
-A board of directors addressing a pending takeover bid has an obligation to determine whether the
offer is in the best interest of the corporation and its shareholders and, in that respect, its decision is
no different from any other responsibility it shoulders and should be no less entitled to the respect it
otherwise would be accorded in the realm of business judgment.
-There is an enhanced duty which calls for judicial examination at the threshold before the
protections of the business judgment rules may be conferred upon a decision of the board of
directors to purchase a stockholder's shares with corporate funds, and this entails an examination
of whether the directors have shown that they had reasonable grounds for believing that a danger
to corporate policy and effectiveness existed because of shareholder's stock ownership.
-The burden of a board of directors to show that a purchase of shares with corporate funds was
required to remove a threat to corporate policy is satisfied by showing good faith and reasonable
investigation.
-Corporate directors have a fiduciary duty to act in the best interest of the corporation's stockholders
and this duty extends to protecting the corporation and its owners from perceived harm whether a
threat originates from third parties or other shareholders.
-Standard of proof for determining whether purchase of shares with corporate funds was designed
as a defensive measure to thwart or impede a takeover is whether purchase was motivated by good
faith concern for welfare of corporation and its stockholders, which in all circumstances must be free
of any fraud or other misconduct.
Revlon
Pantry Pride, Inc. (Pantry Pride) (plaintiff) sought to acquire Revlon, Inc. (Revlon) (defendant) and
offered $45 per share. Revlon determined the price to be inadequate and declined the offer. Despite
defensive efforts by Revlon, including an offer to exchange up to 10 million shares of Revlon stock
for an equivalent number of Senior Subordinated Notes (Notes) of $47.50 principal at 11.75 percent
interest, Pantry Pride remained committed to the acquisition of Revlon. Pantry Pride raised its offer
to $50 per share and then to $53 per share. Meanwhile, Revlon was in negotiations with Forstmann
Little & Co. (Forstmann) (defendant) and agreed to a leveraged buyout by Forstmann, subject to
Forstmann obtaining adequate financing. Under the agreement, Revlon stockholders would receive
$56 per share and Forstmann would assume Revlons debts, including what amounted to a waiver
of the Notes covenants. Upon the announcement of that agreement, the market value of the Notes

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began to drop dramatically and the Notes holders threatened suit against Revlon. At about the
same time, Pantry Pride raised its offer again, this time to $56.25 per share. Upon hearing this,
Forstmann raised its offer under the proposed agreement to $57.25 per share, contingent on two
pertinent conditions. First, a lock-up option giving Forstmann the exclusive option to purchase part
of Revlon for $100-$175 million below the purported value if another entity acquired 40 percent of
Revlon shares. Second, a no-shop provision, which constituted a promise by Revlon to deal
exclusively with Forstmann. In return, Forstmann agreed to support the par value of the Notes even
though their market value had significantly declined. The Revlon board of directors approved the
agreement with Forstmann and Pantry Pride brought suit, challenging the lock-up option and the
no-shop provision. The Delaware Court of Chancery found that the Revlon directors had breached
their duty of loyalty and enjoined the transfer of any assets, the lock-up option, and the no-shop
provision. The defendants appealed.
Paramount
Facts. Time decided to seek a merger or acquire a company to expand their enterprise. After
researching several options, Time decided to combine with Warner. Time was known for its record
of respectable journalism, and Warner was known for its entertainment programming. Time wanted
to partner with a company that would ensure that Time would be able to keep their journalistic
integrity post-merger. The plan called for Times president to serve as CEO while Warner
shareholders would own 62% of Times stock. Time was concerned that other parties may consider
this merger as a sale of Time, and therefore Times board enacted several defensive tactics, such
as a no-shop clause, that would make them unattractive to a third party. In response to the merger
talks, Paramount made a competing offer of $175 per share which was raised at one point to $200.
Time was concerned that the journalistic integrity would be in jeopardy under Paramounts
ownership, and they believed that shareholder
s would not understand why Warner was a better suitor. Paramount then brought this action to
prevent the Time-Warner merger, arguing that Time put itself up for sale and under the Revlon
holding the directors were required to act solely to maximize the shareholders profit. Plaintiffs also
argued that the merger failed the Unocal test because Times directors did not act in a reasonable
manner.
Issue. The issue is whether Times proposed merger acts as a sale of Time that would trigger a
Revlon analysis that would render the merger invalid.
Held. The Delaware Supreme Court affirmed the lower courts holding in Defendants favor. The
court distinguished the Revlon decision as concerning a company that already was determined to
sell itself off to the highest bidder, and therefore the only duty owed at that point was to the
shareholders. In this case, Time only looked as if it were for sale as it moved forward on a long-term
expansion plan. Various facts, such as Times insistence on ensuring the journalistic independence
and its temporary holding of the CEO position, illustrated that the directors were not simply selling
off assets. Once it was determined that the directors decision passed the Revlon test, the Unocal
test was applied. The directors also passed the higher standard called for in Unocal to directors who
are rebuffing a potential buyer. The directors reasonably believed, after researching several
companies, that a merger with Warner made the most sense as far as future opportunities and
maintaining their journalistic credibility.
Discussion. The court has now applied a dual Revlon/Unocal test to determine if the directors
acted reasonably. Once it is determined that a company is not simply putting itself up for sale, then
the courts will apply the Unocal standard
Ebay
Other constituencies statutes Defense tactic against hostile take over threats

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Legislative permission to consider the interest of the enity is a move. How to balance the
conflicting interests? Statutes are silent.
Delaware does not have constituencies, but a common law development : Unocal, Revlon,
Paramount, ebay
In Unocal, for the first time the SC considers it could be K to defense against the threat of
take over in account on other constituencies and balance.
In Revlon, focus on SH benefit
In Paramount, the culture of the corporation but narrowed by Ebay.
Back and forth ovement of the Delaware court for taking into account other constituencies.

Despite general norm of shareholder wealth maximization, many states have adopted other
constituency statutes in takeover contexts.
Delaware has no such statute
But, Del. courts have permitted board actions to block takeover to be grounded in part on
impact on other constituencies (creditors, customers, employees, corporate culture, maybe
even community more generally). Particularly so when corp. in vicinity of insolvency.

New legislative developments (CB Supp. pp. 8-9)

Benefit corporations

Maryland, California, New Jersey, New York, Pennsylvania, Virginia

By contrast to other constituency statutes, benefit corps. require directors to

consider social constituency

Flexible purpose corporations

Closely related to benefit corps. form

Calif.
Charity today

Statutory approaches:
reasonableness limit

donations permitted (Del. 122 and RMBCA 3.02) but

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The legal structure of publicly held corporations

The dominant function of Corporate law is to regulate the manner in which the corporate institution
is constituted, to define the relative rights and duties of those participating is the institution and to
delimite the powers of the institution vis--vis the external world.
Power and roles of a corporations major organ in the governance of publicly held corporations:
the board
the shareholders
the executives

Legal distribution of power between shareholders and the board (directors)

DGCL 141(a)
RMBCA 8.01(b)

List of items for SH approval in most corp. statutes:

election and removal of directors;

power to make by-laws;

power to make organic changes in the enterprise (mergers, sale of substantially all
assets);

dissolution;

authorization and issue of shares over the number authorized in the certificate of
incorporation;

charter amendments;

shareholder resolutions usually addressed at annual meetings, and

miscellaneous matters depending on the particular state's corporation statute.

Policies behind board control

Possible rationales:

the corporation is a separate entity.

Efficiency/expertise considerations
a) shareholders have no expertise;
b) having a "town meeting" on economic matters is inefficient;
c) shs may have conflicting interests.

expectation -- when people buy stock, do they expect to be making decisions or

to have directors make them?

Confidentiality

Bainbridges arguments on the basis of economic theories of the firm. See

Bainbridge blog
Board centrality

Statutes provide that the business and affairs of the corporation shall be managed by or
under the direction of the board of directors. Del. 141, RMBCA 8.01(b) and Fla.
607.0801(2).
Charlestown Boot & Shoe and People ex rel Manice v. Powell
Primacy of board control
Facts: Dunsmore and Willard were voted as directors.
The corporation voted to choose a committee to act with the directors to close up its affairs and
chose Osgood. The directors refused to act with him and contracted more debts to a larger extent

61

than allowed by law. They neglect in disposing of the goods of the corporation (selling the buildings
and machinery) whereas they were urged by Osgood to do so. They did not insure the building that
went on fire.
The business is to be managed by its directors and by such officers and agents under their direction
as the directors or corporation shall appoint. The statute does not authorize a coporation to join
another officer with the directors, nor compel the directors to act with one who is not a director.
They are bound to use ordinary care and diligence in the care and management of the business of
the corporation and are answerable forordinary negligence.
The vote choosing Osgood a committee to act with the directors and closing up the affairs of the
plaintiff corporation was inoperative and void. It was the duty of the directors to keep the property of
the corporation insured.
People ex rel manice v. Powell
In corporate bodies, the board of directors of a corporation do not stand in the same relation to the
corporate body which a private agent holds toward his principal. The powers of the board of
directors are, original and undelegated. The individual directors making up the board are not mere
employees but a part of an elected body ofofficers constituting the executive agents of the
corporation.
Shareholders do not have control over day-to-day operations or even long-term business plans of
the company nor can they control the directors in the exercise of the judgment vested in them by
virtue of their office.
Contracting in for power in the charter

Delaware 141(a), after establishing the core principle of centralization of management,

says: "except as may be otherwise provided in this chapter or in its certificate of
incorporation."

Fla 607.0801(2)(based on RMBCA) says: "all corporate powers shall be exercised by

or under the authority of, and the business and affairs of the corporation shall be managed
under the direction of, its board of directors, subject to any limitation set forth in the articles
of incorporation."
Boards role is strategy, advice, long-term business investment, monitor, creating the
structure for compliance. More polarized boards.
Equitable limits on the boards legal powers
Condec v. Lunkenheimer (271)
Are there limits on board power to issue stock and dilute a SH? If there is a good reason: OK if not:
NO
The standard s : Is there a business purpose?
Facts: Condec wanted to merge with Lunkenheimer but Lunkenheimer resisted. Condec acquired
some shares of Lunkenheimer through a tender offer and made a second tender offer which if
successful would have given Condec slightly more than half of Lunkenheimers shares.
It is fundamental that directors stand in a fiduciary relation to the corporation and its shareholders
and that their primary duty is to deal fairly and justly. It is a breach of this duty for directors to make
use of the issuance of shares to accomplish improper purpose such as to enable a particular group
to maintain or obtain voting control against the objection of SH.
When the objective sought in the issuance of stock is not merely the pursual of a business purpose
but also to retain control it is not a permissible manipulation.
Per se invalidity of corporate acts intended primarly to thwart effective exercise of the SH vote

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Reality check: Management by management

Note: Importance of management rather than simply the board in corporate decisions in
publicly held firms. Key actors include not just boards but CEOs and other high level
officers
Judicial protections of sh voting rights
Schnell v. Chris-Craft
Why shouldnt the board be able to do what the statute gave it the power to do?
Facts: SH filed their intention to wage a proxy fight to replace directors. Management enlarged the
scope of its scheduled directors meeting to include a by-law amendment to limit the time for contest
and advance the date of the meeting from January to December (Under the new Delaware
corporation law it as allow to change the time of the meeting).
Holding: The court decided that the management had attempted to utilize the corporate machinery
and the Delaware law for the purpose of perpetuating itself in office and to that end, for the purpose
of obstructing the legitimate efforts of dissident SH in the exercise of their rights to undertake a
proxy contest against management.
Reasoning: Management contends that it has strictly complied with the new law in changing the bylaw date. It is inequitable action that does not become permissible because it is legally
possible.
The use of power is subject to equitable limitation when the power has been exercised to the
detriment of their interests.
Judicial protection of sh voting rights
Schnell v. Chris-Craft:
What was wrong with advancing the meeting date if the statute permitted it literally?
Improper use
How does the court define inequitable conduct?
Entrenchment?
Note that Delaware courts require the illicit purpose to be the single dominant
purpose behind the conduct.
Blasius v. Atlas: No bad faith, unlike Schnell.
Issue: What should the rule be about actions that impede shareholder voting but are taken in good
faith?
Facts: Directors of Atlas corporation against Blasius Industries, the largest SH (9,1%).
Issue: Who is entitled to sit on Atlas board of directors?
1. Validity of board action taken at a telephone meeting that added to members from 7 to 9.
This measure was taken as an immediate response to the intention of Blasius to increase the
board from 7 to 15 members and elect 8 nominated by Blasius so it will have majority at the
board.
Whether a board acts consistently with its fiduciary duty when it acts in good faith and
with appropriate care for the primary purpose of preventing or impeding an unaffiliated
majority of SH from expanding the board and electing a new majority?
Even though defendants acted on their view of corporations interest and not selfishly their
action constitute an offense to the relationship between corporate directors and SH. Board
action invalid and voided.

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2. Blasius informed that he wanted to obtain the control of Atlas including instituting a tender offer
or seeking appropriate representation on the Atlas board Delano & Lubin).
Atlas did not welcome this idea having almost completed a restructuration and wanted to give a
chance to see the benefit before another restructuring.
A meeting as arranged with Lubin and Delano for Blasius, legal counsel and director and a
representative of Atlas investment bankers (Goldman Sachs).
Lubin and Delano suggested that Atlas engaged in a leverage restructuring and distribute cash
to SH (the company raises cash by sale of assets and significant borrowings and makes a large
one time cash distribution to SH).
Blasius recommended to the board to restructure the corporation and expand the board to 15
members (maximum members number) while electing 8 of them so getting control.
Atlas director called for a special emergency meeting (even if the regular scheduled was to
occur one week ahead) and hold it over the phone to expand the board from 7 to 9. The board
voted for the expand and created a staggered board to preclude the holders of a majority of the
companys shares from placing a new majority on the board.
If the decision was not so motivated to take a defensive action, the action would have been ok
but here the step was taken to impede or preclude a majority of the SH from effectively adopting
the course proposed by Blasius.
Plaintiffs attacked the board action as a selfishly motivated effort to protect he incumbent board
from a perceived threat to its control of Atlas, this is a violation of Schnell: Directors have a duty
to act in good faith pursuing what they reasonably believe to be in the corporations interest.
(business judgment rule).
Members of the board said that they did act in good faith and without a conflict of interest
because Blasius dis not intend to replace the members of the board but expand only. They did
not preclude later recapitatlization but wanted to protect SH from the threat of having a
dangerous recapitalization program. They did not violate the duty of fidelity that a director owes
by reason of his office to the corporation and its SH.
They add their action was fair, measured and appropriate in light of circumstances (intermediate
level of review authorized by Unocal: legal test of fairness).
The court said that even if the action was self-interest motivated, the board acted in a good faith
effort to protect its incumbency not selfishly but in order to thwart implementation of the
recapitalization that it feared, reasonablywould cause great injury to the company.
The question is Whether the board even if its acting with subjective good faith may validly act for
the principal purpose of preventing the SH from electing a majority of new directors?
Blasius v. Atlas:

Issue: What should the rule be about actions that impede shareholder voting but
are taken in good faith?

Whats the standard the court adopts for interference with the SH franchise?

What alternative standards could it have chosen?

What down-sides to a more stringent standard (prohibition, say?)

Why wasnt protection from the Blasius restructuring considered a sufficiently

compelling justification?

What might count as a compelling justification, according to the court in dicta?

In Unocal: a board may take defensive measure to defeat a threatened change in a corporate
control when those steps are taken advisedly, in good faith pursuing to a corporate interest and are
reasonable in relation to a threat to legitimate coportate interests posed by the proposed change in
control.

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Does the rule: reasonable exercise of good faith and due care generally validates the exercise of
legal authority even if the act has an entrenchment effect when applied to an action designed for the
primary purpose of interfering with the effectiveness of a SH vote?
No it has to be closer scrutiny.
Generally SH have only 2 options against perceived inadequate business performance: sell or vote
to replace incumbent directors.
The question is who as between the principal and the agent has authority with respect to a matter of
internal corporate governance?
Defendants must show sufficient justification that the action was intended to prevent an unaffiliated
majority of SH from effectively exercising their right to elect new directors.
Dictum: In this case, the board was not faced with a coercive action taken by a powerful SH
against the interest of a distinct SH constituency (public minority). Moreover, it had time to inform
SH of its views on the merits of the proposal subject to SH vote.
Holding: Even finding the action was taken in good faith, it constituted an unintended violation of
the duty of loyalty that the board owed to the SH. Action is set aside.
V
V

The Trial Court found for Blasius and undid the directors' actions.
The Trial Court found that Atlas' management was not acting selfishly because they were worried
they might lose their jobs, but acting in what they perceived to be the best interests of the
corporation because they honestly believed that Blasius' goals would harm the corporation.
However, the Court found that even when an action is taken in good faith, it could constitute an
unintended violation of the duty of loyalty that the directors owes to the shareholders.
The directors are in effect agents of the shareholders. If the purpose of an action is to obstruct the
shareholders' reasonable control over their business, that is inequitable. Basically, the directors
work for the shareholders, so if there is a disagreement between the shareholders and the
directors, the directors have to defer to the judgment of the shareholders.
The Court noted that there might be some possible "compelling justification" for the directors' action
(so the directors actions aren't necessarily per se forbidden). Compelling justification might be:
When stockholders are about to reject a third-party merger proposal that the independent directors
believe is in their best interests;
When information useful to the stockholders' decision-making process has not been considered
adequately or not yet been publicly disclosed; and
When if the stockholders vote no the opportunity to receive the bid will be irretrievably lost.
After this case, Blasius sold off their interest in Atlas. A few years later Atlas declared bankruptcy
and all the shareholders lost their investments.
Delaware refuses to apply Blasius because it is a too difficult standard and apply the BJR.
Business judgment rule: The most lenient standard: if certain conditions are satisfied, a
disinterested director or officer will not be liable for the adverse consequences of a bad decision
unless the decision was irrational. In Blasius, the conduct that intereferes with SH voting is not
reviewed under the business judgment rule instead a more stringent standard of review of a
compelling justification.
THE ROLE OF BYLAWS IN THE ALLOCATION OF POWER BETWEEN THE BOARD AND THE
SH
A corporation has normally 2 foundational instruments:
its certificate of incorporation
its bylaws

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Together with state, federal and soft law, it set out the rules that govern the roles and powers of
corporate oragns and offices and other important matters.
If there is a conflict between the certificate and the bylaws, the certificate controls.
Corporate bylaws address: time, place, manner of giving notice for the annual SH meeting.
Corporate statutes allow the bylaws to provide higher or lower quorum, voting requirements other
than defaults rules, set forth the power of company officers, permit both the board of directors and
SH to adopt, amend and repeal bylaws.
One defensive use of bylaws was the advance notice bylaw. A SH who intends to wage a proxy
contest for the election of her slate of directors must give the required notice to the company. But it
can be a means for the incumbent management to thwart the efforts of a discgruntled SH.
2 cases highlight the importance of carefully drafted advance notice bylaws and narrowly interpret
the advance notive bylaws in favor of activist investors:
Jana v. Master: JANA informed the board CNET that it wished to solicit proxies for its director
nominees and various proposals. CNET bylaws required a SH seeking to nominate directors or to
propose other business at the annual meeting to have beneficially owned 1000$ of common stock
for not less than a year (Jana only 8 months) and the bylaw required the notice to comply with the
federal securities laws governing SH proposals a corporation must include in its own proxy material.
The court held that the bylaw only applied to proposals and nominations that are to be included in
the companys proxy material and since JANA intended to finance the proxy itself, the bylaw was
inapplicable.
Levitt Corp v. Office depot: Office depot bylaws require advance notice of business to be brought
before the annual meeting. Shareholders attempt to nominate board members at the annual
shareholder meeting. Office depot had sent a proxy statement and notice of annual meeting to SH
informing that 12 directors were to be elected. Levit Corp filed its own proxy material with the SEC
but did not give advance notice to Office Depot of its intention directors.
Holding: Even if the term business include the nomination of directors, because Office depot had
fuldilled the bylaw requirement by itself giving notice of this business to be conducted at the
meeting, Levitt can nominate and vote for its nominees.
CA Inc. v AFSCME
Facts: Board of directors of CA is composed of 12 persons, all of whom sit for reelection each year.
AFSCME is a CA SH, associated with the American Federal of state County and Municipal
Employees.
AFSCME submitted a proposed stockholder bylaw for inclusion in the Companys proxy materials
for its annual meeting. The proposed bylaw is intended to require CA reimburse a SH or group of
SH reasonable expenses by a dissident nominating a rival slate of directors provided that at least 1
nominee from the dissident slate was victorious.
The current bylaws and certificate of incorporation did not address the issue.
The directors of CA objected to the proposal and argued that the shareholder proposal was
improper because under Delaware law (8 Del. 141(a)), the decision as to whether or not to
reimburse election expenses was at the discretion of the directors.
Securities Exchange Act (1934) Rule 14a-8 allows the exclusion of shareholder proposals that
would be illegal.
CA asked the SEC to exclude it from the proxy statement and a no-action letter stating that the
Division would not recommend any enforcment action to the SEC if CA excluded AFSCME proposal

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1
V
V

with a legal opinion of its counsel.

AFSCME (D) argued that a different section of Delaware law (8 Del. 109) grants shareholders the
right to adopt bylaws. So their shareholder proposal was not illegal under Delaware law and Rule
14a-8 did not apply with a legal opinion of its own counsel.
The SEC certified the question to the Delaware Supreme Court, asking them what to do.
Holding : The Delaware Supreme Court ruled for CA.
Relation to director elections is a proper subject matter for a bylaw.
The Court found that in general, the proposed bylaw related to director elections and, thus, was a
proper subject for a shareholder proposal under Rule 14a-8.
However, the Court found that a shareholder proposal to amend the bylaws in the way AFSCME
proposed would violate Delaware law because it "mandates reimbursement of election expenses in
circumstances that a proper application of fiduciary principles could preclude" and, if adopted, could
cause CA to be in violation of the law.
Reasoning : -The court found that both the board and the shareholders, independently and
concurrently, had the power to adopt, amend and repeal the bylaws 109(a); but that shareholders'
statutory power to adopt, amend or repeal bylaws was not coextensive with the board's concurrent
power and was limited by the board's management prerogatives under 141(a).
-SH of corporation may not directly manage the business and affairs of the corporation at least
without specific authorization in either the statute or the certificate of incorporation.
- The court had to decide if the bylaw proposed by AFSCME was a proper subject for SH action
under Delaware law by (1) determining the scope or reach of the SH power to adopt, lter or repeal
the bylaws and then (2) deciding if the bylaw at issue fills within the permissible scope.

(1)

: article 102(b) : what the certificate of incoporation must or may contain, especially any
provision for the management of the business and for the conduct of the affairs of the corporation,
and any provision creating, defining, limiting and regulating, the powers of the corporation, the
directors and the SH () Any provision which is required or permitted by any section of this chapter
to be stated in the bylaws may instead be stated in the certificate of incorporation.
AFSCME relies upon the section which permits bylaws to contain any provision relating to the
powers of its DH and directors .
CA argued that section 109(b) has to be read with regard to 102(b)(1) : any provision that limits the
broad statutory power of the directors must be contained in the certificate.
The court concluded that the bylaw fell within the scope of Del. Code Ann. title 8, 109(b) because
otherwise if any bylaw than in any respect might be viewed as limiting or restricting the power of BD
automatically falls outside the universe of permissible bylaws authorized, then SH cannot even
amend, adopt and repeal bylaws.
Proper function of the bylaw is to define the process and procedures by which the BD makes
decisions therefore it is a proper subject for SH action.
CA alleges that the bylaw intrudes upon board authority because it mandates the expenditure of
corporate funds and leaves no role for BD discretion to decide henever to reimburse expenditures.
The court found that as drafted, the bylaw violated the prohibition derived from 141(a) not saying
clearly if it is only process oriented and not substantive. A bylaw that requires the exependiture of
corporate fun dis not for that reason alone automatically deprived of its process-realted. Ithas to
come in light of its context and purpose. Process for electing directors is a SH legitimate and
protected interests. Promoting the intergrity of the electoral process by facilitating the nomination of
director candidates non management board candidates by promising the reimbursement of proxy
fees) by SH is also a legitimate interest.

(2)

The court concluded that the bylaw as drafted would violate the prohibition against contractual

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arrangements that committed a board to a course of action that would preclude them from fully
discharging their fiduciary duties to the corporation and its shareholders. In Paramount, the Court
has invalidated contracts that would require the board to act or not to act in such a fashion that
would limit the exercise of their fiduciary duties. Because the bylaw also prevent from directors from
exercising their full managerial power in circumstances where their fiduciary duty would otherwise
require them to deny reimbursement to a dissident slate, the bylaw is not valid.
Under Delaware law, a board may exprend corporate funds to reimburse proxy expenses where the
controversy is concerned with a question of a policy as distinguished from personnel or
management.
SHAREHOLDER VOTING : CHANGE OF CONTROL
Two alternatives for changes in control
Changes of control via board vs. board end-runs
Changes in control involving board decisions:
Mergers
Sales of assets
With board approval:
Merger: Two corporations combine to form a single entity.
In some juris., supermajority reqd for merger approvals; % depends on charter provisions too
Jurisdictional differences in whether shareholders have appraisal rights
Triangular merger transactions
Where the acquiring corp. sets up a shell subsidiary which is capitalized with the money to be paid
to target shareholders in the acquisition.
The former target shareholders either become shareholders of the acquirer or are bought out for
cash.
With Board approval
Sale of assets
Board has unconstrained authority to sell, lease, mortgage, or otherwise dispose of
corporate assets except where they try to dispose of all or substantially all corporate assets
in which case shareholder approval is required.
Note Delaware/RMBCA difference:

Under Del. 271(a), required vote = majority of the outstanding voting shares.

But under RMBCA 12.02(e), necessary vote = only a majority of those present
and voting.

Which is easier hurdle?

Changes in control by-passing the board

No board approval required for:

proxy contest: where bidder solicits targets shareholders to vote for its slate of
directors.

tender offer: where the bidder publicly makes an offer directly to the targets
shareholders to buy their shares, giving control of the target to the bidder.

stock purchase: market purchases of controlling share amount

Pros and cons of hostile takeovers:

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Anti

Arguments pro: likely increase in efficiency - takeovers represent a market solution

the problem of corporate mismanagement. Possibility of takeover functions as a prod
good management.
Arguments anti: likely increase in efficiency - takeovers represent a market solution
the problem of corporate mismanagement. Possibility of takeover functions as a prod
good management.

to
to
to
to

likely to lead to corporate looting and significant negative externalities, bad incentives re
business decisions, harmful to shareholders because the future value of the target would be
higher than the premium and the bidder would be usurping that additional value. Likely to
be coercive even to shareholders who dont want to tender their shares.

Defensive responses by target boards - Examples

shark repellents
staggered or classified boards
supermajority voting requirements
restructuring, sale of assets, self-tenders, golden handcuffs, immediate vesting of stock
option grants upon takeover
poison pills (a/k/a shareholder rights plans): various types of defensive measures that
attempt to make the acquisition of stock more expensive for the hostile bidder by triggering
different sorts of consequences if there is a change of control or certain types of share
transfers.
courting white knights/white squires
Poison pills - example
The board issues one right for each common share.
When issued, the rights are worthless, entitling a SH to buy preferred stock at prices far above
current market value (stock out of the money)
First trigger:
The real impact of the rights arises if any acquirer buys at least 20 percent (or makes a tender offer
for at least 30 percent) of the companys shares.
The board then has ten days to redeem the rights for a nominal amount (such as 10 cents per
share).
If the target fails to take this antidote, the rights became poison upon any further action by the
acquirer.
Second trigger:
Any back-end transaction with the tainted acquirer (such as a merger, sale of assets, or other selfdealing arrangement) activates a second trigger in which the target must swallow the plans poison.
The poison? Upon the second trigger, each right becomes exercisable permitting the holder to
purchase $200 worth of the acquirers or the targets securities (depending on the structure of the
back-end transaction) for $100.
(A flip-in plan entitles the holder to buy discounted target securities and sensibly excludes the
tainted acquirer from participating; a flip-over plan entitles the holder to buy discounted acquirer
securities.)
Note on poison pills
Effect: To force any bidder, before beginning a hostile takeover, to negotiate with the board--which
holds the redemption antidote.
Such plans, which have become a favorite antitakeover tactic, have been adopted by a majority of
large public companies.

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Avoidance: One method to avoid a poison pill is for the bidder to seek first to replace the incumbent
board in a voting contest, so the new board can then cancel the plan or redeem the rights and pave
the way for the bidders tender offer.
Another, still uncertain, option is for the shareholders to adopt a bylaw amendment that prevents the
board from adopting a poison pill without shareholder approval.
Status of defensive responses in Delaware:
Poison pills not precluded per se

Only problems are dead-hand and no-hand pills

No hand and dead hand pills rejected by Del. Courts, but on board discretion
rationale and not shareholder rights protection rationale.
Empirical data about poison pills:

Studies have found that companies with poison pills received on average premiums 8%
higher than companies without poison pills.
The Market for Control (Outside constraints on corporate boards and management)

How do we decide whether the market for control really constrains the board and
management?

Does the Delaware jurisprudence (Unocal/Unitrin etc. + anti-takeover defenses) strike

the right balance?
By the way . . .

Some Delaware decisions re: poison pills

Versata Enterprises Inc. v. Selectica, Inc. (upholds 4.99% trigger)

Yucaipa American Alliance Fund II, L.P. v. Riggio (upholds asymmetrical 20% pill trigger
30% SH grandfathered)

But see eBay Domestic Holdings v. Newmark (strikes down assertedly cultureprotecting pill)

Moral of the story? Poison pills in novel situations can still pass muster in Delaware, so
long as the board has reasonably concluded that the pill will prevent an economic threat to
the corporation or its shareholders
Shareholder rights plan endorsement statutes

Limit shareholders ability to prevent management from adopting shareholder rights

plans.

At least 24 states have enacted one.

There is jurisdictional variation.

What do the shareholder activists think about these statutes?

Introduction to standards of review of director action:
Standard of review for defensive measures in Delaware

Not deferential business judgment review.

Instead, its Unocal/Unitrin:

1) Is there a realistic threat to co?
2) If so, was defensive response appropriate and proportionate? Coercive? Preclusive?

Unless a defensive measure is "coercive or preclusive", the board's actions need only be
within a "range of reasonable responses" to be upheld.
JUDICIAL PROTECTION OF THE SH FRANCHISE IN THE TAKEOVER CONTEXT

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Back to the cases From Blasius to MM v. Liquid Audio

MM v. Liquid Audio: The control battle

MM Requests a Special Stockholders Meeting

Thwarted by rules w/ anti-takeover effects

MM Announces its Nominees for Liquid Audio's 2002 Annual Meeting

See impact of advance notice by-laws in these sorts of situations

MM Proposes Charter and Bylaw Amendments

MM Commences Proxy Solicitation and requests stockholder list

Well discuss DGCL 220 and its limitations

Liquid Audio Finds a White Knight

Management-friendly partner
See permissibility of deal protection measures w/r/t white knight transactions in Del.

MM Sues For an Annual Meeting

Liquid Audio Amends its Poison Pill

Liquid Audio Expands its Board

Vote-implicating decisions in takeover contexts

MM v. Liquid Audio:

When the primary purpose of a board of directors defensive measure is to

interfere with or impede the effective exercise of the shareholder franchise in a contested
election for directors, the board must first demonstrate a compelling justification for such
action as a condition precedent to any judicial consideration of reasonableness and
proportionality. . . ..
From Blasius to Liquid Audio . . .:

Unocal no longer the only standard of review in takeover contexts

When defensive tactics implicating the vote involve takeovers, then courts will apply both
Blasius within Unocal.
MM v. Liquid Audio

Did the boards actions stop MM from obtaining control of the board if its bylaw passed?

Since Liquid Audios charter didnt cap the board at 9 members, the board would
have had 11 directors, with 6 being MMs nominees

Is this different from the situation in Blasius?

Should the boards action be seen as an attempt to protect the staggered board
structure that the SHs themselves approved?
Judicial protection of sh franchise

MM v. Liquid Audio

Does MM expand Blasius?

Implications of Liquid Audio

Will should the Blasius standard be applied when boards put in place governance
changes that make it only marginally harder for a dissident to replace the board?
Scope of Blasius standard

Should Blasius apply only to circumstances having to do with the election of directors, or
should it apply more broadly?

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In other words, should stringent review be used to prevent entrenchment, or should it be

extended to any interference with SH voting on ordinary, non-entrenching transactions as
well?

Mercier v. Inter-Tel

The revolt of Chancery!

Why didnt directors breach duties by intentionally postponing shareholder vote that was
certain to defeat a merger they favored?

What standard applied? Blasius or Unocal or both?

Messy standards of review vs. common-sense results

It would hardly be indiscreet for me to acknowledge yet again the widely known reality
that our law has struggled to define with certainty the standard of review this court should
use to evaluate director action affecting the conduct of corporate elections. The results in the
cases make sense, as the decisions do a good job of sorting between situations when
directors have unfairly manipulated the electoral process to entrench themselves against
insurgents and those when directors have properly used their authority over the election
process for good faith reasons that do not compromise the integrity of the election process.
The problem that remains though is that there is no certain prism through which judges are
to view cases like this.
Diminishment of Blasius?

This was only the second case in which the Del. Chancery Court had found the
compelling justification test to have been satisfied.

Does Mercier cut back on the Blasius within Unocal approach of MM v. Liquid Audio?

But remember Mercier is a Chancery decision!

Wrap-up: Protection of shareholder franchise against board interference
Schnell
-- Bad faith, entrenchment motives
Blasius
-- No bad faith
MM (S.Ct.) -- Blasius within Unocal
Unocal standard: reasonable and proportional
potentially much broader than Blasius
Applies not just to vote preclusion, but to impact on effectiveness of vote
Could be read to apply beyond director election context
Mercier (Ch. Ct.)

1) Critique of Blasius incl. judicial evasion

2) Recommends Unocal with teeth instead

3) Rejects broad reading of MM extending it beyond elections

4) Finds that compelling justification Blasius standard has been

satisfied when board wanted to give shareholders new information prior to vote
What was the arbitrageur issue that the court effectively dismissed?
Did the court think the Mercier board acted perfectly?

If not, what could it have done?

Does the fact that the court set out a better template in Mercier mean that failures to
comply with it will receive less deference than the Mercier board received?
Plaintiffs bar
Note the potential impact of high attorneys fees awards even if the plaintiff hasnt won a
large monetary recovery (confirmed recently by the Delaware Supreme Court in EMAK
Worldwide v. Kurz) on the likely growth in state law suits to protect shareholder voting rights

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BY-LAWS: ALLOCATION OF POWER BETWEEN SHAREHOLDERS AND THE BOARD

By-laws:
The role of by-laws in the allocation of power between sh and directors

Compare with charter amendments

Can serve to have a chilling effect on shareholder exercise of governance rights

Power to adopt/amend by-laws

Early common law: shareholders only.

Thereafter: expanded by statutes to include directors.

Some states: vest the power exclusively in directors unless otherwise provided in the
charter.
Power to make and amend by-laws -- Delaware
DGCL 109(a):

only shareholders, unless otherwise in certificate

If the charter gives the right to amend by-laws to the directors, does that eliminate sh rights
to do so?
Power to adopt/amend by-laws RMBCA
RMBCA 10.20(b) -- both directors and sh unless

power reserved solely to sh in certificate, or

shs amend the bylaw to provide that it cant be further amended by directors.

Whats the purpose of these conditions?

Shareholder attack on poison pills via by-laws

E.g., Bebchuk proposal to FedEx: by-law directing that director-adopted poison pills
sunset if no affirmative shareholder vote to retain
Tension:

DGCL 109

DGCL 141
Board-passed by-laws
Forum selection by-laws
In response to burden & expense of multi-forum SH litigation, and possibility of foreign
courts interpreting internal affairs of corp.
Permitted under 109(b)
Boilermakers Local 154 Retirement Fund v. Chevron
Facts: Board-passed exclusive forum-selection bylaws
Holding : the forum selection by-laws that the boards of directors of Chevron and FedEx
unilaterally adopted were valid under Delaware law, and contractually valid and enforceable as
forum selection clauses.
All SH that want to bring a claim has to bring this action in Delaware to prevent from out of
jurisdiction costs.
This could be misued by BD to entranch themselves but SH can repeal bylaws by adopting
amendments to bylaws.
If the amendment leads to an unreasonable and unfair result, the BD may breach its fiduciary futy.
In practice, SH are often hedge funds (institutionals), so if they do not like the amendment they telle
to the BD and often the BD will not adopt.
In 2 cies, BD decided to withdraw the proposition of bylaw

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In 2 other cies, including Chevron, the SH voted against the (repeal) challenge of the bylaw adopted
by BD (they trust the BD).
CA v. AFSCME

Note: SEC certification

2 prongs:

1) Proper subject (procedural re elections is a proper subject)

2) Fails b/c no fiduciary out (could cause board to breach its fiduciary duties if it
followed bylaw against its best judgment)

Delaware Sup. Ct. decision = win for CA? For both directors and shs?
Board repeal of SH governance by-laws? DGCL vs. RMBCA

RMBCA 10.20(b): SH option to draft by-laws to preclude subsequent board repeal.

DGCL 109(a) : infinite regress, cycling amendments and counter-amendments

Except: DGCL 216(b) re: by-laws prescribing the vote required for director
elections
Wrap-up on CA v. AFSCME: Delaware legislative response

DGCL 113. Proxy expense reimbursement.

(a) The bylaws may provide for the reimbursement by the corporation of
expenses incurred by a stockholder in soliciting proxies in connection with an election of
directors, subject to such procedures or conditions as the bylaws may prescribe . . .

But see Race to the Bottom re: irrelevance of 113

Wrap-up: RMBCA in Florida re by-laws:

Florida 607.0206 provides that the incorporators or board of directors shall adopt initial
by-laws unless that power is reserved to the SHS by the articles of incorporation.

Section 607.1020 says that by-laws adopted by the board or the shareholders
may be repealed or changed, by the shareholders and also by the board (unless the
charter reserves that right to the SHS or the shareholders provide that the directors may
not amend or repeal the bylaws or a bylaw provision when they vote to amend or repeal
the bylaws).
Advance Notice By-laws

Amylin

What happens when an advance notice by-law sets a time frame after which
shareholders cannot nominate directors for election at the annual meeting, but
disagreements with the sitting board arise after the deadline has passed.
The infinite regress of cycling by-law amendments

DGCL 216 amendment:

A by-law amendment adopted by stockholders which specifies the votes that

shall be necessary for the election of directors shall not be further amended or repealed
by the board of directors.
In other words, majority (rather than plurality) vote by-laws passed by shareholders cannot
be amended or repealed by the board.
Query: What about other by-laws? A by-law prohibiting board amendment of shareholderpassed by-laws more generally?
Sect.1: Allocation of power between shs and directors

SH voting - Back to the big picture:

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Justifications for shareholder voting

Thompson & Edelman:

Bebchuk: greater SH power to give directors incentives to serve the SH interest

and to restore directors accountability in a system lacking other adequate mechanisms.

Easterbrook & Fishel: more comprehensive theory of voting and filling the gaps
that necessarily appear in contracts and assigning the gap filling role to the group with
the best economic incentive todo so: SH (residual interest in the corporation). The SH
should make discretionary decisions but for practical reasons will delegate those powers
to the directors. (carte blanche power to the SH).

Bainbridge: lack of time and expertise of SH. Director-centric view of

corporate governance provides efficiency while SH should monitor but only limited to
one single constituency.

Eisenberg: SH are the appropriate group to monitor the board and correct
errors because they are uniquely sensitive to the principal signal indicating a deviation
of the board from its duty to the corporation: the market price of the corporations
stock.

View of the relationship between sh and directors will influence justification

Hu & Black
Modern trend: Strategic uses of voting

Not connected to traditional justifications

Voting rights designed to accomplish other goals than board oversight:

Anti-takeover devices (Stroh & Providence): weighted voting (eah share of

common stock carries one vte however voting rights can be conferred on preferred
stocks, issuance of super-voting stock to members of control group for the pupose of
allowing the group to maintain control and defend against takeovers). Voting rights of SH
may be varied from the one share- one vote standard (only certain class or only the first
50 shares and then every twenty) and even some stocks may not include a right to
dividends and assets of the corporation.

Empty voting (described in Hu & Black): record date capture: you borrow
shares so you retain the right to vote but you pay back the lender any dividends decided.
The borrower owns the shares and associated votes while the share lender has
economic ownership without votes. Another method if borrow is not available: short term
ownership: the hedge funds buys shares just before the record date and sell them soon
after. Hedge funds = fonds spculatifs.
Empty voting: voting rights are in person with no economic interest in the shares. Record
date on February 15th, meeting on March 15th, transfer of the share n February 28 th.
Athough the shares are sold the seller who appears on the record date has the right to
vote but not the actual owner at the time of the meeting.
Traditional constraints on shareholder activism

Rational apathy: when shareholdership in a corporation is highly dispersed, the

corporation will be controlled not by the SH but by management (centralized and
professional management).

Collective action problems: problem of coordinating their decisions and actions

Expenses of proxy contests

Traditional sh response to bad management?

Wall Street Walk!: if the SH does not like the management he can sell ann if he does not
sell he shall vote with management.

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Types of sh activism

Active voting posture in voting on management and SH proposals (consider the merits of
the proposal and does not automatically vote with the management)

More aggressive posture: to originate SH proposals

Nominating candidates (careful with the liability for insider trading)

Withhold votes in favor of incumbent director who are up for reelection (relation between
no vote under a regime of plurality voting but under a straight vote it is unnecessary)

Direct discussions with management (important relation between discussion and voting
because the actual or implied threat that an institutional investor will vote in a certan way is
an important incentive for the managemers to take seriously the concern expressed by
institutional investors).
Increase of SH activism: institutional shareholder ownership of public corporations v. individual
SH.
The cost of activism decreases because of:

Sophistication

Large blocks

Easier coordination
SH activism/institutional SHs

What makes institutional investors in their SH capacity competent activists? They are not
equipped to make or meaningfully assess ordinary-course business but have substantial
competence in several areas:

corporations governance rules (Managers are self-interested in these rules because the
rules bear the preservation and enhancement of managerial position).

proposition of structural changes: (M&A. managers are also self-interested to keep their
positions), financial desirability of structural changes and market signal signs (institutionals
ca unse the market sign as strong evidence of proposals merit).

What about free-riding problem? Investitutional-investor activism might be dampered

(amorti) by a free-rider problem, because any expenses for activism than an investor incurs
may benefit other SH more than it benefits the investor. But easy to exaggerate: often the
same issue will occur (so only one expense) and a vote on recurring issue may send a
message to all portfolio corporations.
Why has institutional SH activism increased?

Investor population changes

Legal change

Proxy advisory services

Who are the shareholder activists now? New players
Hedge funds
Proxy advisors (via their clients)
Bainbridge asks: Is trust in large shareholders warranted?
Argument: Because returns to investor activism are low, and because only portions of gains from
activism accrue to activist institutions, such activism can be explained by:
ego/hubris (behavioral economics explanation)
Rent-seeking (L & E explanation)
Bainbridges conclusion: both are illegitimate and should counsel caution!
Proxy advisory firms

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RiskMetrics Group (ISS)*

Glass Lewis & Co.
Egan-Jones Proxy Services
Marco Consulting Group*
Proxy Governance, Inc.* (now apparently out of biz)
C & W Investment Group
* registered with the SEC as investment advisors (subject to fiduciary duties under SEC
rules)
Proxy Solicitation Process

The role of proxy advisory firms

Increasingly significant

Increasingly controversial
Why?
Proxy advisory services wrap-up

ISS and other proxy advisory services are wielding an increasing amount of power.
Recent empirical studies show substantive impact of proxy advisory firm voting
recommendations on say-on-pay vote outcomes, for example.
Contrasting views on proxy advisory services:
Pro:
Enhanced information, sophisticated analysis, neutralizes rational apathy and
collective action constraints on shareholder activism.
The only practical way that
shareholders can powerfully exercise their voting rights!
Anti: Cookie-cutter recommendations regardless of the particulars of the company; undue
focus on governance issues because of proxy advisory firm self-interest; value-decreasing
decisions taken in response by boards (Bainbridge claim); responsible for increasing
tensions between boards and shareholders.
Shareholders are increasingly delegating their voting power to third parties whose business
model depends on both attaining ever more influence through the growth of shareholder
rights and making voting recommendations on a low cost basis. This leads to continual
expansion of the governance practices that the proxy advisors advocate and an overreliance on rigid corporate governance prescriptions on a one-size fits-all basis. The
coordinating impact and rigid influence of the proxy advisory firm risk upsetting the delicate
balance between board and shareholder responsibilities and may undermine the ability of
boards to govern effectively.
Weil, Gotshal & Manges, Preserving Balance in Corporate Governance HLS Forum on
Corp. Governance and Financial Regulation, 2/1/2013

Do you agree? What do you think we need to know to decide?

Why not visit the ISS website?
Hedge funds

New actors in this drama

In what ways is their SH activism likely to differ from other institutional SHs?
Balance of sh/board power

Issues re: effectiveness of shareholder activism

For some, issues re: legitimacy of shareholder activism if fundamental link is

broken between voting and economic stake
Sect.3 Vote buying
Entie fairness test
Whetherthe boards decision is substantively fair

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Are the directors engaged in this decision for the greater benefit of the corporation or is it another
kind of entranchment of the board?
When is there a review by the court: Vote buying can be a fair mean
The first deal with Filipowski was Ok not the second
Vote buying used to be a pure prohibition has shifted to an obligation to disclose

Portnoy v. Cryo-Cell International Inc.

Facts: Several of SH of Cryo-cell were considering mounting a proxy contest to replace the board.
One of the SH, Filipowski used managements fear of replacement to strike a deal for himself to be
included in the management slate for the next annual meeting.
Another SH, Portnoy filed a dissident slate.
Mercedes Walton, CEO was desperate because the current board and management were losing by
huge margins. She ginned up (planifier) a plan with Filipowski to win the proxy contest. Walton
as a matchmaker had to find SH willing to sell their shares to Filipowki. In exchange for this alliance,
Walton promised Filipowski that if their management slate prevailed, Cryo-Cells board would,
using their power as corporate directors, expand the board to add another seat for Filipowskis
designee (accused of insider trading).
This plan was not revealed to the management who did not know that if voting for the management
slate they would vote not for one but two Filipowkis.
In order to secure another key of votes, Walton used a combination of threats: ending of
cooperation on key projects and inducements to secure the vote of Saneron (Cryo-Cell owned 38%
of Saneron shares and Saneron depended on Cryo-Cell laboratory place to conduct many of its
own operations). From undecided on how to vote, Saneron was locked.
The meeting was set up for 11 am but to cast more votes Walton needed more time, she did not
want to close the polls and count the vote when the scheduled presentations were over so she had
members of side to make long presentations and even declared a late lunch break to have more
time to seek votes. Only after confirming the swith of the major blockholders, Walton resumes the
meeting at 4:45.
The management slate won by a very little margin.
Immediately after, Walton began preparing to add Filipowkis designee to the Cryo-Cell board.
Portnoy challenged the results of a contested corporation election.
Holding: The court did not declare Portnoy slate the victor in the election process, but set aside the
election results and order a immediate special meeting because the election results were tainted by
the inequitable behavior of the CEO and her allies and were to be set aside.
Reasoning: - Cryo-Cell SH cast their votes in ignorance of material fats regarding the promise
made to Filipowski to add a seat for his designee and because of the pressure (threats and
inducement=incitation, pot de vin) exerting on Saneron, both of which involved the use by Walton of
corporate resources and fiduciary authority motivated by the desire to protect herself from the risk
of losing her corporate offices.
i. addition of Filipowski to the managment slate: illegal vote buying arrangement.
How should we define objectionable vote buying arrangements? Vote-buying is a a voting
agreement supported by consideration personal to the SH, whereby the SH divorces his
discretionary voting powerand votes as directed by the offeror.
Whats the standard of review? Sort of heightened scrutiny given to more questionable
arrangements.

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Voting agreement is not per se improper except if the object or purpose of the vote buying was to
defraud or disenfranchise (priver du droit de vote).
Here although it was not publicly disclosed that Filipowskis agreement to vote for the management
slate was conditioned on his addition to that slate, and that the incumbents had added Filipowski to
the management slate in exchange for his support: that inference was unmistakable to any rational
SH. Surely it was known to Portnoy because Filipowski had flirted with running a slatewith Portnoy
only to secure a place for him on the management slate.
SH knew that Filipowski sought a seat and he had to obtain their votes to get on the board so the
vote buying is OK.
ii.

the promise of a second board for Filipowski group: NO. board colleagues of Walton were
extremely deferential to leadership, and the very material event was not disclosed to Cryo-Cells SH.
Directors of Delaware corporation are under a fiduciary duty to disclose fully and fairly all
material information within the boards control when it seeks SH action.
management influence over Sanerons vote: even absent Walters conduct toward Saneron, the
judge would have set aside the election. Walton fails both the two prongs of action being
motivated by a good faith desire to advance corporate interests, rather than to entrench
herself and even if Walton acted in good faith to justify their dealings with Saneron as entirely
fair. Walton clearly used company resources to coerce Saneron voting in the procedd and
thereby breached her duty of loyalty. The election was tanted by misbehavior by insiders who
could not win an election simply using the traditionally powerful advantages afforded incumbents.
Our law has no tolerance for unfair election tactics.
The annual meeting: Walton did not take a lupper (meal between lunch and supper) but
undertook action that affected the conduct of an election of directors in a potentially important way,
has to show that Waltons actions were motivated by a good faith concern for the SHs best
interests and not by a desire to entrench herself. Defendants have failed to prove that Waltons
tactics were undertaken in selfless good faith.

iii.

iv.

Compare Portnoy with Mercier

Sect. 4: Funding proxy contests

Proxy sollicitiation: SH deputizes an agent to vote on his behalf
Proxy contest: Proxy danse

Rosenfeld v. Fairchild:
Proxy contest expenses
Very divided decision: Both agreethat incumbent can pay all his proxy contest expenses if
the contest is about policy reason.
In this very case, there is a dispute whether it is about a policy or personal struggle?
Facts: Derivative action of a SH who seeks to compel the return of 261.522 $ paid out of the
corporate treasury to reimburse both sides in a proxy contest for their expenses:
106.000 $ was spent by the old board of directors while still in office in defense of their position
in said contest.
28.000 was paid by the old board to the new board after the change of management to
compensate the former directors for such of the remaining expenses of their unsuccessful defense
as the new board found was fair and reasonable,
127.000 $ representing reimbursement to the new board of directors, was expressly ratified by
16 to 1 majority vote of the SH.
After the new board won, they authorized Fairchild to reimburse the old board for most of their
expenses, and they voted to have Fairchild reimburse their own expenses. Plaintiff did not allege
any fraudulent behavior, and agreed that the expenses were reasonable, but nonetheless not legal.

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Issue : The issue is whether directors can use the company treasury to fund the solicitation of
proxies.
The test is clear: when the directors act in god faith in a contest over policy, they have the right
to incur reasonable and proper expenses for solicitation of proxies and in defense of their corporate
policies and are not obliged to sit idly by.
The members of the new group can be reimbursed by the corporation for their expenditures in
this contest by affirmative vote of the SH.
The rule is: in a contest over policy, as compared to a purely personal power contest,
corporate directors have the right to make reasonable and proper expenditures, subject to
the scrutiny of the courts when dully challenged, from the corporate treasury for the
purpose of persuading SH of the correctness of their position and sollicitng their support for
policies which the directors believe, in all good faith, are in the best interests of the
corporation. The SH have the right to reimburse successful contestants for the reasonable
and bona fide expenses incurred by them in anay such policies contest.
Judge Desmond concurring: Some of the payments attacked in this suit were on their face
for lawful purposes and apparently reasonable in amount, but as to others, the record does
not simply contain evidentiary bases for a determination as to either lawfulness and
reasonableness.
Dissent (Van Hooris): No resolution was passed by the SH approving payment to the
management group. Not all of the 133966$ was designed merely for the information of SH:
entertainment, planes, limousinesThe directors should have assume the burden of proof
explaining and justifying their expenditures. Whether the amount paid by the new board to
the old board was for a corporate purpose?
Incumbent reimbursement when policy, not personal power struggle
It hard to characterize because sometimes a change in personel is indispensable to a change of
policy, a new board may be the symbol of the shift in policy as well as the means of obtaining it.
Reasonable compared to what?
As a management group is concerned, it may charge the corporation with any expenses
within reasonable limits incurred in giving widespread notice to SH of questions affecting
the welfare of the corporation. The corporation lacks power to defray the expenses of the
insurgents. Expenditures in excess are ultra vires. They could not be ratified unless by
unanimous vote if there were ultra vires.
Incumbent reimbursement whether win or lose, and without sh approval, so long as policy
contest + reasonable expenditures
Are these bright line rules?
How well would you expect them to police the board and management?
Any changes as a result of the use of proxy contests as part of hostile takeovers?
When does winning insurgent get reimbursed? Why?
Why not loser, if contest deemed beneficial?
Van Voorhis seems to think only expenses used to inform should be reimbursed to
incumbents.
What would be the consequences of this view?
Sect. 5: Allocation of power between the board and the CEO

1.

The managing model of the board:

In the traditional model corporate structure, the board managed the business of the corporation.

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Under modern practice: the management is ordinarily located on the executives and the central
figure is not the board but the CEO.

Why? Time, businesses are far too complex to be managed by directors who are essentially
part time. Number of board meeting is limited. Information, the executives have enormously
more information than the board and by controlling the information that the board receives, the
executives can shape the decision that the board makes.
2.
The monitoring model of the board: Today

Shift from a managing model to a monitoring model.

Move from management board to outside (independent) board charged with monitoring
management.
Outside board seen as a means of addressing agency costs flowing from separation of ownership
and management.
To reinforce the independence of directors, designation od a lead independent director in
corporations where the CEO is also Chairman of the board.
Note move away from imperial CEO
Board composition shift
Move from management board to outside (independent) board charged with monitoring
management.
Outside board seen as a means of addressing agency costs flowing from separation of
ownership and management.
Modern board?
Said to be monitoring board
Query: Is the new board model neither managing nor monitoring, but simply geared to the
creation of compliance mechanisms?
Board demands
For outsiders, increased time demands
Average director of public company: 140+ hours/year
Where does that time come from when outside directors of Corp A are CEOs/CFOs etc. of
Corp B? When theyre on multiple boards?
Independent director as panacea?
How deal with board demands?

Retired execs?
Fisch excerpt: positive view of movement to outside boards. Some controversy on this.
How broadly do we (should we) define independence?
Relationship of independence, expertise, professionalization of board service and
shareholder responsiveness = complex issue
The problem with empirical studies on the subject: its likely that widely differing levels of
independence and commitment across outside directors make it virtually impossible to
measure the effectiveness of independent directors by assessing firm performance.
Current developments influencing board function
Corporate raters/corporate governance industries
Use of search firms
Director School programs: networking, homogen effects, I have a degree so I am not liable

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Fear of grand jury and aggressive plaintiffs bar

Directors informational rights

Generally plenary, though some jurisdictional differences as to whether there should be
inquiry into the intent of the director.
Kalisman v. Friedman

Even access to privileged dox granted board member seen as adverse

Delaware 220: corps burden to show improper purpose on part of director
How boards operate contd
Kahan & Rock: Tell us the boards functions have been balkanized across numerous
committees

Partly b/c of listing requirements, SEC disclosure requirements, SOX etc.

Do balkanization and compliance agendas rob board of traditional role as

sounding board for business policies, practices and management plans?
Takeovers
It was extremely difficult for insurgens to oust incumbent management of a publicly held corporation
by voting new directors into office: proxy fight (costs).
It was also difficult to acquire a corporation over the opposition of its managers because the
principal form of acquisition such as mergers and the purchase of substantially all of a corporations
assets, require approval by the board of the corporaton that is to be acquired.
Then hostile takeovers: A the bidder makes a bid or a tender offer to purchase stock in B, the target,
up to a stated amount and subject to certain condition. The bid is made to the targets SH over the
head of the targets management who is resisting the takeover.
The board resists by taking defensive actions to block the bid which often invoke a restructuring of
the allocation of power between management and SH.
The question is what standard of review the courts apply in reviewing the defensive actions by
management.
In Unocal: Whether the defensive action is reasonable in relation to the threat posed.
In Unitrin (important gloss on Unocal): enhanced scrutiny: (1) whether the repurchased program
was draconian by being either preclusive or coercive which requires the board to demonstrate that
after a reasonable investigation, the board determined in good faith that the bidder presented a
threat that warranted a defensive response and (2) if the defensive measure is not draconian,
whether it was within the range of reasonable responses to the threat (proportionality test).
SHAREHOLDER INFORMATIONAL RIGHTS AND PROXY VOTING
Access to documents depends on the State
Requirement for a SH to show a proper purpose

Articles, bylaws, and minutes of shareholder meetings are available as of right.

See, e.g., RMBCA 16.01(e) and 16.02(a).
Del GCL 220: The courts really limit the documents the SH can access. The demand
has to be written with rightful precision. Part of the arsenal of a lawyer

Inspection of books and records.

(a)
As used in this section:
(2) "Stockholder" means a holder of record of stock in a stock corporation, or a person who is the
beneficial owner of shares of such stock held either in a voting trust or by a nominee on behalf of
such person.

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(b)

Any stockholder [in person or through lawyer/agent] shall, upon written demand under
oath stating the purpose thereof, have the right during the usual hours for business to inspect for
any proper purpose, and to make copies and extracts from corporation's stock ledger (grand
livre), a list of its stockholders, and its other books and records. A proper purpose shall mean a
purpose reasonably related to such person's interest as a stockholder. * * *
(c)
Where the stockholder seeks to inspect the corporation's list of stockholders and
establishes that such stockholder is a stockholder and has complied with this section , the burden
of proof shall be upon the corporation to establish that the inspection such stockholder seeks is for
an improper purpose.
Why differential treatment of the following under 220?
Shareholder lists
Corporate books and records
Access to shareholder lists
In Del., who has the burden to show the shareholder wants the list for an improper purpose:
Corp
Whats a proper purpose?

Pillsbury approach vs. Credit Bureau approach

Access to corporate books and records:
On whom is the burden to show the sh has a proper purpose for the access request to books and
records? SH

i.

Standard for access to corporate books & records/Del

Whats standard for access in Del.?
Saito v. McKesson HBOC
Limitations on a SH statutory right to inspect corporate books and records.
Facts: Stat. Del. 220, enables SH to investigate matters reasonably related to their interest,
including among other things, possible corporate wrongdoing.
McKesson corporation entered into a stock-for-stock merger agreement with HBO & Company.
Saito purchased McKesson stock. The merger was consummated. HBOC continued its separate
corporate existence as a wholly-owned subsidiary of McKesson HBOC.
Saito was one of four complaints (derivative action) which alleged that McKessons directors have
breached their duty of care by failing to discover the HBOC account irregularities before the merger,
have breached their fiduciary duties by failing to monitor the companys compliance with financial
reporting requirements prior to the merger.
Saitos demand was to further investigate breaches of fiduciary duties relating to their oversight of
their respective companys accounting procedures and financial reporting
Proper purpose reasonably related to such person's interest as a stockholder. He demanded
access to eleven categories of documents to investigate possible wrongdoings relating to
McKesson and McKesson HBOCs failure to discover HBOCs accounting regularities.
The scope of a SHs inspection is limited to those books and records that are necessary and
essential to accomplish the stated proper purpose. A proper purpose shall mean a purpose
reasonably related to such persons interest as a SH. Once a SH establishes a proper purpose the
right to relief will not be defeated by the fact that the SH may have secondary purpose.
Standing limitation: SH who bring derivative suit must allege that they were SH of the
corporation at the time of the transaction of which such stockholder complains. The court does not
read 327 as defining the temporal scope of a SHs inspection rights under 220. The claim may
involve a continuing wrong that predates and postdates the SHs purchase date. The wrongs may

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ii.

iii.

have their foundation in events that transpired earlier. If activities that occurred before the purchase
date are reasonably related to the SH interest he should be give access to the records.
Financial advisors documents: The Court of Chancery denied Saito access to documents in
McKesson possession that the corporation obtained from financial and accounting advisors on the
ground that 220 cannot be use to develop potential claims against third parties. The source of
documents in a corporate possession should not control a SHS right to inspection under 220. The
issue is whether the documents are necessary and essential to satisfy the SHs proper purpose?
Since McKesson and McKesson HBOC relied on financial and accounting advisors to evaluate
HBOCS financial condition and reporting, those advisors reports and correspondence would be
critical to Saitos investigation.
HBOC documents: Saito is a SH of HBOCs parent. The rule is SH of a parent corporation are
not entitled to inspect a subsidiarys books and records. But it does not apply to the relevant books
and records that HBOC gve to McKesson before and after the merger. HBOC provided financial
and accounting information to its proposed merger partner and later to its parent company. Saito
should have access to those documents.
Credible basis equirement: As a general proposition investigating for wrongdoing or
mismanagement is a proper purpose for SH access if he shows by a preoponderance of the
evidence credible basis from which the court can infer there is a possible mismanagement or
wrongdoing.
The credible basis may be satisfied by a credible showing through documents, logic, testimony, or
otherwise.
Many or more statutes may apply to only certain kinds of SH (5%, those who are record
holders for at least 6 months )
Scope of relief = narrow (essential)
Pillsbury v. Honeywell
Pillsbury was a SH of Honeywell. Pillsbury opposed the Vietnam War and asked Honeywell to
produce its SH ledger (Grand Livre) and all corporate records dealing with weapons and munitions
manufacture. Pillsbury admitted his only motive in purchasing Honeywell stock was to persuade
Honeywell to cease the production of munitions but argued that the desire to communicate with
fellow SH was per se a proper purpose. Honeywell argued that a proper purpose contemplates a
concern with investment return. The court decided that such a motive is not a proper purpose
because Pillsbury had no interest in the affairs of Honeywell to his economic interest as a
SH.
Espinoza v. Hewlett-Packard (2011)
A shareholder who has discharged his burden of showing his entitlement to a section 220
inspection must also satisfy an additional burden to show that the specific books and records he
seeks to inspect are essential to the accomplishment of the shareholders articulated purpose for
the inspection. A document is essential for section 220 purposes if, at a minimum, it addresses
the crux of the shareholders purpose, and if the essential information the document contains is
unavailable from another source. Whether or not a particular document is essential to a given
inspection purpose is fact specific and will necessarily depend on the context in which the
shareholders inspection demand arises. In making that scope of relief determination, our courts
must circumscribe orders granting inspection with rifled precision.
Rock Solid Gelt v. SmartPill
On credible basis:

Plaintiff doesnt have to show that misconduct is actually occurring.

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But neither dilutive refinancing nor execution of a more favorable stock purchase agreement
with another shareholder -- without more = credible basis to infer corporate waste or
mismanagement.
On scope: blunderbuss requests unlikely to succeed:

the court should not be burdened with clearing away the clutter that an
unjustifiably broad request produces

The SH list in a dematerialized world

As a practical matter, courts are understandably more willing to grant access to SH list and
the like than to grant access to otherwise-confidential financial and businesss information.
Requiring the SH is almost invariably a necessary step for SH to exercise their role in corporate
governance.
SH have the right to vote to elect directors and to approve or reject major corporate transactions at
SH meetings.
Under state law, SH can appoint a proxy to vote their shares on their behalf at a SH meeting and
the major national securities exchanges generally require their listed companies to solicit proxies for
all meetings of SH.
Because, most SH do not attend public company SH meetings in person, voting occurs almost
entirely by the use of proxies that are solicited before the SH meeting, thereby resulting in the
corporate proxy becoming the forum for SH suffrage.
Types of shares ownership and voting rights
The proxy solicitation process starts with the determination of who has the right to receive proxy
materials and vote on matters presented to SH for a vote at SH meetings. It depends on the type of
ownership: whether registered or beneficial owners.

Registered owners (=record holders). Because they have the right to vote, they also have the
authority to appoint a proxy to act on their behalf at SH meetings. It can be a book-entry
(certificated form) or an electronic form through DRS (an investor can electronically transfer his
or her securities to a broker-dealer to effect a transaction without the risk, expense, or delay
associated with the use of securities certificate.

Beneficiary owners (=owning in street name): They hold their securities in book-entry form
through a securities intermediary such as a broker-dealer or bank. The beneficial owner does
not own the securities directly, he has an entitlement to the rights associated with ownership of
the securities.

Distribution of the proxy materials :

To registered owners
It is a relatively simple process for an issuer to send proxy materials to registered owners.
Registered owners execute the proxy card and return it to the issuers transfer agent or vote
tabulator for tabulation.
To beneficial owners
- Complexities in the distribution of proxy materials to beneficial owners : Depository Trust Company
(a registered clearing agency acting as a securities depository, most US broker-dealers and banks
areDTC participants). DTCs nominee, Cede & Co, appears in an issuers stock records as the sole
registered owner of securities deposited at DTC. DTC holds the securities in fungible bunk. Each
participant owns a pro rata interest in the aggregate number of shares of a particular issuer. Once
an issuer establishes a date for the SH meeting and a record date for SH entitled to vote on matters

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presented at the meeting, it send a formal announcement of these dates to DTC. DTC forwards to
all participants. The issuer requests a securities position listing as of the record date. The record
date securities position listing establishes the number of shares that a participant is entitled to vote
through its DTC proxy. For each SH meeting, DTC executes an omnibus proxy transferring Its
right to vote the shares held on deposit.
- Securities intermediaries: broker-dealers and banks: once the issuer identifies the DTC
participants holding positions in its securities, it is required to send a search card to the registered
owners to determine whether they are holding shares for beneficial owners. Once the search card
process is complete, the issuer should know the approximate number of beneficial owners owning
shares through each securities intermediary. The issuer must then provide the securities
intermediary or its third-party proxy service provider, with copies of its proxy materials for forwarding
to those beneficial owners.
Proxy voting process
-registered owners execute the proxy card and return it to the vote tabulator
- beneficial owners indicate their voting instructions on the Voting Instruction Form and return it to
the securities intermediary. The securities intermediary, executes and submits to the vote tabulator
a proxy card for all securities held.
Note the various third parties involved in the proxy process: transfer agents (agents of the issuer
who maintain a recordof securities holders), proxy service providers (securities intermediary retain
proxy service providers to facilitate distribution and voting process for beneficial owners), proxy
solicitors (issuers sometimes hire third-party proxy solicitors to identify beneficial owners holding
large amount of shares and to telephone SH to encourage them to vote their proxies consistent with
the recommendations of management), vote tabulators (inspectors of elections), proxy advisory
firms (some institutional investors may retain an investment adviser to manage their investments
and may also delegate proxy voting authority to that adviser, they provide analysis and voting
recommendations on matters appearing on the proxy).
Consent and who is a record holder? P358-361?
Reporting under state law: sh rights to financial info
The SHs general inspection right requires a SH to take affirmative action and incur costs to obtain
information, and may be defeated in litigation.
Important aspect of ownership is being informed regarding the companys financial performance
and position. Approximately half of the states have adopted the Model Business Corporation Act
and require that every corporation must furnish to its SH annual financial statements including a
banlance sheet and an income statement.
Delaware is alone in having no provision mandating corporations to furnish financial statements to
SH even on written request.
Historically, no annual or periodic disclosure of financial information to shareholders required
under state law.
By contrast, RMBCA 16.20.

Annual financial information, including year-end balance sheets, income

statements, and statements of changes in shareholders equity.
But, RMBCA financial reports dont have to be filed publicly.
Federal proxy regulation: Securities Exchange Act of 1934

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Requirement for reporting companies to file with the SEC, quarterly and annually a broad range of
financial and non-financial information. With respect to non-reporting companies, the informational
rights of the SH are governed by state law.
There is something of unfulfilled need to require corporations that have significant public
ownership but not covered by the SEC Act, to report to their SH information not just their
financial results and position, but a wide range of matters bearing on managements of the
firm.
Overview of the SEC and the SEC Act
Goal: to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital
formation . . .
How: promote the disclosure of market-related information, maintain fair dealing, and protect
against fraud.
Exchange Act and SOX
SEC is empowered with broad authority over all aspects of the securities industry: power to register,
regulate and oversee brokerage firms, transfer agents and clearing agencies and nations securities
Self Regulatory Organizations.
The Act also identifies and prohibits certain types of conduct.
The Act also empowered the SEC to require periodic reporting of information by companies with
publicly traded securities defined under 12(g).
CEO and CFO certifications under SOX
The SEC Act also governs proxy regulations such as the disclosure in materials used to
solicit SHs votes in annual or special meeting held for the election of directors and the
approval of other corporate action.
Disclosure rules of private organizations
broadly worded and require issuers to disclose much business information that would have
an effect on the market, including confidential information on pending deals.
But much discretion to management provided as well, a corporation may make voluntary
timely disclosure of material corporate developments even if ot required to do so by law.
SEC Rules: regulate proxy consultations
Rules 14(a)(1) 14(a)(12) passed pursuant to Section 14.
We will focus on: 14(a)(9), 14(a)(7), 14(a)(8)
What constitutes a proxy solicitation?
Definitions:
Proxy holder: A person authorized to vote shares on a SHs behalf.
Proxy or form of proxy: Written instrument in which such an authorization is embodied.
Proxy solicitation: Process by which SH are asked to give their proxies.
Proxy statement: A written statement sent to SH as a means of proxy solicitation.
Proxy material: proxy statement and form of proxy.
Proxy rules
Proxy voting is the dominant mode of SH decisionmaking in publicly held corporations (SH are
geographically dispersed and represent small fraction of a SHs total wealth).
Proxy solicitation: process of systematically contacting SH and urging them to execute and return
proxy forms that authorized named proxy holders to cast the SHs votes.
Format requirement: Rule 14(a)

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Short-slate provision: Rule 14a-4(d): split vote

Under state law, the later executed proxy prevails over the earlier granted proxy.
Anti-bundling (=groupage): one clever method to obtain approval of a matter likely no to be popular
with SH is to include within that proposal a provision that would be popular with SH.
But rule 14a-4(b) requires separate voting on matters that are not related.
Mandated disclosure: Require full disclosure in connection with transactions that SH are being
asked to approve, such as mergers, certificate amendments or election of directors. Section 14A
details the information that must be furnished when specified types of transactions are to be acted
upon the SH. This rule is backed-up by rule 14a-9 which provides that no solicitation subject to the
proxy rules shall contain any statements that is false or misleading with respect to any material fact
or omits a material fact.

Proxies for election of directors on behalf of a corporation: the corporation must send an annual
report to its SH. The contents of the annual report are governed by rule 14a-3 (must include
corporations financial statements, managements discussion and analysis of the corporations
financial condition and results of operations: MD&A).
Filing with the SEC: Rule 14a-6 governs the filing of proxy materials with the SEC.
The premiliminary proxy statement and the ballot (form of proxy) must be filed wth the SEC before
the definitive copies of these materials are expected to be given or sent to the SH. SEC has time to
review the materials. The filed materials become immediately available and can be used in
solicitation although the actual circulation of the ballot must await the filing of the definitive proxy
statement.
2 broad notable exceptions.
Coverage: Rule 14a-2 provides that the proxy rules apply to all companies with securities registered
under Section 12 of the Exchange Act
- Formerly an extremely broad standard: "communication to security holders under circumstances
reasonably calculated to result in the procurement, withholding or revocation of a proxy."
- Including any communication which, even if it did not itself request any authorization, could be
read as part of a continuous plan intended to end in a successful solicitation.
- Narrowed under 1992 changes. Now, informational newspaper ads relating to voting are ok.
Note JOBS Act changes on registration Supp. P. 11
14(a)(2) exemptions
14a-1(l)(2) lists several acts that are excluded most significantly. It does not constitute a
solicitiation for a security holder to announce his intent to vote in a certain manner (just say
no campaign)
14a-2(b)(2): proxy requirements a security holders communication directed to ten or fewer
persons
14a-2(b)(1): communications by a person who is not seeking a proxy authority and who
does not have a substantial interest in the matter that is subject to a vote.
Rule 14a-3 prohibits proxy solicitation unless sh is furnished proxy statement containing
Schedule 14A information
Registrant has to file all proxy materials with SEC
Relevant rules: 14a-1 to 14a-12

Rule 14a-2 (b) Rules 14a-3 to 14a-6 ... do not apply to the following:

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(1) Any solicitation by ... any person who does not ... seek ... the power to act as proxy for a
security holder and does not furnish or otherwise request ... a form of revocation, abstention,
consent or authorization.

Sect.3: The proxy rules: Shareholder access

Federal law on access to shareholder lists : Rule 14a-7
The proxy rule from time-to-time address more than disclosure.
Rule 14a-7 provides a means for a SH who wishes to solicit proxies to gain access to her fellow SH.
This provision requires that the company shall in response to a request by a record or beneficial
holder either provide a list of SH or circulate the requesting SHs material.
Which option do you think the company will prefer? Send the proxy material itself and immediately
because only the later proxy material is binding.

When does it apply? When management is making solicitations, it has the option to furnish
shareholder list or mail requesters contending proxy material
Is there are requirement of proving purpose? Sidesteps state law issues of proving purpose,
But does not preempt state law
Whose option to furnish shareholder list or mail requesters contending proxy material? The
company.
Which option under 14(a)(7) would the requesting shareholder prefer?
Who has to pay for sending the requesting shareholders proxy materials? Requesting
shareholder has to pay
14(a)(7) is the flip side of 220
You can access to the SH through 14(a)(7) at the SH expenses, the management decide for
which option (send the SH list to the Sh or send his proxy material). By circulating themselves,
the BD engages in strategy, the last material sent counts.
SH will prefer to make a SH proposal because the company pays for it
If the SH only wants to change the policy 14(a)(8) permits to put SH proposal.
14a-8 Shareholder proposals: town meeting rule not applicable to elections
Rule 14a-8 gives shareholders the possibility of including shareholder proposal in managements
proxy materials.
Threshold requirements: eligibility, notice and attendance at meeting, timeliness,
length of proposal.
Notice SEC Staff Legal Bulletin 14(F): adding statement of ownership from broker/banker to
establish proposers status as record holder (See Supp p. 12)
What effect? Certainty/accuracy vs. increased trans. costs
Note: Plain English style
Note: issue about bundling Supp. P. 12
What is a shareholder proposal?
Shareholder proposal rule
(1) What is a proposal?
(2) Who is eligible to submit a proposal, and how do I demonstrate to the company that I am
eligible?
(3) How many proposals may I submit? Only one
(4) How long can my proposal be? Limited to 500 words
(5) What is the deadline for submitting a proposal? not less than 120 calendar days before
(6) What if I fail to follow one of the eligibility or procedural requirements explained in answers to
Questions 1 through 4 of this section?

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(7)

If I have complied with the procedural requirements, on what other bases may a
company rely to exclude my proposal?

A shareholder proposal is your recommendation or requirement that the company and/or its board
of directors take action, which you intend to present at a meeting of the company's shareholders.
In order to be eligible to submit a proposal, you must have continuously held at least $2,000 in
market value, or I %, of the company's securities entitled to be voted on the proposal at the meeting
for at least one year by the date you submit the proposal. You must continue to hold those
securities through the date of the meeting.
Each shareholder may submit no more than one proposal to a company for a particular
shareholders' meeting.
The proposal, including any accompanying supporting statement, may not exceed 500 words.
(1) If you are submitting your proposal for the company's annual meeting, you can in most cases
find the deadline in last year's proxy statement.
(2) The proposal must be received at the company's principal executive offices not less than 120
calendar days before the date of the company's proxy statement released to shareholders in
connection with the previous year's annual meeting.
The company may exclude your proposal, but only after it has notified you of the problem, and you
have failed adequately to correct it. Within 14 calendar days of receiving your proposal, the
company must notify you in writing of any procedural or eligibility deficiencies, as well as of the time
frame for your response. Your response must be postmarked, or transmitted electronically, no later
than 14 days from the date you received the company's notification. * * * If the company intends to
exclude the proposal, it will later have to make a submission under Rule 14a-8 and provide you with
a copy ***
(1) Improper under state law: If the proposal is not a proper subject for action by shareholders
under the laws of the jurisdiction of the company's organization;
(5) Relevance: If the proposal relates to operations which account for less than 5% of the
company's total assets at the end of its most recent fiscal year, and for less than 5% of its net
earnings and gross sales for its most recent fiscal year, and is not otherwise significantly related to
the company's business;
(7) Management functions: If the proposal deals with a matter relating to the company's ordinary
business operations;
Excludability: 14a-8 subject matter restrictions:
Making social policy related proposals, mostly onstitutional SH want to oversee the BD not
in their everyday decisions but to make sure that they have put in place a compliance
service and that there is no entrnachment of the BD.
Rule 14a-8 provides that if management believes a SH proposal may properly be excluded from the
corporations proxy statement under rule 14a-8, it must submit to the SEC, staff a statement of the
reasons why it deems omission of the proposal to be proper. It the staff agrees with the
managements statement, it send the management a no-action letter, that is a letter stating that if
the SH proposal is omitted, no action will be taken by the SEC. If the staff disagreed, the no letter
is a clear statement that if the management omit the proposal this could lead to a SEC enforcement
action. No action letters are opinions of the staff of the SEC, and not the commissioners, they are
not reviewable orders of an agency under the Administrative procedure Act.

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Examples:
14a-8(i)(1): Improper under state law
14a8(i)(5): Relevance
14a8(i)(7): Ordinary business/mgment functions
14a-8(i)(8): Elections
Standard Pacific Corp. no action letter sequence
Facts: Standard Pacific Corp is a leading builder of single-family attached and detached homes.
Standard Pacific Corp intended to omit from its proxy statement a SH proposal and statements in
support.
The proposal requested that the board of directors of the company adopt quantitave goals based on
availbale technologies for reducing total greenhouse gas emissions from the companys products
and operations and report to SH on its plan to achieve those goals.
The board considered that the proposal should be excluded because it deals with matters related to
the companys ordinary business operations, specially the assessment of risk.
Even if the proposal does not specifically use the word risk adopt quantitative goals for reducing
greenhouse gas emissions from the companys products and operations is nothing but an
assessment of costs, risks and liabilities. Ths internal assessment is part of the ordinary day-to-day
operations and implicates the companys ordinary business.
The excludability is supported by precedents of the staff of the SEC indicating that the staff looks
beyond whether the SH proposal refers specifically to an assessment of risk.
Careful drafting of the proposal may not be sufficient to eliminate any reference to risks and
liabilities.
The Staff had concluded that certain operations related proposals may focus on sufficiently
significant policy issues so as to preclude exclusion in certain circumstances.
The SH replied that the proposal focuses on minimizing or eliminating operations that may
adversely affect the environment not on an internal assessment of risks and liabilities. In applying
the ordinary business exclusion to proposals dealing with environmental and public health matters,
the staff distinguishes between proposals that focus on an internal assessment of the risks and
liabilities that the company faces as a result of its operation that may adversely affect the
environment or the publich healths which are excludable and proposals that focus on the
company minimizing or eliminating operations that may adversely affect the environment or the
publich healths that are not excludable.
To avoid micro-management, the proposal gives standard board a substantial discretion in
determining what the goal should be.
Response of the SEC: the proposal shold not be omitted. Earlier dichotomy of the SEC precedents
regarding to SH proposals related to environmental, financial, health and other risks proved
unworkable.
As most corporate decisions involve some evaluation of risk, the evaluation of risk should not be
viewed as an end in itself, but as a means to an end. The SEC rather than focusinf on the company
engaging in an evaluation of risk, will instead focus on the subject matter to which the risk
pertains or that gives rise to the risk. The fact that the proposal would require an evaluation
of risk will not be dispositive. The SEC will look at the underlying subject to see if it involves
a matter of ordinary busness or raises policy issues so significant that it will be appropriate
for a SH to vote as long as a sufficient relation exists between the nature of the proposal and
the company.
Non racial discrimination employment was at first considered as non social policy but
employment and therefore was excludable.
Shift: if the Sh proposal is related to employement but concerns a social policy standard it is
OK

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1998 SEC release standard :

proposals requesting an assessment of risks or liabilities
Staffs traditional approach:
What about proposals addressing both ordinary and non-ordinary business matters?
excludable
What about proposals that focus on significant social policy issues?
Non excludable
Shareholder access to the nominating process: Rule 14a-11 proxy access
Whether the proxy rules authorize SH initiatives to nominate individuals to stand for election to the
board of directors.
Struck down in Business Roundtable v. SEC (on TWEN under Course Materials)
In Delaware 216 allows for SH to nominate his nominees
The SEC amended rule 14a-8(i)(8) to expressly provide that a proposal could be omitted if the
proposal relates to a nomination of a director.
At the same time, provisions in Delaware and the Model Act were amended to expressly authorize
bylaw provisions that authorized procedures for SH to nominate directors as well as bylaws
authorizing reimbursement of insurgent proxy expenses.
Congress passed a financial reform legislation and authorized the SEC to adopt rules providing for
SH to nominate directors to the boards of reporting companies: Sec adopted rule 14a-11.
Rule 14a-11: SH and SH groups who collectively have held investment and voting power of at least
3% of the voting power of a companys securities continuously for at least 3 years, the right to have
nominees on the companys ballot that represent a maximum of 25% of the entire board (a
minimum of one director).
Sect. 4: Materially misleading proxies and rule 14(a)-9 THE ANTI-FRAUD RULE
You cannot omit, mislead in the solicitation proxy
Standing to sue under 14(a)
J.I. Case v. Borak: A SH has a private right of action for violation of the Proxy rules under section
14a although neither the1934 Act nor the Proxy Rules themselves explicitly provide for such an
action. Shareholder derivative suit claiming that management had secured approval for a merger
through the issuance of a false and misleading proxy statement. Private enforcmenet of the proxy
rules provides a necessary weapon supplement to Commision action (civil damages or injunctive
relief).
Rule 14(a)(9) : Anti-fraud provision that undergirds the rest of the federal proxy scheme
Causation:
Mills v. Electric Autolite: 14a-9 causation made out if:
1) proxy = an essential link in the transaction and
2) the misstatement or omission was material.
Facts: A corporate merger was accomplished through the use of a proxy statement that was
materially false or misleading.
Petitioners were SH of the Electric Auto-Lite company when it was merged into Mergenthaler
Linotype Company.

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SH of Electric Auto Lite brought suit on the day before the SHs meeting at which the vote was to
take place on the merger against Auto-Lite and a third company Amercian Manufacturing
Company.They asked for the merger to be set aside.
They alleged that the proxy statement sent out by Auto-Lite management to solicit SH votes in favor
of the merger was misleading in violation of 14(a)-9.
Before the merger, Mergenthaler owned over 50% of the outstanding shares of Auto-Lite common
stock and had been in control of Auto-Lite for two years.
American Manufacturing owned about one-third of the outstanding shares of Mergenthaler ad
through it Auto-Lite.
The proxy was misleading while telling to Auto-Lite SH that their board of directors recommended
approval of the merger wthout telling them that all of 11 Auto-Lites directors were also nominees of
Mergenthaler and were under control and domination of Mergenthaler.
The Court found that under the term of the merger agreements, an affirmative of the 2/3 of the AutoLite shares was required for the approval of the merger and that the respondent companies owned
and controlled about 54% of th outstanding shares, so it needed the approval of a substantial
number of the minority SH.
The Court concluded that a causal relationship between the finding that there has been a violation
of rule 14(a) and the alleged injury to the plaintiffs.
The Court of Appeal affirmed that the proxy statement was deficient but reversed on the question of
causation: if an injunction had been sought a sufficient time before the SHs meeting, corrective
measures would have been appropriate. However since the suit has been brought too late, the
courts had to determine whether the misleading statement and omission caused the submission of
sufficient proxies. The CA ruled that the issue was to be determined by proof of fairness of the
terms of the merger: was the terms fair enough so that the SH would have vote in favor despite the
misleading statement?
The Supreme court that the test is irrelevan because it would insulate from private redress an entire
category of proxy violations, those relateing to matters other than the term of a merger. Such a
result would subvert the congressional purpose of ensuring full and fair disclosure to SH.
Use of a solicitation that is materially misleading is itseld a violation of the law.
Where there has been a finding of materiality, a SH has made a sufficient showing of causal
relationship between the violation and the injury, if he proves that the proxy solicititation
itself rather than the particular defect, was an essential link in the accomplishment of the
transaction.
Issue: What causal relationship must be shown between such a statement and the merger to
establish a cause of action based on the violation of the Act?
Rule: So long as the misstatement or omission was material, the causal relation between violation
and injury is sufficiently established. There is no need to demonstate that the alleged defect in the
proxy statement actually had a decisive effect on the voting.
Note: On remand the DC held the exchange to be unfair and awarded damages of 1.233.918$
as well as 740.000$ in pre-judgement interests, the CA reversed finding the terms of the
merger to be fair.
14(a)(9) materiality:
How is materiality defined?
Mills: " [the defect] might have been considered important by a reasonable shareholder who was in
the process of deciding how to vote".
TSC industries v. Northway

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Definition of materiality (heightened significance)

Changed the Mills standard: an omitted fact is material if there is a substantial likehood that
a reasonable SH would considerate important in deciding how to vote
An omitted fact is material if there is a substantial likelihood that a reasonable shareholder would
consider it important in deciding how to vote.
It is fully consistent with Mills general description of materiality as a requirement that the defect
have a significant propensity to affect the voting process.
To demonstrate a substantial likewood that the disclosure of the omitted fact would have been
viewed by the reasonable investor as having significantly altered the total mix of information made
available.
Why the change? So the board does not feel from liability and overload the SH with trivial
information that is hardly conducive to informed decision making.
Mills remains for materiality does not require demonstration of causal relation but definition
of materiality has changed (only substantial likehood)
Materiality under 14a-9

Hypo 1: Lyman v. Standard Brands: Proxy materials didnt disclose securities law
indictments of proposed accounting firms Okla. City office.

Hypo 2: Levy v. Johnson: in election of directors, proxy didnt disclose that directors had
been found guilty of violating the Foreign Corrupt Practices Act by bribing foreign officials
Wrap-up on causation
Mills v. Electric Auto-lite
Why wasnt materiality at issue?
Why did the Supreme Court reverse the 7 th Circuits fairness-based assessment of
causation? It is hard to prove reliance in ublicly held corporation so the court will check if the
merger was fair
Why the shift from might to would in defining materiality in TSC?
Is an objective might standard all that different from the TSC would standard?
possible way of reading: at what point of winnowing do we assess?
The TSC Court is clearly attempting to narrow the scope of materiality for 14a-9
purposes chipping away at the Borak private right of action?
Remedies for 14a-9 violations
It seems that the Court differs if the misrepresentation is about a proxy solicitation about
transaction (merger) or election (BD election). No award of domagaes if BD election
Ironic story of Mills:

fairness through the back door, at the remedy end

Possible remedies: 1) Federal; 2) Lots of judicial discretion injunction, rescission,
damages (not limited to declaratory relief)
Federal/state conflicts
Virginia Bankshares Inc v. Sandberg (J.Souter delivered the opinion)
Test: fairness of the deal

The Supreme Courts latest statement on materiality and causation under Rule 14(a)(9)

2 key issues:

1) materiality of conclusory statements of belief

2) causation when proxy not essential element in accomplishment of the

transaction

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Facts: First American Bankshares (FABI) holding, began a freeze-out merger in which the First
American Bank of Virginia (Bank) eventually merged into Virginia Bankshares (VBI) a wholly owned
subsidiary of FABI.
VBI owned 85% of the Banks shares, the remaining 15% being in the hands of some 2000 minority
SH.
FABI hired an investment bank (KBW) to give an opinion on the appropriate price for the shares of
the minority SH who would lose their interests in the Bank.
KBW gave an opnion that 42$ would be a fair price. The executive committee approved.
Although Virginia law required only that such a merger proposal be submitted to a vote at a SHs
meeting and that the meeting be preceded by circulation of a statement of information to the SH,
the directors nevertheless solicited proxies for voting on the proposal at the annual meeting.
The directors urged the proposals adoption because of its opportunity for the minority SH to
achieve a high value which they elsewhere described as fair price.
Almost all the SH gave the proxies requested except Sandberg.
He argued that the board had not recommended the merger because they believe the price was
high or that the terms of the merger was fair but because they wanted to keep their positions. The
jurys verdicts were for Sandberg.
The Court of Appeal affirmed holding that certain statements in the proxy solicitation were materially
misleading for purposes of the Rule and that respondents cold maintain their action even though
their votes has not been needed to effectuate the merger.
The SC considered the actionability per se of statements of reasons, opinion or belief.
The directors did not believe what they stated. SH know that directors usually have knowledge and
expertise far exceeding the normals investor resource and state law obliged them to act in the
shareholders interest.
The fact that such conclusory terms high, fair in a commercial context are reasonably understood
to rest on a factual basis that justifies them as accurate, the absence of which renders them
misleading.
Disbelief or undisclosed motivation standing alone, is insufficient to satisfy the element of
fact that must be established under 14(a).
There would be no justification for holding the SH entitled to judicial relief, that is when
given evidence that a stated reason for a proxy recommendation was misleading and an
opportunity to draw that conclusion themselves.
Here the directors omitted to say:
that they would loose their seat if they do not support the merger.
That the closed market dominated by FABI
The the claim that the price exceeded the book value was controverted by the evidence of a
higher book value than the directors conceded reflecting appreciation in the Banks real estate
portfolio more than 60$ instead of 42$.
Dissent (Justice Stevens)
The case before us today involves a merger that has been found unfair, the interest in providing a
remedy to the injured minority SH therefore is stronger not weaker than in Mills. He thinks that
remedy should be avaiblabe whether the vote of the SH as necessary or not as long as the
statement is misleading.
Once corporate officers have decided for whatever reason to solicit proxies they should comply with
the statute.
Dissent (Kennedy, Marshall and Blackmun)
The courts distinction between cases where the minority SH could have voted down the transaction
and those where causation must be proved by non voting theories is suspect. The real question

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ought to be whether an injury was shown by the effect the non disclosure had on the entire merger
process, including period before votes were cast.
This disctinction does not create clear categories. Those who lack the strength to vote down a
proposal have all the more need of disclosure.
14a-9: Conclusory statements of belief are actionable under 14a-9as long as BD provides
enough information for a reasonable SH to understand
Directors statements are material

knowingly false statements of reasons may be actionable even though

conclusory in form

But 14a-9 requires that [a]n opinion by the board must both misstate the boards
true beliefs and mislead about the subject matter of the statement, such as the value of
the shares in a merger. Mere disbelief isnt enough for liability.

1) misstatement of true belief

2) substantive falsity of statement

Can misleading statements be neutralized by true facts set out in proxy

materials?
Yes, but its a factual issue.
You shouldnt have to be a financial wizard to assess the claims.
14a-9: Va. Bankshares on causation
5-4: minority shareholders whose votes weren't needed to authorize a merger failed to
show that an allegedly false proxy statement caused them damages compensable under
14a.

We hold that . . . respondents have failed to demonstrate the equitable basis

required to extend the 14a private action to such shareholders when any indication of
congressional intent to do so is lacking.
Does this overrule Mills on causation?
No.
In Mills, the merger had to be approved by a supermajority of shareholders. So their votes
were needed!
Virginia Bankshares
Does Justice Souters opinion leave any opening for a viable 14a-9 claim in federal court by
shareholders whose votes were not an essential link in the accomplishment of the transaction?
Virginia Bankshares back-door:
Loss of state law remedy seems to be a back door to the federal courthouse under 14a-9
This supports reading this aspect of Virginia Bankshares as grounded in federalism
concerns
Why wasnt case brought as fiduciary duty claim under state law?
Virginias apparent cap on damages for fiduciary claims of this sort?
Wilson v. Great American Industries
Chenango engaged in a merger with Great American. Minority SH in Chenango exchanged their
shares of Chenango common stock for new preffered stock in Great American based on a
mmaterial misstatements in the Proxy statement.

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NY law required that Chenango have a SHs meeting to approve the merger and only a given notice
of the meeting accompanied by a copy of the plan of merger.
There was no need for the SH approval because 73% was held by different SH connected to the 2
corporations.
Chenango seek nevertheless the approval of the miniority SH.
Unlike in Virginia, state law accorded SH who voted against the merger to an appraisal remedy t get
the fair value of their shares.
Subsequent cases e.g. Wilson take the back door to federal court
Judicial concerns: frivolous litigation, federalism
Standard of fault 14a-9
Q left open in TSC and Virginia Bankshares, so no S. Ct. clarification
Most lower courts say scienter not necessary showing

Why not?
Why difference re outside accountants (Adams)

Negligence?

Why shouldnt it be strict liability standard?

Compare with state law

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PERSONAL LIABILITY IN A CORPORATE CONTEXT

Several contexts in which personal liability can be imposed upon a SH or upon a person
associated with a proposed or defectively formed corporation.

liability of a promoter for preincorporation

liability of a person who is a would-be SH in a defectively formed corporation
liability of a SH for corporate obligations.

2) Consequences of defective incorporation

De Facto Corporations/Corps By Estoppel
Circumstances of personal liability despite attempts to incorporate

Sect 1. Preincorporation transactions by promoters

A promoter enters into preincorporation contracts for the benefit of a corporation that has not yet
been formed.
General rule on promoter liability:
When a promoter makes a contract for the benefit of a proposed corporation, the promoter is
personally liable on the contract, and remains liable even after the corporation is formed,
unless a subsequent novation releases the promoter from liability.
RS 3rd 6.04
RS 2nd 326
One exception: If the party who contracted with the promoter knew that the corporation was
not in existence at the time of the contract and nevertheless agreed to look solely to the
corporation for performance. In such cases, the promoter is not deemed a party to the contract.
An agreement of this type may be express or implied.
Compare Goodman approach with Pottery Warehouse approach:
Goodman v. Darden
Facts: Goodman has proposed to renovate an apartment building owned by Darden, Doman &
Associates. During the course of negotiations, Goodman informed Darden that he will form a
corporation to limit his personal liability. A contract was formed with the company in formation and
Goodman president. DDS knew the corporation was not formed. Later Goodman filed the certificate
of incorporation. DDS made 5 progressive payments on the contract, the first was made to Building
Design Development Goodman, Goodman struck out his name as payee, endorsed the check
and asked DDS to make further payments only to the corporation. DDS did so.
Holding and rule: The court held Goodman liable.
Analysis: - the fact that a contracting party knows that the corporation is nonexistent does not
indicate any agreement to release the promoter. To the contrary, such knowledge alone would
seem to indicate that the members of DDS intended to make Goodman a party to the contract.
the first payment was made to the corporation and Goodman as an individual, the following
payments were made payable to the corporation only after Goodman gave the instruction. This
does not show with a reasonable certainty that DDS intended to contract only with the
corporation.
In contrast,

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Company stores v. Pottery Warehouse

Facts: Company stores leased a store to Pottery Warehouse. Pottery was not incorporated at the
time of the lease. The lease recited that the corporation was to be organized and was signed by the
promoter The porttery warehouse, a corporation to be formed under the laws of the State of
Tennessee, by Jane Vosseler, its president.
Holding: The Court held that the promoter was not liable.
Reasoning: At the time the lease was signed, plaintiff was aware that the corporation was not
incorporated and did not requested the promoter to sign in an individual capacity but as the
president of a future corporation. There is no intention on the part of Vosseler to be bound
personally.
Corporations liability for pre-incorporation transactions
General rule : No liability
A corporation that is formed after the promoter has entered into a contract on its behalf is not
bound by the contract without more. Because when the contract was made the corporation did
not exist. So the corporation could not have authorized the promoter to act on its behalf.
Exception: Liability upon contract adoption
Ratification, adoption, novation, receipt of benefits (the proposition made to the promoters is a
continuing offer to be accepted or rejected by the corporation when it comes into being, and
upon acceptance become a new contract).
By accepting the benefits of a contract, the corporation is estopped to deny its liability on the
contracts.
But the fact that the corporation also becomes liable does not relieve the promoter of liability,
instead they are jointly and severally liable.
Sect.2 Consequences of a defective corporation
Sometimes there is a defect in the process of forming a corporation, but no-one knows.
The issue arises when:
a third party wants to enforce the contract and seek to hold the would-be SH personally
liable on the ground that corporate status was not attained and therefore there was nor
limited liability.
In a quo warranto proceedings brought by the state to test the validity of corporate statutes.
The question arising is whether the corporation exists:
De jure: Substantial compliance suffice to the requirements for incorporation, case-by-case basis.
Some courts hold that there must be exact compliance with all mandatory statutory requirements
but the failure to comply with the requirements that are directory will not preclude de jure status.
Conesquently the corporation rather than persons associated with the corporatop is liable.
For ex: mistake in the number of the street of the place of incorporation.
De facto: When the steps taken to incorporate the enterprise were insufficient to result in a de jure
corporation with respect to a challenge by the state in a quo warranto proceeding but were sufficient

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to treat the enterprise as a corporation with respect to third parties. Status can be invalidated by
the state but not by third parties. Ex: for unexplained reasoned, the certificate of incorporation was
not officially filed by the Secretary of States until two days after the lease was signed.
3 requirements are typically cite for application of the de facto corporation doctrine:
a statute in existence by hich the corporation was legally possible
a colorable attempt to comply with the statute
some actual use or exercise of corporate privileges.
The three factors often dissolve in once: whether defendants attempts to incorporate has
gone far enough to be deemed colorable compliance.
Estoppel: Cases in which neither a de jure neither a de facto has been formed but the courts held
that a third party who has dealt with an enterprise on the basis that it is a corporation is estopped
from denying the enterprises corporate status and cannot seek the personal liability of the business
owner. It is not a clear doctrine some says that estoppel only applies cor a specific transaction.
Estoppel v. De facto theory
In estoppel: a decision will turn heavily on the plaintiffs conduct, it may have a limited
precedential effect on future decisions brought by other plaintiffs.
In de facto: a decision will turn on the defendants conduct so it may have a significant
precedential effect on future decisions.
The estoppel theory is a cluster of Denial of corporate status :
Denial of corporate status by the would-be SH: At the time of the transaction, the owners
claim that the enterprise is a corporation, later a third party suit against the purported
corporation and the entreprise and its owner deny that the enterprise is a corporation. This is
a true estoppel case.
Technical contexts: when the question of corporate status is raised in a technical procedural
context. In a suit brought by a would-be corporation, the defendant may seek to raise the
defense that the plaintiff is not really a corporation and therefore cannot sue in a corporate
name. The third party is estopped.
Liability of the would-be SH: when a third party who has dealt with an enterprise on the basis
that it is a corporation seeks to impose personal liability on the would-be SH, who in turn
defend on the ground that the third party is estopped to deny that the enterprise has
corporate status.
Cranson v. International bus: IBM had sold typewriters to the real estate bureau on credit.
IBM has delt with the Bureau as it was a corporation but it was not because without the
knowledge of the would-be SH, their lawyers had negligently failed to file the certificate of
incorporation before the transaction with IBM.IBM is estopped.
Who may be held liable: the modern trend imposes personal liability only against those
owners who actively participated in the management of the business.
Why?
Why equitable doctrines to save shareholders when incorporation is so easy these days?
Jurisdictional differences
Some statutes purport to eliminate de facto corporation and estoppel doctrines
MBCA 2.04
All persons purporting to act as or on behalf of a corporation, knowing there was no
incorporation under this Act, are jointly and severally liable for all liabilities created while so

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doing. It protects the would-be SH that honestly and reasonably, although erroneously,
believed that a corporation had been properly formed.
Florida 607.0204
Liability for pre-incorporation transactions
All persons purporting to act as or on behalf of a corporation, having actual knowledge that
there was no incorporation under this chapter, are jointly and severally liable for all liabilities
created while so acting except for any liability to any person who also had actual knowledge
that there was no incorporation.
Sect. 3: Limited liability and its exception: PIERCING THE CORPORATE VEIL
DISREGARDING THE CORPORATE ENTITY
Ordinary rule Limited liability:
SH limited liability for corporate obligations. A SHs risk is limited to her investment.
However the term limited liability is universally used to refer to no SH liability for debts of
the corporation.
Ditto (=idem) for officers acting in their business capacities
Except when there is direct liability, based on their own acts
See, e.g., MBCA 6.22(b)
Possible piercing scenarios
Parent/sub liability: Pierce to get at parents assets to satisfy subsidiarys debt
Enterprise liability: Pierce to get at assets of other companies in the same enterprise
Classic piercing: personal liability of shareholders for corp. debt
Pros and cons of limited liability
Pros: Efficiency: if unlimited liability, tort creditors would only sue wealthy SH, the market
would not be uniform, stock held by wealthy SH would be more risky and would need to
monitor other SH. The need to incur these costs will make the market less efficient.
Encourage investment :
Foster diversification
Encourage mgmt risk-taking
Facilitate stock markets/liquidity
Reduce agency costs
Reduce monitoring costs
Cons: Bad incentives/externalities
Moral hazard:
Discourage extension of credit
Insider opportunism
Externalization of risks
Sh irresponsibility
Piercing metaphors/factors
"alter ego" "instrumentality" dummy corporate double
"to achieve equity," to "prevent fraud, oppression or illegality."
acting so as not to accord integrity to the corporate form (e.g., commingling assets, history
of mismanagement, failure to maintain adequate records or otherwise comply with corporate
formalities, stripping corporation of assets); thin capitalization and diminished assets

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whether shareholders are actually doing business in their individual capacities.

Fletcher v. Atex
Facts: Fletcher and Hermanson plaintiffs seeked recovery from Atex and its parent Kodak.
Atex was a wholly owned subsidiary of Kodak.
The plaintiffs claimed that:
Atex was merely Kodak alter ego: because Kodak dominated and controlled Atex by
maintaining significant overlap between the board of directors of the 2 companies, and
siphoning funds from Atex through a cash management system requiring Kodaks approval for
major expenditures
Atex was Kodaks agent in the manufacture and marketing of of keyboards
Kodak was the apparent manufacturer of the keyboards
Kodak acted in tortious concert with Atex in manufacturing and marketing the defective
keyboards.
What establishes alter ego liability in Delaware?
No requirement of showing of fraud
The plaintiff must show :
that the parent and subsidiary operated as a single economic entity: among the factors
whether the corporation was adequately capitalized, whether the corporation was solvent,
dividends paid, corporate records kept, officers and directors, other corporate formalities
observed, whether the corporation simply functioned as a faade for the dominant SH
and that an overall element of injustice and unfairness is present:
Here, Atex and Kodak observed all corporate formalities (regular meetings, minutes of the meetings
maintained in coroporate books, financial records, filed its own tex returns, its own employeed and
management executive) and maintained separate corporate existences and held that there was no
issue of material fact regarding Kodaks liability under an alter ego theory.
First prong: Single economic entity
i.
ii.
iii.
iv.
v.

cash management system is consistent with sound business practice and does not show undue
domination or control. At all times a strict accounting is kept of each subsidiairys funds. It is
not the equivalent of intermingling funds.
Type of conduct typical of a majority SH or parent corporation: approval for major expenditure,
presence of Kodaks employees at periodic meetings with Atex with Atexs CEO is entirely
appropriate,
Parents and subsidiaries have often overlapping boards of directors while maintaining separate
operations.
The description of the relationship between Atex and Kodak and the presence of the Kodak logo
in Atexs promotional literature does not justify piercing the corporate veil.
The two companies observed all corporate formalities.

Second prong: No injustice or unfairness

There is no indication that Kodak sought to defraud creditors and consumers or to syphon funds
from its subsidiary.

Why did Kodak operate Atex as a separate subsidiary rather than a division?

After Fletcher

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Is it hard or easy to pierce between a parent and sub in Delaware?

Is that result desirable?

Walkovsky v. Carlton NYC taxis

Standard: Whether or not the SH is operating the business as a personal
Facts: Rather common practice in the taxicab industry of vesting the ownership of a taxi fleet in
many corporations, each owning only one or two cabs.
Plaintiff was severly injured when he was run down by a taxicab owned by defendant Seon Cab and
negligently operated by defendant Marchese. Carlton the individual defendant is claim to be the SH
of 10 corporations including Seon each of which has but 2 cabs registerd in its name and has a
minimum automobile liability insurance.
All the corporations are to regarded as a single economic entity with regard to financing, supplies,
repairs, employees and garaging.
Reasoning: - limited liability but not without limits
Judge Cardozo said that general rules of agency are guidelines: whenever anyone uses control
of the corporation to further his own rather than the corporations business, he will be liable for
the corporations acts upon the principle of respondeat superior.
Here none of the corporations has a separate existence of their own, all are named as
defendants. The fact that the corporations may have been one large corporation, however, does
not prove that Defendant was controlling the corporations for his own behalf, that the
corporation is a dummy (=mannequin) for its individual SH who are in reality carrying on the
business in their personal interest rather than corporate ends.
The corporate form may not be disregarded merley because the assets of the corporation
together with the mandatory insurance coverage of the vehicle which struck the plaintiff are
insufficient to assure him the recovery sought. It is the role of the legislature.
To pierce the veil: separate corporations undercapitalized, assets intermingled, SH act in their
individual capacities, shuttling their personal funds in and out of the corporations without regard
to formalities and to suit their immediate convenience: this is not the case here.
It is not fraudulent for the owner-operator of a single cab to take out only the minimum required
liability insurance.
Dissent: The defendant was the principal SH and organizer of the defendant corporation which
owned the taxicab. The corporation was one of 10 organized by the defendant eaxh containing
two cabs and each cab having the mimimum liability insurance coverage. The sole assets are
the vehicles apparently subject to mortages. The corporations were coluntarily under-capitalized
for the purpose of avoiding liability. All income was continually drained out of the corporations for
the same purpose. The SH should all be held liable because the corporation is organized and
carries on business without substantial capital in such a way that the corporation is likely to
have no sufficient assets available to meet its debts, it is inequitable that SH should set up a
flimsy (mince) organization to escape personal liability.
Minton v. Cavaney Cal. Swimming pool
Facts: Seminole conducted a swimming pool that it leased from its owner.
Plaintiffs daughter drowned in the pool.
Defendant Cavaney held personny liable, died, his widow the executrix oh his estate was
substituted as defendant.
Cavaney was the director and secretary and treasurer of Seminole. The shares were never issued.
For a time Seminole kept records and received mailed at Cavaneys office. There was no asset. The
corporation was duly organized but never functioned as a corporation.

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Cavaney was an attorney at law and was approached by Kraft and Wettrick to form Seminole, he
was the attorney of Seminole.
He held the function of director, secretary and treasurer temporary and as an accommodation to his
clients.
Here, there is evidence that there was no attempt to provide adequate capitalization. The lease was
forfeited for failure to pay the rent. Cavaney was secretary and treasurer but also director. He was
to receive third of the shares which infers that he was an equitable owner. He actively participated
in the conduct of business because the records were kept in his office for a time.
Arnold v. Browne
Evidence of inadequate capitalization is at best merely a factor to be considered in deciding
whether or not to pierce the corporate veil but cannot stand alone.
Undercapitalization
How do we define undercapitalization?

Slottow, Truckweld, Radaszewski

Slottow v. Fidelity Bank
Parent subsidiary
Under California law, undercapitalization can stand alone.
Truckweld Equipment v. Olson
Capitalization may be so thin that it manifests a fraudulent intent, it was not the case here. Olson
acquired Aztec when it was troubled and tried his best to improve, there is no requirement from a
corporate SH to commit additional private funds to an already faltering corporation.
Radaszewki v. Telecom
Contruw was undercapitalized in the accounting sense, most of the money contributed to its
operation by Telecom was in form of loans and not equity. When COntrux first went into the
business, Telecom did not pay for all the stock that was issued. It was undercapitalized but Telecom
said it does not matter because Contrux had 11.000.000 $ worth of liability insurance available to
pay judgments like the one Radewki hoped to obtain. Telecom therefore was not motivated in
setting up Contrux in the sense of either knowingly or recklessly establishing it without the ability
to pay tort judgments.
But Contruxs insurance carrier became insolvent.
The federal regulation does not speak about proper capitalization but of an appropriate level of
financial responsibility.
Insurance meets this policy even better than a healthy balance sheet.
Minton v. Cavaney Cal. Swimming pool
Facts:
How is this different from Walkovsky?
Which piercing factors existed in Minton?
Did court say that undercapitalization alone should have been sufficient to justify piercing?
Whats status of undercapitalization in Minton? Arnold v. Browne?
So what PCV factors seem relevant?
Close vs. public corporation
Fail to observe formalities
Commingling personal and business
Inadequate capitalization

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Active participation

Undercapitalization
How do we define undercapitalization?
Slottow, Truckweld, Radaszewski
Tort vs contract
Why would theory suggest that piercing is more justifiable in tort than in contract cases? The
party prices the risk, opportunity to negotiate
Whats the empirical evidence?

Are all contract creditors alike?

Exam: Piercing the veil
1. Public Hel corp/ closed
2. Formalities?
3. Fraud?
4. Parent-Sub?
5. Contract/tort/consumer buys a plate on internet
Direct liability
Direct liability comes from what a SH/director did
Ex: Director/Sh gave a personal guarantee
Kinney Shoe Corp. v. Polan
Facts: Kinney Shoe subsleased a portion of a building to Industrial Realty which was wholly owned
by Lincoln Polan.
Polan put no capital in Industrial, Industrial had no assets, no income and no bank account. It did
not observe corporate formalities, had no stock, no minutes, no officers.
Industrial filed for bankruptcy and Kineey sued Polan to collect the amount of the sublease.
Analysis: 2 prongs test: - such a unity of interest and ownership that the separate personalities of
the corporation and the individual no longer exist,
- fairness requirement
- some of the commentators suggest that in a breach of contract case, there is a third prong for a
certain types of contract creditors of the corporation, specifically those capable of protecting
themselves because they are deemed to have assumed the risk of the gross undercapitalization
and will not be permitted to pierce the veil.
- The third prong is permissive and not mandatory. Even it applies to Kinney, POlan set up
Industrial to limit hi s liability in his dealings with Kineey. The corporation as no more than a
shell. When nothing is invested in the corporation, it provides no protection to its owner.

Whats the third factor under West Virginia law?

Should this factor be applied?
Why wasnt it applied in this case?

Judicial articulation of PCV policy

Berkey
Relation between parent and subsidiary corporations
The essential term to be defined is the act of operation. Dominion may be so complete,
interference so obstrusive, that by general rules of agency the parent will be a principal and the

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subsidiary the agent. Where the attempted separation between parent and subsidiary will work a
fraud upon the law.
Carte Blanche v. Diners Club International
Whether in the light of the circumstances, the policy behind the presumption of corporate
independence and limited SH liability (encouragement of business development) is outweight by the
policy justifying disregarding the corporate form (the need to protect those who deal with the
corporation).
Sea-Land Services Inc. v. Pepper Source
Facts: Sea-Land, an ocean carrier shipped peppers on behalf of the Pepper Source. PS stiifed
(sopposer) on the freight bill which was rather substantial.
PS was nowhere to be found, it has been dissolved for failure to pay the annual state franchise tax.
PS has no assets.
Sea-Land brought an action against Marches and five business entities he owns. Marchese was
also named indidually. Sea-Land sought to pierce PSs corporate veil and render Marchese
personally liable for the judgment owed to Sea-Land. He wanted to reverse pierce to hold other
Marcheses companies liable as alter egos of each other and hide behind veils of alleged separate
corporate existence for the purpose of defauding plaintiff and other creditors and also because he
manipulated assets his own personal uses.
Analysis
2 requirements:
- such a unity of interest and ownership that the separate personalities of the corporation and the
individual no longer exist
- fraud or promote injustice
4 factors: - failure to maintain adequate corporate records or to comply with corporate formalities
- commingling of funds or assets
- undercapitalization
- one corporation treating the assets of another corporation as its own.
Here: Prong 1: Marchese is the sole SH of the 5 corporations, none of the corporations ever held a
single corporate meeting, no articles of incorporation, bylaws or other agreements, same office,
same phone line, same expense accounts, borrows substantial sums of money which left at least
PS completely ot of capital, paid personal exepenses including alimony, child support, education
expenses, health care for his pet and maintenance of his personal automobile.
Prong 2: promote injustice: unjust enrichment (Marchese was enriched by his intentional
manipulation and diversion of funds from his corporate entities to allow him to use these ame
entties to avoid liability) that belongs to someone else and not only sea-land but also IRS and other
creditors. Marchese was the dominant force behind all the corporations
Unjust enrichment
Corporate entities used as playthings to avoid his responsibilities to creditors.
Fraudulent conveyances
Alternatives to PCV?
Insurance requirement?
Minimum capitalization requirement?
Pro rata liability?
Disregard of the corporate entity piercing
Alter ego
Undercapitalization

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Fraudulent conveyance
Tort v. k argument
Close v. public corps question

Direct personal liability

Effect of federal statutes on limited liability

US v. Bestfoods: Environmental liability. Ott Chemicals manufactured chemicals

and significantly polluted the soil and the ground water by both intentionally and
unintentionnaly dumping hazardous materials over a long period of time. US sued CPC
under CERCLA. A parent corporation is not liable for the acts of its subsidiaries only
because it controls it through ownership. But nothing in the statute bars a parent
corporation from direct liability for its own actions in operating a facility owned by
its subsidiaries. The fact that the corporate subsidiary owned a polluting facility
operated by its parent does nothing then to displace the rule that the parent
corporation itself is responsible for the wrongs committed by its agents in the
course of business.

It is entirely appropriate for directors of a parent corporation to serve as directors

of its subsidiary, and that fact alone cannot serve to expose the parent corporation to
liability for its subsidiarys acts. The government has to show that the parent dorectors
were still acting as parents directors nd not susbidiarys directors.

The court must look at the exercise of direction over the facilitys activities
(the way it operates) : need to distinguish between :

acts of direct operation (parental liability) from interference that stems from
the normal relationship between parent and subsidiary. Corporate behavior is
crucial reference points.

Whether the parental officer oversight a subsidiary or control over the

operation of the subsidiarys facility. Monitoring the subsidairys performance,
supervising subsidiarys finance and capital budget decisions, general policies and
procedures are ok. The issue is the degree and detail of actions directed to the facility
are consistent with the accepted norms of parental oversight of a subsidiarys facility.

Here, there is some evidence, that agent of CPC alone played a

conspicuous part in delaing with the toxic risks emanating from the operation
plan. He was not an employee, officer, or director of the subsidiary.
Holding: Raise an issue of CPCs operation of the facility through Williams action.

Liability imposed on the basis of federal statute (CERCLA)

Note relationship to state piercing doctrine

District of Columbia: disregard of formalities withot more can constitute evidence
of unfairness and inequity
Maryland: extraordinary measure of deference apparently relaxed only in
instances of proven common law fraud
Virginia takes into account he totality of the circumstances.

Could have direct liability under a federal statutory scheme in circumstances where state
laws would not permit piercing.

Various factors listed in the cases:

Alter ego

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Undercapitalization
Fraud/misrepresentation
Fraudulent conveyance

Failure to observe formalities

What does this mean?
Why should this be a key factor?
Commingling personal and business funds

What does commingling mean?

Does it mean lending the company money?

Paying for the companys bills from your own checking account?

What does Sea Land tell us?

Should there be anything short of the Sea Land facts that should count as
commingling?
Active participation/control

Should this factor be enough in itself? In combination with other factors?

How does this distinguish the usual kind of closely held corporation?

Close vs. public corporation distinction in piercing cases

Undercapitalization

Should undercapitalization alone lead to piercing?

What problems would such a rule entail?

What if found along with other factors?

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LIMITED LIABILITY COMPANIES

No uniformity in jurisprudence. Lot of instability across jurisdictions.
First LLC statutes: Wyoming and Florida
Xhat is the jurisdiction you are working under?
Hybrid business form: Non-corporate entities that are created under statutes that combine
elements of corporation and partnership law.
Benefits of LLCs
Owners have limited liability and great freedom to structure its governance by agreement. Custom
tailored
LLC is an entity hold property and sue and can be sued in its own name.
Member-managed LLCs managed by their members
Manager-managed LLCs managed by managers who may be not members
Partnership-type pass-through tax treatment
Formation
Small LLCs tend to be formed in the state wheretheir business is located.
LLC is formed by filing articles of organization (name, address of its principal place of business,
name and address of its agent, purpose, duration )
LLCs can be formed by a single person
Operating agreement (called limited liability company agreement): agreement among the LLCs
members concerning the conduct of its affairs. Provides for the governance of the LLC, its
capitalization, admission and withdrawal of members and distributions.
Management & voting
Management: member-managed or manager-managed
Default rule in most LLC statutes: comparable to PP, vesting management in the LLCs members.
The most common statutory provision Is that the statutory default rule concerning management can
be varied only by a provision in the LLCs articles of organization, unless otherwise agreed, by the
operating agreement.

Voting: jurisdictions split on per capita one vote per member) or pro rata (by financial
interest). Normally members act by a majority vote (per capita or pro rata)
howerversome statutes require a unanimous vote for such actions such as the
amendment of the articles of the operating agreement.

Warnings about drafting LLC agreements!

The Delaware Supreme Court has made it clear that investors in LLCs get what they
bargained for in their LLC agreement, but not much more. That seems attractive to those
who manage LLCs because they feel they can limit their liabilities to investors by the terms
of the LLC agreement. Yet, management may be overstating the benefits of the LLC form,
as this decision points out.
In this case, very sophisticated counsel advised on how to issue additional interests in the
LLC to raise more capital. Unfortunately, and despite being the drafter of the LLC
agreement, he got it wrong and failed to follow the terms of the agreement. This points out

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that LLC agreements are often so complicated that compliance with their terms is tricky.
Each agreement is individually crafted, unlike in a corporation where the statute generally
spells out in well understood terms what are the rights and obligations of the investors and
managers. These errors have happened time after time. Hence, use of the LLC or LLP
form needs to be with great caution.
(Discussing Zimmermann v. Crothall)
Authority
In member-managed: each member has power to bind the LLC for any act that is apparently
carrying on the business of the LLC in the usual way or ordinary course. Even if an action is
not the usual or ordinary course, the remaining members mauy confer on a member an
actual authority to bind the LLC or withdraw the actual authority. In that case, the LLC will be
bound by virtue of the members apparent authority, but the member will be obliged to
indemnify the LLC for any loss that results from her contravention of the other members
decision.

In manager-managed LLCs, typically only the manager has apparent authority to bind the
firm

But see Delaware 18-402: each member and manager has authority to bind

Inspection of the books and records

Members are entitled to access to the LLCs books and records. Many statutes include that the
inspecton should be for a proper purpose.
Fiduciary duties
Largely unspecified by the LLC statute.
Important provisions concerning particular issues of fiduciary duty: elements of the duty of
care, responsibility of the manager for gross negligence, bath faith, reckelessness or
equivalent conduct.
Mechanism for self-interested transactions by disinterested managers or members
Some statutes limit fiduciary duties and some eliminate fiduciary duties. However, the
statutes generally prohibit a waiver of the duty of good faith.
Extensive fiduciary duties can be waived. Courts will look at the waiver provisions with
extremely hars eyes. Supreme stringent scrutiny when dilutionor elimination of fiduciary
duties.
Derivative actions
Most of the statutes explicitly permit members of the LLCs to bring derivative actions on the LLCs
behalf, based on a breach of fiduciary duties.
Even chen a statute does not explicitly permit such actions, courts are highly likely to permit them
both on analogy to coporation and limited partnership law.
Distributions
Usually pro rata, but per capita under some statutes
Members Interests
A member of an LLC has financial rights and may also have governance rights as a member, apart
from governance rights as a member.

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Members governance rights include her right to participate in management, to vote on

certain issues and to be supplied with information.
Financial interests referred to as units;
Financial and governance rights split in some jurisdictions;
A member of an LLC can freely transfer her financial rights by transferring her interest in the
LLC however the majority of the statutes provide thata member can transfer her governance
rights only with unanimous consent of all other the members.
Free transferability of financial rights only;
Jurisdictional differences re: % needed to agree to governance right transfers

New statutory amendment DLLCA

If a member of an LLC assigns her interest in the LLC as a pledge to secure a debt and if
the creditor can get a charging order against the members interest, it gives the creditor the
right to the members share of any distributions.
A charging order is the exclusive remedy by which a judgment creditor of a Delaware limited
liability companys member (or a members assignee) may satisfy a judgment against such
members LLC interest
Attachment, garnishment, foreclosure and other legal or equitable remedies are not
available to a judgment creditor
regardless of whether the Delaware LLC is a single-member or multi-member entity.
Dissociation
Termination of a members interest in an LLC other than by voluntarys transfer of a
members interest.
Some statutes provide for withdrawal at any time subject to a notice requirement
Most statutes provide that a withdrawing member is entitled to some payment on
withdrawal.
Consistent with the potential costs of dissolution at will, LLC statutes provide that
dissociation does not dissolve or trigger liquidation of the firm.
Piercing with LLCs
All of the LLC statutes provide that the members and managers of an LLC are not liable for the
LLCs debts, obligations and other liabilities. However, members may become liable if the conditions
for PCV of an LLC are satisfied.
-

Kaycee Land & Livestock v. Flahive

Certified question
Wyoming LLC Act silent on issue whether in the absence of fraud, the entity veil of an LLC can
be pierced in the same manner as that of a corporation.
Why assume LLCs should be treated like corporations, although factors justifying piercing are
different (see recognition of this in the case itself)?
Facts: Flahive Oil & Gas had no assets at this time. Kaycee entered into a contract with Flahive
to use the surface of the real property. Roger Flahive is and was the manager at all time.
Kaycee alleges that Flahive caused environmental contamination to its real property. Kaycee
seeks to PCV and hold the manager individually liable for the contamination, there is no
allegation of fraud.

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Reasoning: - As a general rule, a corporation is a separate entity distinct from the individuals
comprising it.
- The statute of Wyoming does not address the issue of PCV.
- The concept of PCV is a judicially created remedy for situations where corporations have
not been operated as separate entities as contemplated by statute and therefore are not
entitled to be created as such.
- The court has espoused the concept that a corporations legal entity will be disregarded
whenever the recognition in a particular case will lead to injustice. In a case, when the
corporation is not only influenced and govern by a particular person but when there is such
a unity of interest and ownership that the individuality or separateness of such person and
corporation has ceased and that the facts are such that an adherence to the fiction of the
separate existence of the corporation would fraud or promote injustice.
- Lack of explicit statutory language (especially when Wyoming was a pioneer in the LLC
arena) should not be considered an indication of the legislatures desire to make LLC
members impermeable.
- Factors:
fail to follow the statutorily mandated formalities,
commingling of funds,
ignoring the restrictions in their articles of incorporation regarding separated
treatment of corporate property.
The SC sees no reason to treat LLCs differently than corporations but the court added
that a showing of fraud or an intent to defraud is not necessary to disregard a corporate
entity.

Bainbridge
Critique of extending piercing law from corporations to LLCs
What should the standards for piercing be in the LLC context
Cant focus on formalities, so what should the approaches be?
Cant tell from Kaycee because facts not at issue there
Right of LLC members to bring derivative suits:
Statute is silent about the existence of derivative action.
Tzolis v. Wolff
Facts: Pennington property was the owner of a Manhattan apartment buidings. Plaintiffs who
owned 25% of the membership interests in the LLC brought a derivative action.
They claim that those in control of the LLC and others acting in concert with them arranged to
lease and sell the LLCs principal asset for sums below marketvalue, the lease was unlawfully
assigned.
The plaintiffs seek to declare the sale void and termination of the lease.
Issue: Whether derivative suits on behalf of LLCs are allowed?
Holding: Yes
Reasoning: - Derivate suit has been part of the general corporate law of the State of NY. It was
not created by Statute but by case law because the Chancelor thought it essential for
shareholders to have recourse when those in control of a corporation betrayed their duty

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(similar to law of trust: when fiduciaries are faithless to their trust, the victims must not be left
wholly without a remedy).
- Alternative remedy exists: direct claims of the injured LLC members against fiduciairies for
conduct that injured the LLC.
Why permit such suits if LLC statute doesnt explicitly permit them? Courts have repeartdely
recognized derivative suits on the absnec of express statutory authorization. So mere
absenceof authorizing language in the LLC law does not bar the courts. Since legislature
did not intend to give corporate fiduciairies a license to steal, a substitute remedy must be
devised.
Fiduciary duties in LLCs

Salm v. Feldstein
Facts: Plaintiffs are defendant were members of an LLC that owned an automobile dealership,
each having an equal financial interest in the company.
Defendant was the managing member bought the plaintiffs interest for $ 3,750,000, plus $
1,350,000 payable under a consulting contract. Two days later, the buyer sold the dealership for
$ 16 million. The seller alleged that the buyer misrepresented the value of the dealership as
being between $ 5 and $ 6 million and failed to disclose that the non-party purchaser had made
a firm offer to buy it for $ 16 million before the buyer acquired the seller's interest.
Holding:The appellate court ruled that, as the managing member of the LLC and as a comember with the seller, the buyer owed the seller a fiduciary duty to fully disclose all material
facts.
Reasoning : Also, since the buyer was the managing member and also a co-member with the
plaintiff he owed the seller a fiduciary relationship to make full disclosure of all the material
facts.
The disclaimers in the contract did not relieve the buyer of the obligation of full disclosure. The
alacrity (promptitude) with which the dealership was sold was sufficient to establish that facts
essential to justify opposition may have existed but could not have then been stated.
NY Full disclosure re $16 million deal, regardless of disclaimers contained in the K
agreement. Ny seems to impose a significative fiduciary duty

VGS v. Castiel (Delaware)

The failure to notify amounts to a breach of fiduciary duty
Facts: Defendant, David Castiel, formed LLC to pursue an FCC license to build and operate
satellites. The members of LLC included Virtual Geosatellite Holdings, Inc. (Holdings) which
controlled 660 units of LLC; Ellipso, Inc. (Ellipso) which controlled 120 units; and Sahagen
Satellite Technology Group LLC (Sahagen Satellite) which controlled 260 units. Castiel had
controlling ownership of Holdings and Ellipso, and Peter Sahagan controlled Sahagan Satellite.
Castiel was able to appoint two of the three managers (Castiel and Tom Quinn) and Sahagan
was the third manager. Sahagan and others associated with LLC believed that Castiels
management of LLC was deficient. Sahagan was able to convince Quinn to vote with him to
merge LLC into VGS, a move which would change Castiels majority status into a minority
status. Because Castiel would remove Quinn and make sure his majority standing remained if
he knew of the merger vote, Quinn and Sahagan voted without Castiels knowledge. After the
merger, the LLC ceased to exist, its assets and liabilities passed to VGS : Sahagans ownership
went from 37.5% to 62.5% while Castiels ownership was 37.5% of VGS compared to 75% of

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LLC. The incorporators of VGS did not name Castiel to VGSs Board. Sahagan justified the vote
by declaring that only a majority had to vote in favor (not unanimous).
Issue : Whether a clandestine vote between Sahagan and Quinn to merge LLC into VGS
without notifying the controlling shareholder renders the merger invalid ?
Holding: Yes.
Synopsis of Rule of Law : Minority shareholders owe the majority shareholders a duty of
loyalty to inform them in advance of any plans for a merger or the structure of a merger.
Reasoning: The LLC Act read literrally did not require notice to Castiel before Shagen and
Quinn could act by writte consent. Nonethelss it seems clear that the purpose of permitted
action by written consent without notice is to enable LLC managers to take quick, efficient action
in situations where a minority of managers could not block or adversely affect the proposed
action, i.e, there was only a requirement of the majority of LLC managers to vote for the merger.
The General assembly never intended to enable two managers to deprive, clandestinely and
surreptiously, a third manager representing the majority interest in the LLC of an opportunity to
protect that inreste by taking an action that the third managers member would surely have
opposed if he had knowledge of it.
The action was taken by a majority that existed only so long as it could act in secrecy.
Sahagan and Quinn owed a duty of loyalty to the LLC, its investors and Castiel.
The fact that Castiel may have been a poor performer does not exempt the other members of
their duty to inform him in advance of the meeting.
Del.: While written consents w/o notice literally permitted under DLLCA, failure to notify
amounted to breach of duty of loyalty
Solar Cells v. True North Partners
Obligation to entire fairness as a standard to assess conflict of interest transactions: Fair
dealing (process-time) and fair price.
Facts : First Solar, LLC is a manager-managed Delaware LLC.
First Solars two members, Solar Cells, Inc. (plaintiff) and True North Partners, LLC (True North)
(defendant), each initially held 4,500 of First Solars voting membership units. According to First
Solars operating agreement, True North had the right to appoint three of First Solars
managers, while Solar Cells appointed two.
First Solar began facing financial difficulty and exploring a possible restructuring around 2001.
On March 7, 2002, the True North managers (defendants) unilaterally issued a document
approving the merger of First Solar into First Solar Operating, LLC (FSO), a Delaware LLC
wholly owned by True North.
The day before this consent was executed, on March 6, a meeting of the full board of managers
of First Solar was held, and the True North managers made no mention of the impending
merger.
The Solar Cells managers received notice of the merger by fax on March 8. It was presented as
a fait accompli, set to close on March 15. By the terms of the merger, Solar Cells interest in the
surviving company would be reduced from 50 percent to five percent. Further, the price terms
were based on a valuation that was significantly lower than prior valuations.
On March 13, Solar Cells filed for a preliminary injunction blocking the merger, which they allege
was negotiated in bad faith and falls short of the entire fairness standard.

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Holding : Operating agreement read to require entire fairness. Application of the entire
fair ness tandard requires a demonstration of both fair dealing and fair price.

Reasoning: - Even if there is in the operation agreement a waver of liability for engaging in
conflicting interest transactions, that does not mean that there is a waiver of all fiduciary duties
to Solar Cells.
Indeed, the operation statement states tjat the True North managers must act in good faith.
At the full board, the True North managers made no mention of the planned merger abd the very
next day informed by fax as a fait accompli that the memrger will drop Solar Cells interestfrom
50 to 5%. These actions do not appear to be those of fiduciaries acting in good faith.
Defendants are required to show the entire fairness of the proposed merger by establishing that
the challenged transaction was the result of fair dealing and offered a fair price.
There was on independant bargaining mechanism set up to protect its interests.
All the decisions regarding th terms of the merger and its approval were made unilaterally by
True North through its representative managers.
Fair price : valuation materail as a quick and dirty analysis of First Solars value on that date.
This contrast to the earlier valuations based on multiple methodologies.
Gatz v. Auriga (Del. S. Ct. 2012)
Facts: Pecony Bay LLC, a Delaware LLC was formed by Gatz Properties LLC and Auriga
Capital Corp, together with other minority investors for the purpose of leasing and developing a
golf course on property owned by the Gatz family.
Peconic Bay was managed by Gatz Properties which was managed by William Gatz (who also
managed controlled and partially owned Gatz Properties).
In 1998, Peconic Bay entered into a long-term sublease with a national golf course operator. By
2005, Gatz was aware that the golf course operator intended to exercise its early termination
right in 2010 and hired an appraiser who valued the land at $10.1 million with golf course
improvements and at $15 million as vacant land available for development.
In 2007, Gatz was approached by RDC Golf Group, Inc. (RDC) with an offer to acquire the
long-term sublease. Although Gatz refused to provide due diligence materials to RDC, RDC
submitted two proposals, each of which was rejected by the Peconic Bay members.
In response to a request from the Minority Members that Gatz determine RDCs interest in a
deal at $6 million, Gatz told RDC that an offer well north of $6 million would be required to
continue discussions. RDC indicated it was willing to proceed on those terms, but Gatz failed to
respond and told the Minority Members that negotiations had broken off without informing them
of RDCs continued interest. Gatz then offered the Minority Members approximately $700,000
for their interests in Peconic Bay, which the Minority Members rejected. For the next year, Gatz
pursued a course of action that led to a sale of Peconic Bay as a distressed asset in a poorly
run auction. Gatz was the only bidder at the auction and purchased Peconic Bay for $50,000
cash plus assumption of its debt, yielding proceeds to the Minority Members well below what
they would have received had Peconic Bay been sold to RDC in the previously proposed
transactions. The Minority Members sued for money damages based on, among other things,
breach of fiduciary and contractual duties.
Analysis : - The Supreme Court upheld the Chancery Courts decision regarding Gatzs liability
for breach of fiduciary duty; however, it based its decision exclusively on contractual grounds
and not on the existence of any default fiduciary duties under Delawares limited liability
company statute.

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In determining that Gatz owed fiduciary duties to the Minority Members of Peconic Bay, the
Supreme Court reviewed de novo the contract interpretation issues. The Supreme Court
interpreted the relevant LLC Agreement provision, which required agreements between Peconic
Bay and related parties to be on terms and conditions no less favorable than those that could be
obtained from arms-length third parties, to be the contractual equivalent of the entire fairness
equitable standard of conduct.
Under this standard, Gatz was required to establish the fairness of the transaction since his
acquisition of Peconic Bay had not been approved by the informed vote of the holders of twothirds of the interests in Peconic Bay held by unconflicted members, as required under the LLC
Agreement.
After reviewing the Chancery Courts factual findings and the trial proceedings, the Supreme
Court was satisfied that Gatz had failed to carry his burden of proof and held that Gatz had
violated his contractual fiduciary duties based on, among other things, his refusal to negotiate
with RDC and his subsequent sale of Peconic Bay to himself at an unfair price in a flawed
auction.
The Supreme Court also upheld the Chancery Courts finding that Gatz was not entitled to the
benefit of the exculpation and indemnification provisions in the LLC Agreement because he
acted in bad faith and made willful misrepresentations to the Minority Members.
Notably, the Supreme Court stated that whether the managers and controllers of a limited
liability company are subject to default fiduciary duties under the Delaware Limited Liability
Company Act is an issue about which reasonable minds could differ. The Supreme Court also
noted that it was unnecessary for the Chancery Court to decide sua sponte, the default
fiduciary duty issue in this case because dispute over the application of fiduciary standards was
determinable solely by reference to the LLC Agreement and no litigant had asked the
Chancery Court to decide this issue as a matter of statutory law. For these reasons, among
others, the Supreme Court held that the Chancery Courts statutory pronouncements must be
regarded as dictum without any precedential value.
The courts unremarkable holding, given the facts, was that the manager breached his fiduciary
duties of loyalty and care.
Gatz approves the lower court approach of the contract operating agreement has a fiduciary
duty in it.
Footnote 20 : in a corporation with a controlling stockholder, the burden of showing
fairness is flipped from the defendant to the plaintiff.
Affirms finding of K breach and damages
Gratz critiques Strines dictum on default fiduciary duties in LLCs. Strine assumed that the
fiduciary duty would attach unless the agreement waived it: strcit reading of the contract.
The SC said it is not the job of courts but the legislature to decide whether there is a fiduciary
duty in LLC if the LLC agreement is silent.
This decision lead to a later amendment of the LLC Act.
Amendment to Section 18-1104 of the LLC Act
[i]n any case not provided for in this chapter, the rules of law and equity, including the
rules of law and equity relating to fiduciary duties and the law merchant, shall govern.
Adopted in response to Supreme Courts decision in Gatz

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Means that if the LLC agreement is silent on the issue, fiduciary duty precepts will apply
to the same extent that they apply in law or equity to managers and members of the
LLC.

Gerber v. Enterprise Products Holdings

Implied duty of good faith and fair deal: What does the Delaware Court does in a limited
partnership context is imported in the LLC context.
Facts: Enterprise GP Holdings, LP, (EPE) was a limited partnership tied into a complex
partnership structure with Enterprise Products, L.P. (Enterprise Products LP) and Enterprise
Products Holdings, LLC (Enterprise Products GP). In May 2007, EPE bought Texas Eastern
Products Pipeline Company, LLC (Teppco) for $1.1 billion worth of EPE limited partnership
units. Two years later, EPE sold Teppco to Enterprise Products LP for approximately $100
million (the 2009 Sale). The sale was first approved by the Audit, Conflict and Governance
Committee (ACG Committee) of Enterprise Products GP the general partner of EPE and
later by the board of Enterprise Products GP itself. As part of the approval process, Morgan
Stanley delivered an opinion to the ACG Committee finding that the total consideration paid for
Teppco and a Teppco affiliate sold in a separate transaction was fair in the aggregate. The
opinion only addressed the combined transactions and did not assess the fairness of the
consideration specifically paid in the 2009 Sale.
In July 2010, Enterprise Products LP and Enterprise Products GP started negotiating a merger
between EPE and Enterprise Products LP (the 2010 Merger). According to the Court of
Chancery, the primary purpose of the proposed merger was to extinguish unliquidated legal
claims held by the EPE partnership unit holders. These included a pending derivative suit
challenging the fairness of the $1.1 billion paid for Teppco in 2007, and any claims that could
later arise in connection with the sale of Teppco in 2009 for 9% of the original purchase price.
Enterprise Products GP ultimately accepted an offer from Enterprise Products LP to convert
each outstanding partnership unit in EPE into 1.5 partnership units of Enterprise Products LP.
Prior to acceptance, Enterprise Products GP consulted Morgan Stanley for an opinion on the
fairness of this exchange ratio. Morgan Stanley stated that the ratio was fair, but did not factor
the value of EPEs legal claims into its analysis. Thus, Enterprise Products GP never considered
the claims in deciding whether Enterprise Products GPs offer was fair to the partnership unit
holders of EPE.
Derivative claim: In March 2011, Joel Gerber, a former owner of partnership units in EPE,
brought an action against Enterprise Products GP, Enterprise Products LP, the board of
Enterprise Products GP, and the estate of Dan Duncan, who had previously controlled all three
companies. Gerber alleged, among other things, that the defendants breached their contractual
duties under EPEs Limited Partnership Agreement (LPA) and the implied covenant of good
faith and fair dealing in carrying out the 2009 Sale and 2010 Merger. He claimed that the
consideration received in the 2009 Sale was grossly inadequate, and that the 2010 Merger
unfairly deprived EPE partnership unit holders of compensation for their legal claims.
The Delaware Court of Chancery dismissed Gerbers complaint after determining that the
provisions of the LPA insulated the defendants from liability. The LPA modified fiduciary duties in
accordance with 6 Del. C. 17-1101, and provided that Enterprise Products GP and its affiliates
would only be subject to a contractual duty of good faith, defined as a belief that the
determination or action was in the best interests of the Partnership. Two additional LPA

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provisions limited judicial review into whether the conduct of Enterprise Products GP or its
affiliates satisfied the contractual fiduciary duties. First, the LPA stated that transactions
involving a conflict of interest between EPE and Enterprise Products GP could not give rise to
claims for a breach of fiduciary duties if the transactions received Special Approval by a
majority of members of the ACG Committee. Second, the LPA provided that a conclusive
presumption of good faith would arise if, in taking a course of action, Enterprise Products GP
consulted with investment bankers and acted in reliance on their opinion
Because both the 2009 Sale and 2010 Merger received Special Approval by the ACG
Committee, the Chancery Court held that the claims for breach of the contractual duty of good
faith were barred by the LPA provisions. Moreover, the ACG Committees reliance on Morgan
Stanleys fairness opinion in approving the 2009 Sale and 2010 Merger gave rise to a
conclusive presumption under the LPA that the duty of good faith was discharged, which
automatically foreclosed any claim under the implied covenant of good faith and fair dealing.

Can a contract provision that presumes good faith preclude a claim for a breach of the
implied covenant of good faith and fair dealing in a limited partnership agreement?
Delaware S.Ct. answer: NO
The waiver in a limited partnership agreement of the fiduciary duty of good faith, and the
substitution of a new contractual definition for good faith, cannot eliminate the implied
and unwaivable duty of good faith and fair dealing. Even if you eliminate fiduciary futy,
you cannot eliminate good faith.

LLC fiduciary duties

Contractarian vs. anti-contractarian approaches
Dissolution
In the matter of 1545 Ocean Avenue LLC
Facts : 1545 Ocean Avenue, LLC (1545 LLC) was an LLC with two members, Crown Royal
Ventures, LLC (Crown Royal) (plaintiff) and Ocean Suffolk Properties, LLC (Ocean Suffolk)
(defendant). Crown Royal and Ocean Suffolk held an equal stake in 1545 LLC, which they formed
for the purpose of rehabilitating an existing building and building another. The entity was run by two
managers, one from each member: Walter Van Houten was a member of Ocean Suffolk, and John
King was a member of Crown Royal. Van Houten also owned and operated a construction
company, Van Houten Construction (VHC). Disagreements soon arose. Though the two managers
agreed to solicit third-party bids for construction work, VHC began performing work on the property.
Ocean Suffolk claimed that King consented to VHCs work, while King said Van Houten acted
unilaterally. King claimed VHC overbilled for this and other work and that Van Houten refused to
meet regularly with him. King conceded that VHC did good work. Nonetheless, due to the
disagreements, King sought to have Ocean Suffolk buy out Crown Royals interest in 1545 LLC.
When this was unsuccessful, Crown Royal petitioned the court for dissolution, citing deadlock. The
LLCs operating agreement did not specifically address dissolution, and also stated that any
individual manager may unilaterally take any action not prohibited by the agreement, unless the
agreement or the LLC law specifically requires the approval of more than one manager. VHC
continued work on the project throughout the dispute. The trial court granted the petition for
dissolution, and Ocean Suffolk appealed.

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Reasoning: - The Operating agreement provided any matter not secially covered by a provision of
the operating agreement, including without limitation dissolution of the Company shall be governed
by the applicable provisions of the LLC Act.
- The sole ground for dissolution cited by Crown Royal is deadlock between the managing
members.
- The court may decree dissolution whenever it is not reasonably practicable to carry on the
business in conformity with the articles of organization or the operating agreement.
- There is no definition of not reasonably practicable.
- The courts must first look at the operating agreement.
- It has been suggested that judicial dissolution is only available when the petitioning member can
show that the LLC is unable to function as intended or that is failing financially.
- The operating agreement permits a single manager unilateral action in furtherance of the
business. It does not require that the managers conduct the business by marjority vote.
- Therefore, no dissolution.
Limited authority to the Court.
Haley v.Talcott
Facts:- The manager member (Haley) and the investor member (Talcott) formed an LLC to own
property upon which the manager member managed therestaurant that the investor member
owned.
-The members each owned 50 percent of the LLC and gave a personal guaranty for the LLC's
debt to a bank.
-After the members had a falling out, Talcott discharged Haley as a manager. Haley rejected a
new lease that Talcott proposed for the Gril and voted to terminate the Grills lease and sell the
property. As a 50% member, Haley could not force the LLC to take action on these proposals
because Talcott opposed them. The Grills lease expired but continued to pay a rent to the LLC,
situation that Talcott favored. The manager member alleged that pursuant to Del. Code Ann. tit.
6, 18-802 the court had to exercise its discretion and dissolve the LLC because it was not
reasonably practicable for it to continue the business of the company in conformity with the LLC
agreement.
-The investor member responded that the manager member was limited to a contractuallyprovided exit mechanism in the LLC agreement, by which he could buy out the manager
member.
Holding:-The court found that it was not reasonably practicable for the LLC to continue to carry
on business in conformity with the LLC agreement.
Analysis:-Further, the exit mechanism was not a reasonable alternative, as it was not sufficient
to provide an adequate remedy to the manager member under the circumstances, as he would
then be personally liable for the LLC's debt.
-Therefore, the manager member was entitled to a judicial dissolution of the LLC.
CORPORATE FIDUCIARY DUTIES
DUTY OF CARE
In corporations, you cannot get ride of fiduciary duties.
Promote good faith decision making to promote corporate and SH interests.
The duty does not require perfection. It is a way of promoting reasonable decision-making.

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It does require attention, intelligent reflexion, a certain process that, directors have to go through
to inform themselves.
In most statutes, the duty of care is expressed as follows:
directors must exercise that degree of care, skill and diligence that a reasonably
prudent person in a like position would exercise in similar circumstances.

Statutes
MBCA 8.30, 8.31
Cal. Corp. Code 309
NYBCL 717
ALI Principles of Corporate Governance 4.01(a),(b), 4.02, 4.03

RMBCA 8.30, 8.31

8.30: Standards of conduct for directors:
Each member of the board shall act in good faith and in a manner the director
reasonably believes to be in the best interests of the corporation.
8.31: Standards of liability for directors:
A director shall not be liable for any decision unless the plaintiff shows that there
are no defenses under specified provisions (see p. 820) and the challenged
action was the result of actions not in good faith, or a decision which the director
didnt reasonably believe was in the corps best interests or as to which s/he was
not reasonably informed, or a lack of objectivity due to self-interest.

I.

Cal Corp Code 309 (p. 1087)

309(a): A director shall perform the duties of a director . . . in good faith, in a manner
such director believes to be in the best interests of the corporation and its shareholders
and with such care, including reasonably inquiry, as an ordinarily prudent person in a like
position would use under similar circumstances.
NY Corp Law 717 (p. 1221)
717 (a): A director shall perform his duties as a director . . . in good faith and with that
degree of care which an ordinarily prudent person in a like position would use under
similar circumstances. . . .
BASIC STANDARD DUTY OF CARE

Francis v. United Jersey Bank

Facts : P&B was a reinsurance broker or intermediary. They earned a commission on the
transactions between the two entities. Typically, brokers in the reinsurance business hold funds
from the ceding and reinsuring companies in a separate account and pay each party from that
account. The former CEO of P&B, Charles Pritchard, Sr. (the husband of Lillian Pritchard) did
not practice this method, but he still ensured that the funds deposited by third parties were
never used as personal funds. Charles Pritchard, Sr., eventually stepped down and his two sons
controlled the business. Once the sons had control they took out personal loans from the
account but never paid back the loans or any interest. This practice of misappropriating funds
continued until P&B could no longer meet their obligations, and they went into bankruptcy.
During the entire period that the sons controlled P&B, Lillian was the majority shareholder and
sat on the Board as a director
During her tenure as director, she never participated in any business matters of P&B. Defendant
argued that Lillian was elderly and sick, and therefore should be excused for her absence.

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Issue : Whether a corporate director is personally liable in negligence for the failure to prevent
the misappropriation of trust funds by other directors who were also officers and shareholders of
the corporation ?
Reasoning : Lillian Pritchard, as a director on the Board, had a duty of care in managing the
business. She did not have to know every detail of day-to-day operations, but she needed to
have a baseline understanding of the finances and important activities. If she did not understand
the activities, then she was obligated to consult counsel for advice. Her absence from the
business did not excuse her duties. The court determined that if she did intervene in the dubious
financial decisions of her sons, or at least consulted an attorney or expert, it may have
prevented her sons from fleecing the company. Therefore, her lack of care was a proximate
cause of the damages to the company and the third parties who relied upon the company.
Because of the nature of the business (holding assets of third parties), she was liable to the
third parties for any damages.
The director was a complete inattentive director, did not even participate to meetings. Very
basics most fundamentals duty of care that are required from directors have not been satisfied.
What is required from director that is implicit in that view: the monitoring view of directors role.
Even though if a lot of duty care cases have been about directors that were completely
inattentive, a lot of new cases have been about much more sophisticated companies in which
directors do the minimum.
What explains the finding of duty of care breach here?
Was this a classic duty of care case? To whom did the duty run?
What was wrong with what Ms. Pritchard did?
ALI principles.
Kind of standard that Eisenberg is suggesting.
ALI Principles 4.01: A director or officer has a duty to the corp. to perform the directors or
officers function in good faith, in a manner that he or she reasonably believes to be in the best
interests of the corporation, and with the care that an ordinarily prudent person would
reasonably be expected to exercise in a like position and under similar circumstances.
ALI Principles 4.01(c) : A director or officer who makes a business judgment in good faith
fulfills the duty under this Section if the director or officer (1) is not interested in the subject of
the business judgment; 2) is informed with respect to the subject of the business judgment to
the extent s/he reasonably believes to be appropriate under the circumstances, and 3) rationally
believes that the business judgment is in the best interests of the corporation.
Broader reading of minimal duties:
1. get a rudimentary understanding of the business;
2. keep informed about the corporation's activities;
3 engage in general monitoring of corporate affairs;
4. attend board meetings regularly;
5. review financial statements regularly; and
6. make inquiries into doubtful matters, raise objections to apparently illegal actions, and
consult counsel and/or resign if corrections aren't made.
Business judgment rule standard: gross negligence. Director will be held liable only if
committed gross negligence.

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There is a distinction between standard of conduct (very high), but the standard of liability when
the court attaches liability is not that high.
The one case in Delaware deciding of violation of duty of care is contested.
There is a lot of reputation at stake when you are director. Shame is an important motive factor.
Even if you do not comply with all ethical guidelines you act within norms: there will not have
been misconduct each time because it is not legally conducted. Board directors go to business
school. They manage in a relative good faith.
Gross negligence
Aronson v. Lewis.

Directors have a duty to inform themselves, prior to making a business decision of all
material information reasonably available to them. Having become so informed, they
must then act with requisite care in the discharge of their duties.
But under the business judgment rule : liability is predicated upon concepts of gross
negligence.
What does this mean?
So long as the board was acting in good faith and making business judgments, the rule
provides a presumption of due care.
The BJR is the boundary (frontire) to the duty of care.
Proceduralization of the duty of care.
Re-emerging communication.
What is the degree of special obligation that should be placed of board members?
How you think boards should run?
Causation: we do not know what would have happened. We are assuming causation but
we do not know.
Why gross negligence?
The standards of duty can be read as being reasonably high at least because it seems
to be measured by a standard of reasonability.
If so, why is the standard of liability so low (namely, gross negligence)?
Attack on gross negligence concept
E.g., Quillen: gross negligence is practically meaningless. A better standard would be
reasonable care under the circumstances

What is the difference?

In results, probably not much.
In approach, focus on a keener negligence standard and emphasis
more on the qualitative nature of the varying circumstances.
What do you think? It does not say much.

What about directors with special expertise?

Should special expertise increase their burden under the BJR?

How broadly should we read In Re Emerging Communications?

What factors suggest reading it narrowly?
What might be the consequences of a broader reading?

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In Re Emerging Communications`
Facts : Muio is culpable because he voted to approve the transaction even though he
knew, or at least had strong reasons to believe that 10,25$ per share merger price was
unfair. Muio was in a unique position to know that. He possessed a specialized financial
expertise and an ability to understand ECMs intrinsic value. Muio conceded that 10,25$
price was at the low end of any kind fair value, his view was that the corporation might
be able to get up to 20$ share. In this circumstances, it was incumbent upon Muoio as a
fiduciary to adocate that the board reject the 10,25$. Muoio instead joined the other
directors in vting without objection to approve the transaction.
Most of the ECMs directors could plausibly argue that they voted for the transaction in
reliance on the opinion of an outside financial advisor however the argument is
implausible because of Muoios expertise equivalent.
Reasoning : The court found that a director violated his duty of care by agreeing to a
merger in which his corporation would be purchased for an excessively low price.
According to the court, the directors financial expertise should have alerted him to the
fact that the proposed price was unfairly low. The court held that this knowledge
obligated him to object to the merger.

What about directors with special expertise?

Should expert directors failure to use expertise constitute non-feasance?

What about causation?

Cases in the duty of care area sometimes raise difficult causation issues.
(1) if the violation of the duty of care consists of an omission by a director would the loss have
occurred even if the director had not violated his duty?
(2) If the whole board, or a substantial majority of the directors, violates the duty of care, can an
individual director be excused on the ground that the result would have been the same even
if she had acted differently ?
Some passages in Barnes v.Andrews may be read to suggest that an inattentive director will
not be held liable for a loss that would have been prevented by an attentive board unless it is
shown that if the director wouls have beenn attentive, his colleagues would have followed his
lead. However this cas can also be read to stand for the more modest proposition that an
inattentive director will not be liable for a corporate loss if full attentiveness by all the directors
would not have save the situation, because in that case the inatentiveness of any single director
will not have been a ceause-in-fact of the loss. That is the position taken by the ALI principle.

E.g., discussion in Francis.

Why should we insulate directors business judgments under the BJR?
Hindsight bias (prjug) are always 20/20.
Courts wrong forum: Courts are not the appropriate vehicule to determine what was
substantially the right business decision. Its hard to determine what was the right
decision to make at the time (judicial modesty).
Deterrence: If there is going to be liability all over the place, who will want to become a
director? Because of the money, directors will not be that easily deterred. DNO
insurance: Insurance that corporation to insure directors against claims that they have
violated their duty of care. The reason is to prevent from creating undue obstacles in the
way of directing.
Voluntary acceptance: argument: This is not coercive situation, SH have bought shares.
Risk-aversity incentives: Risk-aversity incentives: You do not want the law to create risk
adversity incentives. The directors will keep on taking overly cautious decisions. To

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protect themselves SH diverse their shares portfolio to minimize (neutralize) the risk
taking.
II.

THE BUSINESS JUDGMENT RULE

BJR exceptions set out in Kamin v. American Express

Facts : Stockholder derivative action
Defendant corporation purchased common stock for $29.9 million, and now the stock has a
market value of $4 million. The directors decided to declare a special dividend, giving the shares
of stock to the shareholders. Plaintiff demanded that Defendants sell the stock on the open
market and use the $25.9 million capital gains loss to offset other capital gains. The offset would
save Defendant corporation $8 million in taxes. Plaintiffs decided not to pursue Plaintiffs
demand, reasoning that the significant loss would adversely affect the value of Defendants
stock. Plaintiff then brought suit, classifying the directors decision as negligent decision-making.
Issue. Whether Plaintiffs can bring a derivative action challenging the business decision of the
directors of the corporation ? Should the directors be liable for committing waste?
Held. The court will not overrule a business decision of the directors of a company unless there
is evidence of fraud or some other dishonest dealing. The decision to declare a dividend may be
an unwise judgment, but it is a judgment that is outside the scrutiny of the court. The only
accusation of dishonest dealing was a general assertion that four of the twenty directors had a
financial interest in the outcome. The directors should not be liable for committing
waste.

the BJR does not apply in cases of fraud, illegality or conflict of interest; nonfeasance;
lack of rational business purpose/no win situations; gross negligence.
Burden of proof on the Plaintiff.
Lack of rationale business purpose/no win situations: decisions that are irrational and do
not pass the standard
In every one of those cases, one possibility is there is unproven conflict of interest that
the court is reacted to. The other explanation is that the courts are looking at business
decision from an unduly point of view. The news business is doing super bad 40.000
jobs lost. Taint of self-interest. They are doing for other business purpose than financial
decision. Should there the court expand their view: it looks a crazy decision but lets look
at what makes it rational. What is the outer limit of business rule judgment?
Everybody it was dumb but American Express got away with it.
The first time court is taking notice of a clumsy notice of insiders, saying outside
directors are not going to have an interest.
What must directors do to retain BJR protection?
Why isnt this like Francis?
Why no gross negligence here?

See note on divergence of standards of conduct and standards of review

Divergence of standard of conduct and standard of review is particularly common in corporate
law.
Traditional standard of conduct applicable to directors and officers : A director has a duty to
perform his functions in good faith in a manner that he reasonably believes to be in the best
interests of the corporation and with the care that an ordinarily prudent person would reasonably

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be expected to exercise in a like position and under similar circumstances.

Several distinct duties:
1) Duty to monitor
2) Duty to inquiry
3) Duty to make prudent or reasonable decisions
4) Duty to employ a reasonable decisionmaking process
The standard of review are less stringent: the decision ust merely be rational or must have a
rational basis.
4 conditions has to be fulfilled:
1) Decision
2) Reasonable decisionmaking process
3) good faith - No illegality
5) No self-interest
If the conditions of the BJR are not satisfied then the standard by which the quality of the
decision is reviewed is comparable to the standard of conduct for making the decision: entire
fairness or reasonability.
Cede v. Technicolor
Facts :CEO of MAC entered into negotiations with the CEO of Technicolor with a view to an
acquisition of Technicolor by MAF. On the basis of an investment banker, Goldman Sachs, CEO
of Technicolor was told that a price of 20-22 $ per share was worth pursuing, that a price of 25$
was feasible and that he should consider other possible purchasers. 6 days later they agreed o
a price of 23$. CEO of Technicolor called for a special meeting and approeved an agreement
with a price of 23$.
The Chancellor found with great doubt that Technicolors board had exercised due care in
making its decision : agreement was not preceded by a prudent search of alternatives, given the
terms of the merger the directors had no reasonable basis to assume that a better offer from a
third party could be expected once the agreement was signed, most of the directors had little
knowledge of the terms of the sale, or that a sale was pending.
Holding : Technicolors failed to reached an informed decision when it made its decision,
so the BJR did not apply

Delaware treats the business judgment rule as a presumption: if a plaintiff shows there
was a breach of the duty of care the presumption is overcome to a prima facie case of
liability even without showing liability. The burden then shift to the defendants to show
the transaction was entirely fair. (Until now in the regular duty of care: the plaintiff has
the burden of proof)
Standard is entire fairness. The factor that influences the most Allens decision is
whether there is a dominant director leading the boards decision (like in Van Gorkom).
Entire fairness is required both in price and process. What happen in a case without any
information (board was uninformed)?
Smith v. Gorkom
Revolutionary case.

Facts :

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Jerome Van Gorkom Chairman (who wanted to retire and sell the company) and CEO of
Trans Union discuss Trans Union difficulty in producing sufficinet taxable income to
offset its creating investment tax-credit (benefit of 90 M). CFO tried to figure out how
much money they would have to borrow and what much money to make to pay the
interest. They merely ran the numbers at 50$ a share and at 60$ with the rough
form of their cash figures at the time. Under those figures, 50$ would be very easy
while 60$ very difficult. It was numbers made for a particularly different business reason
rather than value for investment.
Van Gorkom stated that he would be willing to take 55 $ per share for his own shares.
Marmon was trying to buyout TransUnion. TransUnions CEO suggested a sale price
($55/share) which turned out to be an artificially, speculative price that did not reflect
research into the companys actual worth. Van Gorkom called an emergency meeting
with the board of directors in which he proposed the merger without disclosing all of the
relevant information regarding the proposed share price. He did not invite Trans Unions
investment banker. Additionally, Van Gorkom did not provide directors with copies of the
merger agreement or provide information to shareholders. The offer had to be acted the
next day. Van Gorkom presented the price of 55$ to be fair. Attorney who as present
advised the members of the board that they might be sued if they failed to accept the
offer. The board meting lasted about two hours. Based solely upon Van Gorkoms oral
presentation, CEO oral statement and attorneys legal advice, the directors approved the
merger. Consequently, shareholders filed suit, arguing that Van Gorkom did not meet his
fiduciary duties.

Issues: 1. Whether the BJR apply, i.e, Whether the directors have informed
themselves prior to make business decision of all material reasonably available to
them? 2. Whether the directors (including Van Gorkom) were grossly negligent to approve
the merger without any disclosures or proof that what Van Gorkom had provided was
sufficient.
Holding: 1. The Board did not reach an informed business judgment in voting the
merger for 55$ :
2. The board was grossly negligent in that it failed to act with informed reasonable
deliberation in agreeing to the Prisker merger proposal.
Reasoning:
1. BJR : The BJR itself is a 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. Thus, the party attacking a
board decision as uninformed must rebut the presumption that its business judgment
was an informed one.
2. the directors did not adequately inform themselves as to Van Gorkom forcing the sale
and in establishing the per share purchase price : no report, only oral presentation of
Van Gorkom, brief statement of the CEO, urgent time
3. There has to be a serious process for reflecting the price : they were uninformed as to
the intrinsic value of the company : a substantial premium may provide one reason to
recommend a merger but in te absence of other sound valuation information, the fact of
a preimum alone does not provide an adequate basis upon which to assess the fairness
of an offering price. The market test did not provide the right to accept a better offer or
the right to give information to third parties.
4. given these circumstances they were grossly negligent in approving the sale upon two
hours consideration without prior notice.

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Dissent: The dissenting opinion was made on the grounds that the directors were not
grossly negligent because there was no indication that if they had had additional time, they
would have come to a better decision (deny the merge), because ultimately, it added to the
companys financial stature.
Van Gorkom is a classic dominating CEO figure so nothing would have happened.
CFO said the number was fair and a lawyer said they were going to be sued if there did not
go ahead with that deal. SH would have also sued if such a premium was wasted by
refusing the deal.

What are the options of Prisker? If somebody comes with a better offer, Prisker would
receive a million shares.
After Smith v. Gorkom the legislature enacted an exculpation statute. By doing this,
message to the courts.

Whats the standard it establishes for liability for breach of the duty of care?
Why gross neglience?
Gross negligence as to what? Process? Substance?
What constitutes gross as opposed to mere negligence?

What role is played in the decision by the fact that this board was completely dominated
by an imperial CEO/Chairman?
What has happened to the imperial CEO model?

What was wrong with the boards process?

Are they any factors that favor the boards procedures? The board has to at quickly.
Counsel advice the board that they might be subject to suit. Significant premium over
trading price. Would have been perceived as a very good deal may be not the best one
but still a very good deal.

Is the court supposed to second-guess the substantive decision?

The court is very clear in saying that they can not second guessing the decision but have
to check if the process was sufficiently reasonable.

Why did the amount of time spent at the meeting matter? Would having spent
more time at the meeting have made a difference?
What if they had still spent 2 hours discussing, but had an effective market test?
Why shouldnt sophisticated business people be able to make quick decisions
under time pressure? Isnt that what we hire them for?

Should the context matter? How do we determine at what point the deal is too good to
be true? Process regardless what the offer is?
What if the offer had been a greater premium?

What was wrong with the market test they had? The board did not know
about the limitations. The members of the board did not have the deal sheet and relied
to the existence of a market test that was not real.

Reliance on reports
Whats the Delaware law on the boards ability to rely on reports made to it?

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141(e): good faith reliance on books, reports but not blind reliance. How much of an
inquisitorial duty should we put on boards when the records come from an officer.
Florida law on reliance on reports: 607.0830(2) says director can rely on "information,
opinions, reports or statements, including financial statements" presented by officers or
employees who the director reasonably believes to be reliable and competent in the
matters presented. . ."

Assessment of Van Gorkom

Contrast Kamin and Van Gorkom:
In Kamin, board won even though it lost $8 million, while in Van Gorkom, board lost even
though the deal assured shareholders up to a 62% premium.
Kamin : ordinary business decision (not a SH decision)
Van Gorkom: Merger of the company (end of the company)
The courts are going to be more deferential from imposing their views if the board is
doing ordinary business and follow a reasonable process but on the other hand if the
board decision cannot be corrected subsequently (terminal kind decision), the court will
look more carefully.
Ways to read Smith v. Van Gorkom narrowly?
Some people read Van Gorkom case very narrowly. It is not a case about the duty of
care but pure self interest case of Van Gorkom it is rather a violation of duty of loyalty.

How about the argument that Van Gorkom is less a duty of care case than a pre-Revlon
change of control case requiring enhanced scrutiny?
Others say, it is a take over case (Revlon), the goal of the board is to maximize the sale
price

Does the duty of care work?

The standard/conduct distinction for D/C is contested by some
See, e.g., Velasco, Bainbridge
Some say: The jurisprudence of the duty of care of corporate boards is incoherent,
arbitrary, and inefficient. Bainbridge: Duty of care does not work because it lacks
content. It is only aspirational. Courts should step out, business people should make
those decisions.

Application of gross negligence standard

Since the Van Gorkom standard is supposed to focus on the boards process rather
than second-guessing its substantive outcome what should we do when the process is
flawed but, somehow, the deal is substantively good?
What happens if the board decision isnt protected by BJR protections?
Whats the standard?
Entire fairness
But how can that be shown if the process was insufficient to
trigger BJR protections?
Who has the burden?
Professor Maceys read:
Macey says this is Delawares version of a lawyer employment act!
Note: post-decision settlement for $ 23.5 million, $10 million of which was paid by D & O
insurance and 13.5 million by Pritzker group on behalf of the defendant directors
What does this suggest?

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LIABILITY FOR FAILURE TO MONITOR: CAREMARK DUTIES

This case is about approving a settlement case. Usually an approval is a one paragraph but
here he uses the case to reverse the Delaware jurisprudence. Upends Delaware jurisprudence
in the dictum in this case.
Internal affair structure put in place with regard that you do not violate Medicare and Medicaid.
Directors only had a duty that there was no law breaking.
All that changed with Chancellor Allen.
Caremark
Caremark is about violations of duty of care.
Facts : Caremark International, Inc., a health services company, was the subject of a major
federal criminal investigation. The company allegedly violated laws that prohibit health care
companies from paying doctors to refer Medicare or Medicaid patients to their services.
Prior to 1991, Caremark had a regular practice of entering into financial arrangements with
referring doctors which were not clearly prohibited but which raised legal questions. However,
Caremarks board issued guidelines that attempted to clarify what sort of arrangements were
acceptable.
After they were notified of the federal investigation, the board announced that it would no longer
pay certain types of fees to Medicare and Medicaid doctors. The board also employed an
outside auditor to review its practices for business and ethical concerns.
The federal investigation resulted in indictments of junior officers in 1994. The officials took plea
deals to lesser charges and Caremark paid roughly $250 million in civil and criminal penalties.
A group of Caremark shareholders (plaintiffs) promptly brought derivative suits, alleging that
Caremarks directors (defendants) breached their duty of care by failing to adequately oversee
the conduct of Caremarks employees and thereby exposing the company to enormous civil and
criminal penalties. The parties negotiated a settlement. In the settlement, the board did not
agree to any monetary penalties; it simply agreed to implement a number of more cautious
policies moving forward, such as the creation of a compliance and ethics committee.
Issue : Whether the Board exercised an appropriate level of attention to the possibility of ARPL
violations.
Holding : There was no evidence that the directors knew that there were ARPL violations, and
there was no systemic or sustained failure to exercise oversight. However, the terms of the
settlement merely required Caremark to institute policies to further assist in monitoring for
violations. Therefore the settlement was approved.
Synopsis of Rule of Law. Directors are potentially liable for a breach of duty to exercise
appropriate attention if they knew or should have known that employees were violating the law,
declined to make a good faith effort to prevent the violation, and the lack of action was the
proximate cause of damages.
Reasoning : Potential liability for directoral attention for a breach of the duty of care may arise
in 2 contexts
(1) follow from a board decision that results in a loss because that decision was ill advised
or negligent : Standard of review : BJR (director protective)

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(2) result in a loss that arise from an unconsidered failure of the board to act in
circumstances in which due attention would arguably have prevented the loss.
- Chancelor Allen is going to use the duty of good faith, and develops it in a gigantic dictum.
What is the board responsibility with respect to the organization and monitoring of the enterprise
to assure that the corporation functions within the law to achieve its purposes ?
Increasing tendency under federal law to employ the criminal law to assure corporate
compliance with external legal requirements (environmental, financial, labor, product safety,
health and safety) : Existence of sentencing Federal guidelines. Incentive for coporations to
have in place compliance programs : detect violations of law, promptly report to appropriate
public officials and take prompt, voluntary remedial efforts.
- Recognition by Chancelor Allen of a change in the boards perceived role. The only thing
management can do in public held corporation is to monitor the management.
With this two things in mind: the change of the role of the board and sentencing guidelines. By
having the appropriate kinds of compliance in place you can avoid from being hold liable.
Duty to Ensure that the Corporation has Effective Internal Controls/Duty to Monitor:
Shift from Graham approach (espionage) to Caremark approach
Engaging pro active to mitigate the extent of such sentencing criminal liability. Invitation
to self police on the part of the corporation.
Self police makes sense with the new role of the board.
What are these law compliances to be like?
They can be industry relating: environmental, anti-trust, anti-doping.
What is the definition of internal control? No definition can be narrow or broad.
Is Caremark good enough for monitoring liability on the part of board of directors?
The illusion of monitoring.
Is the way to make it less illusory? Is the Delaware Chancery court going the way of giving new
teeth to Caremark?

How stringent a burden does Caremark impose on plaintiff?

The plaintiff must show :
that the directors knew
should have known that violations of law were occuring
and in either event, that the directors took no steps in a good faith to prevent or remedy that
situation
and that such failure proximately resulted in the losses complained in Cede v. technicolor

When will there be liability for failure to monitor? Very high standard
only a sustained or systematic failure of the board to exercise oversight - such as an
utter failure (complet) 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.

Articulated duty to have internal controls

Not having such controls = violation of duty of good faith because of a failure to
monitor/oversee management/employee behavior.

What does internal controls mean?

Process effected by an entitys board of directors, management and other personnel,

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designed to provide reasonable assurance regarding the achievement of objectives in 3

categories:
- effectiveness and efficiency of operations
- reliability of financial reporting
- compliance with applicable laws and regulations
The boards role is to use due care to assure itself that an internal control structure is in
existence, is appropriate, and is effective.

Why is the board the best locus?

Managerial opportunism
Asymmetries of information
Increasing number of independent, outside directors

Virtually meaningless standard giving the mere illusion of accountability

Recent cases with Caremark components

In Re Massey. The plaintiff stockholders of Massey alleged that the Massey Board breached
their fiduciary duties by not negotiating to have the pending Derivative Claims transferred into
a litigation trust for the exclusive benefit of Massey stockholders. The Derivative Claims were
the result of an April 5, 2010 explosion which occurred at Masseys Upper Big Branch mine in
West Virginia and as a result, 29 miners died. In addition stockholders of Massey filed derivative
suits, seeking to ensure that to the extent that Massey itself was harmed by the legal obligation
to pay fines, judgments to the lost miners families, and by the lost cash flows from the
destroyed mine, the corporate directors and officers who managed the firm were held
responsible for what the plaintiffs argued was a failure to make a good faith effort to make sure
that Massey complied with mine safety regulations.
The plaintiffs argued that the Merger was unfair because it would result in Alpha being able to
acquire Massey without paying fair value for the economic value of the Derivative Claims. In
addition, plaintiffs alleged that the Massey Board never attempted to value the Derivative Claims
but proceeded on the assumption that the Derivative Claims would survive the Merger.
The Court agreed that the Massey directors did not consider the Derivative Claims in an ideal
manner, but concluded that they exercised reasonable, good faith efforts to get as favorable a
deal as they could, and were not improperly motivated by a desire to escape liability for the
Derivative Claims. Accordingly, the Court refused to scrutinize the Massey directors conduct
under the entire fairness standard, but noted they could likely show the merger was
economically fair because the value of the Derivative Claims was not material
Vice Chancellor Strine began his analysis by explaining that, as a matter of black letter law
pre-merger derivative claims will pass to the acquirer except in two circumstances: (1) where
the merger is a fraudulent attempt to deprive shareholders of standing or (2) the merger is
merely a reorganization that does not affect shareholders relative ownership in the resulting
entity.
The Court noted that it was surprising and regrettable that the Massey directors did not
analyze their value, reiterating any board negotiating the sale of a corporation should attempt to
value and get full consideration for all of the corporations material assets.
The board of members has not taken into account that the behavior would have influenced the
value of the shares. It looks like that the board of director would have had to fire the
domineering CEO and has the compliance systems in place. Then maybe the court would have
said the standard of Caremark is satisfied.

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Board of directors said that they have met the standard of Caremark, they have put in place a
lot of motion in response to complaints. Ordinarily, board of directors thought they could get
away with liability. They put formal response in place to complaints. But interestingly, the court
did not dismiss the complaint. It was not changing the culture of the company when a lot of bad
things were happening. It is only at the stage of a motion to dismiss.
There is formal compliance with Caremark but it is not enough because there is a culture of
problems in the company (recidivist). Directors cannot take comfort in the illusion of compliance
rather than make good faith efforts. Safety violations but nothing was substantially
accomplished to correct.
While the Court found that the Derivative Claims likely stated a claim for director oversight
liability under Caremark, the record did not support the inference that the Derivative Claims
were material in comparison to the overall value of Massey as an entity and that the record did
not persuade the Court that the Merger would likely be found to be economically unfair to the
Massey stockholders.
Flags: not domineering director, not highly regulated industry. You can go away with liability.
Other new cases other than Massey: 3 about China:

indicating that Caremark duties would be violated by board complicity in

Chairmans flouting of mining regulations.
Is this an extension of the Caremark standard requiring changes to
company culture, or a mere application in a red flag type of case?
Recent Caremark claims contd

Rich v. Chong; In re China Agritech

Two of several China reverse merger cases; lots of red flags
Can directors just quit?

Rich v. Chong
Facts : Fuqi was formed as the result of a reverse-merger transaction involving Fuqi BVI and
VT Marketing Services, Inc. in November 2006. Fuqi initially reported very strong growth but
then three and one-half years after it was created, Fuqi announced that its fourth quarter 10-Q
and 10-K for 2009 would be delayed because it had discovered certain errors related to the
accounting of the Companys inventory and cost of sales. On September 8, 2010, Fuqi
announced that the SEC had initiated a formal investigation into Fuqi, related to its failure to file
timely periodic reports, among other matters.
Fuqi subsequently released additional negative information about its accounting errors,
lack of internal controls, and mismanagement of corporate resources.
On July 19, 2010, plaintiff made a demand to the Fuqi Board asking the board of directors to
take action to remedy breaches of fiduciary duties by the directors and certain executive
officers of the Company as well as to correct the deficiencies in the Companys internal
controls that allowed the misconduct to occur. While Fuqi never responded to the demand, the
directors formed a Special Internal Investigation Committee which the board authorized to
retain experts and advisors to investigate whether the claims in the demand were meritorious.
However, the plaintiff contended that the Special Committee never conducted any investigation
or any other activity during its short-lived existence. By March 2012, the Special Committee
effectively ceased to exist.

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Although there was no evidence that the Special Committee performed any investigation, the
Audit Committee did begin an investigation into Fuqis accounting problems. Unfortunately,
whatever progress the Audit Committee made in uncovering and correcting the problems ended
when Fuqi management failed to pay the fees of the Audit Committees outside legal counsel,
forensic specialists, and auditor. Because the Audit Committee had failed to complete its audits
of years 2009, 2010, and 2011, Fuqi did not file any audited financial statements for over three
years. In March 2012, Fuqi represented to the SEC and to the Court of Chancery that it is
unable to estimate when it will file its audited financial statements.
Court of Chancery Rule 23.1 permits a stockholder to pursue an action on behalf of a
corporation derivatively, where the corporation . . . [has] failed to enforce a right which may
properly be asserted by it . . . Rule 23.1 requires a stockholder to make (or justify excusal of)
a demand to the board of directors before the stockholder may bring a suit derivatively. A
stockholder must allege with particularity the efforts, if any, made by the plaintiff to obtain the
action he desires from the directors . . . and the reasons for his failure to obtain the action or for
not making the effort. Once the stockholder makes a demand, the board has an affirmative
duty to evaluate the demand and to determine if the litigation demanded is in the best interest of
the stockholders. Where the board has not responded to a demand, the plaintiff satisfies the
rule, and may proceed, upon raising a reasonable doubt that the boards lack of a response is
consistent with its fiduciary duties.
Because Fuqi did not formally reject the plaintiffs demand, the Court was required to determine
whether the plaintiff had pled particular facts creating a reasonable doubt that the Fuqi Boards
lack of a response was acting in good faith and with due care in investigating the facts
underlying the Demand to assess whether the plaintiff has satisfied Rule 23.1 and may proceed
derivatively. The Court noted that the plaintiff had alleged the following: (1) he made a demand;
(2) Fuqi took steps to begin an investigation; (3) that investigation appeared to have uncovered
some amount of corporate mismanagement; (4) Fuqi did not act on the information that it
uncovered; (5) the Special Committee appointed by the Board to investigate the demand ended
without making a recommendation; (6) by failing to pay the advisors to the Audit Committee, the
company deliberately abandoned the investigation, and has taken no action through the Audit
Committee for at least 12 months; and (7) the independent directors have left the company,
some in protest of managements actions. Based upon those allegations, the Court found that
the plaintiff had pled with particularity facts that create a reasonable doubt that the Fuqi board
acted in good faith in investigating the plaintiffs demand.
Plaintiff alleged that Fuqis directors were liable for Caremark violation in failing to oversee the
operations of the corporation.
Under Delaware Supreme Court precedent, there are two possible scenarios in which a plaintiff
can successfully assert a Caremark claim: (a) the directors utterly failed to implement any
reporting or information system or controls, or (b) having implemented such a system or
controls, consciously failed to monitor or oversee its operations thus disabling themselves from
being informed of risks or problems requiring their attention. Under either scenario, a finding of
liability is conditioned on a plaintiffs showing that the directors knew they were not fulfilling their
fiduciary duties. Where directors fail to act in the face of a known duty to act, thereby
demonstrating a conscious disregard for their responsibilities, they breach their duty of loyalty
by failing to discharge that fiduciary obligation in good faith.
Fuqi Had No Meaningful Controls in Place.
While the Court noted that Fuqi had some sort of compliance system in place, it appeared to

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have be woefully inadequate. The Court needed only to look at Fuqis own press releases to
see detailed evidence of Fuqis problems including: (i) incorrect carve-out of the retail segment
from the general ledger; (ii) unrecorded purchases and accounts payable, (iii) inadvertent
inclusion of consigned inventory, (iv) incorrect and untimely recordkeeping of inventory
movements of retail operation; and (v) incorrect diamond inventory costing, unrecorded
purchases and unrecorded accounts payable. Moreover, there were allegations that the board
ignored the following warning signs: (i) the board knew that it had problems with its accounting
and inventory processes by March 2010 at the latest, because it announced that the 2009
financial statements would need restatement at that time; (ii) Fuqi acknowledged the likelihood
of material weaknesses in its internal controls; and (iii) Fuqi received a letter from NASDAQ in
April 2010 warning Fuqi that it would face delisting if it did not bring its reporting requirements
up to date with the SEC.
When faced with these and other signs that the company controls were inadequate, the
directors were required to take steps to prevent further wrongdoing from occurring. After noting
that [a] conscious failure to act, in the face of a known duty, is a breach of the duty of loyalty,
the Court found that the plaintiff had alleged facts sufficient to state a claim for breach of the
duty of good faith under Caremark.
It may be that the Caremark application is easy to distinguishing.
Delaware court does not like these reverse mergers: they do not like them.
Has apparent internal control but in fact it was not actually working, the board failed to monitor.
Did not meet the Caremark standard.
NASDAQ sent letters. Credulity to tolerate a big movement of money or the directors were too
stupid. When they did not pay the auditors committees bills fees they disabled from being
informed.
It looks like this case was narrow.
Can directors just quit : No!!!!
Clearly fraudulent enterprises. The companies are making different representations to the
Chinese SEC and the U.S. Chinese.
These are potentially narrow cases.
Goldman Sachs: appropriate amount of risk.
In dismissing a wide-ranging stockholder challenge to compensation practices at Goldman
Sachs, the Delaware Court of Chancery has issued a strong reaffirmation of traditional
principles of the common law of executive compensation. The decision emphasizes that boards
are free to encourage and reward risk-taking by employees and that Delaware law protects
directors who adopt compensation programs in good faith. In re The Goldman Sachs Group,
Inc. Shareholder Litigation (Oct. 12, 2011).
Shareholders of Goldman Sachs brought suit on a variety of theories, claiming that Goldmans
compensation policies, which emphasized net revenues, rewarded employees with bonuses for
taking risks but failed to penalize them for losing money; that the directors allocated too much of
the firms resources to individual compensation versus investment in the business; that while the
firm adopted a pay for performance philosophy, actual pay practices failed to align stockholder
and employee interests; and that the board should have known that the effect of the
compensation practices was to encourage employees to engage in risky and/or unlawful
conduct using corporate assets. In dismissing the claims, the Court relied on basic principles of
Delaware law.
In particular, the Court notes that [t]he decision as to how much compensation is appropriate to
retain and incentivize employees, both individually and in the aggregate, is a core function of a

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board of directors exercising its business judgment. If the shareholders disagree with the
boards judgment, their remedy is to replace board members through directorial elections. The
decision further states that it is the essence of business judgment for a board to determine if a
particular individual warrants large amounts of money as payment for services. Recognizing
that boards set compensation in part as a function of encouraging appropriate risk-taking by
employees, the court reasoned that even when risk-taking leads to substantial losses, there
should be no finding of waste. any other rule would deter corporate boards from the optimal
rational acceptance of risk. Similarly, the Court accepted that legal, if risky, actions that are
within managements discretion to pursue are not red flags that would put a board on notice of
unlawful conduct.
The decision also contains a significant discussion of director duties in supervising risky
employee conduct. The Court refrained from reading into Delawares Caremark doctrine the
doctrine that requires boards to put systems in place to monitor fraud and illegal activity a
further duty to monitor business risk. Because determining the trade-off between risk and
return is at the heart of business judgment, the courts should avoid second-guessing a boards
determination of the appropriate amount of risk. The Court cautioned against expanding the
frontiers of liability in this area, since to do so could gut the Delaware statute protecting directors
from personal liability for breaches of the duty of care, and could potentially chill the [ability of
Delaware companies to obtain the] service of qualified directors. In sum, oversight duties
under Delaware law are not designed to subject directors to personal liability for failure to
predict the future and to properly evaluate business risk.
The Goldman Sachs decision stands as a profound and persuasive restatement of fundamental
principles of corporate law, and should give directors confidence that well-informed business
decision-making in the realm of executive and employee compensation remains strongly
protected by the business judgment rule.
Potentially liable under Caremark if utterly fail to address the issue of risk management.
Goldman Sachs
Compensation scheme said to create incentives to engage in highly risk-taking,
unethical and illegal conduct
Issue: Should risk assessment be part of the internal control requirement
under Caremark?

What impact does SOX have on the state law of duty of care?
Argument that SOX serves as a pressure on state courts to interpret the duty of
care as including at least the norms of SOX internal controls and disclosure.
Audit Committee rules
Maintain procedures regarding accounting, auditing and internal control matters.
Members of the auditing committee have to be only outside auditors.
There got to have appropriate funding for payment of the auditors and appropriate
investment bankers.
Duty of care of officers
Adopt a duty of care for officers regardless the content of the statute.
Upper management is responsible (essentially officers) for making adequate certificates
of putting adequate control.
Under SOX, have to be financial control and upper management in place.
SOX has specified officers responsibilities.
Invitation to State courts to incorporate same kinds of norms (federal has create rules for
behavior).

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Corporate criminal liability

Effect of federal sentencing guidelines
Effect of director guidebook recommendations
Override Del. 102(b)(7) opt-in liability shields?
Legislative responsive to Smith v.Gorkom: Liability shield under Del.102(b)(7)
Applies only to violations of the duty of care.
Is it an opt-in or opt-out statute?
1. In Virginia it is an opt-out statute: there is a presumption that directors will not be held
liable.
2. In Del. It is Opt-in statute
102 (b) In addition to the matters required to be set forth in the certificate of
incorporation by subsection (a) of this section, the certificate of incorporation may
also contain any or all of the following matters:
(7) A provision eliminating or limiting the personal liability of a director to
the corporation or its stockholders for monetary damages for breach of
fiduciary duty as a director, provided that such provision shall not
eliminate or limit the liability of a director: (i) For any breach of the
director's duty of loyalty to the corporation or its stockholders; (ii) for acts
or omissions not in good faith or which involve intentional misconduct or a
knowing violation of law; (iii) under 174 of this title; or (iv) for any
transaction from which the director derived an improper personal benefit.

102 (b)(7) does not cover the director for violation of law, violation of
duty of liability or personal profit in a transaction.
Is RMBCA 2.02(b)(4): Delaware says violation of duty of loyalty cannot be exculpated
but RMBCA does not exclude violations of duty of loyalty. More protective of the
directors than the Delaware statute.
All of a sudden, lawyers shifted to duty of loyalty and good faith. Inextricably intertwined
with duty of care. That leads to how the change of good faith is perceived starting from
Caremark (Emerald).

Emerald Partners v. Berlin (Del)

What is the likely practical impact of making a 102(b)(7) exculpatory clause an
affirmative defense?
The shield from liability provided by a certificate of incorporation provision is in the nature
of an affirmative defense. Defendants seeking exculpation under such a provision will
normally bearthe burden of establishing each of its elements.
There will probably have to be of not a whole trial, discovery. This is why defendants do
not like Emerald.
If a court finds that what is being plead is nothing more than a duty of care claim you can
obtain an earlier dismissal.
Malpiede v.Townson operationalizes 102 (b)(7).
Facts : Fredericks of Hollywood (Frederick) was the target of a bidding contest between
Knightsbridge Capital Corporation (Knightsbridge) and two other suitors. After several
rounds of bidding, Knightsbridge made an offer of $7.75 per share on September 6,
1997. The offer was conditioned on Fredericks accepting strict limitations on its ability to
entertain other offers. Fredericks board unanimously accepted Knightsbridges terms.

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On September 11, 1997, Veritas, Inc. made an offer of $9 per share. Fredericks board
rejected the offer, citing the agreed-upon restrictions among other factors. Knightsbridge
ultimately completed the merger and acquired Frederick. Fredericks articles of
incorporation included an exculpatory provision pursuant to Delaware General
Corporation Law (DCL) 102(b)(7). The provision shield its directors from personal
liability provided they have not acted in bad faith or breached their duty of loyalty to the
corporation. Disaffected Frederick shareholders (plaintiffs) sued the directors of
Frederick, arguing that they breached their fiduciary duty. They asserted that one of the
four directors received improper personal benefits from the transaction, and that together
they improperly favored Knightsbridge over other bidders. The trial court dismissed the
suit for failure to state a claim, ruling that the directors were shielded by the exculpatory
provision. The shareholders appealed.
There is only be a dismissal if no rational case can me make out other than a duty of
care discussion. Invitation for clever lawyering (duty of loyalty as bad faith).
Issue : Can the directors be personally liable for breaching the duty of care?
Holding : The directors cannot be personally liable for breaching the duty of care.
Reasoning : Section 102(b)(7) of the Delaware General Corporation Law insulates
directors from personal liability for breaching the duty of care. Since the shareholders
have not alleged that the directors engaged in conduct falling within any of the
exceptions to 102(b)(7), the directors cannot be held personally liable.
Directors & Officers liability insurance (D&O): relies on misleading information,
misrepresentation.
Extremely important for the company and the director that the application is perfect.
Certain numbers of exclusion. To settle the plaintiffs it will make it easier to negotiate with
the board if it is within the policy limits.
Directors & Officers Liability Insurance
Technical issues:
What does D & O insurance cover? Certain types of non-indemnified losses.
Corporate reimbursement ,which insures the corporation against its potential
liability to officers and dicrectors.
Personal coverage which insures the directors and officers themselves against
losses based on claims against them for wrongful conduct.
What limits? Usually all policies will cover violation of duty of care owed to the
corporation but not all will cover duty of care owed to the general public.
Does D & O insurance completely eliminate risk for D & Os? Variety of claims are
excluded such as claims pther than derivative actions against director or officer
and limitation of the combined amount of liability and legal expenses.Must give
notice of the claim
Why should corporations pay for insurance and indemnify directors against liability for
fiduciary breaches?

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DUTY OF GOOD FAITH

In re Walt Disney Company derivative litigation
Facts : Disney hired Ovitz to be their executive, however he lacked any management
experience at a public corporation.
-After 13 months, he was fired.
-Ovitz was given $140M as severance.
-Most of the compensation came from stock options that were negotiated as part of Ovitz's
employment.
-Shareholders, led by Brehm, filed a derivative lawsuit against Disney executives, represented
by Eisner (the CEO) for hiring Ovitz, the board was under the pressure of Ovitz when decided to
hire Ovitz a friend of Eisner for 25 years, for hiring him whre as he was not qualified, for
agreeing to pay Ovitz such a large amount of money.
-The shareholders argued: Eisner breached his fiduciary duties to act in good faith, by agreeing
to pay Ovitz so much, and for not consulting the board of directors before firing Ovitz.
Issue : Whether the Chancellors standard for bad faith corporate fiduciary conduct (intentional
dereliction of duty, conscious diregard for ones responsibilities- is legally correct ?
Procedural history:
-The Trial Court found for Eisner in summary judgment.
-The Trial Court found that a large severance package alone is not enough to show a lack of
due care or to constitute waste.
-The severance package turned out to be large, but it wasn't "sufficiently unusual" to warrant an
evidentiary hearing on the issue of waste.
-Shareholder's appealed.
-The Delaware Supreme Court remanded, and thought that the shareholders' had a weak case,
but should be allowed more discovery of Disney's corporate records.
-After discovery, the Trial Court looked at the new evidence and found that there was enough to
proceed to trial.
-The Trial Court found that there was evidence that the directors had breached their duty of
good faith.
"These facts, if true, do more than portray directors who, in a negligent or grossly negligent
manner, merely failed to inform themselves or to deliberate adequately about an issue of
material importance to their corporation. Instead the facts alleged in the new complaint suggest
that the defendant directors consciously and intentionally disregarded their responsibilities..."
-Turns out, the directors relied on the advice of a financial consultant named Crystal, who never
bothered to calculate how much Ovitz would be entitled to if he left early.
-The Trial Court found for Eisner. The shareholders appealed.
-The Trial Court found that the directors' conduct was less than ideal, but not in bad faith or
grossly negligent.
-The Court stated ordinary negligence is insufficient to constitute a violation of the fiduciary duty
of care.
-The Delaware Supreme Court affirmed.
Reasoning : 3 different categories of fiduciary bad faith behavior :
- subjective bad faith, intent to do harm
- lack of due care : gross negligence without intent to do harm or failure to inform ones self
of available material facts

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in the middle category : intentional dereliction of duty, conscious diregard for ones
responsibilities (misconduct that is more culpable than simple inattention or failure to be
informed of all facts material to the decision (Caremark duty))

Issues of good faith are necessarily intertwined with the duties of care and loyalty.
But Gross negligence without more does not constitute bad faith.
Exculpating its directors from monetary liability for a breach of duty of care is possible but not fro
conduct that is not in good faith.
Delaware statute permits to indemnify a director or officer against expenses including attorneys
fees under the condition that he acted in good faith (145)
Good faith Fiduciary fails to act in good faith where he or she (i) "intentionally acts with a
purpose other than that of advancing the best interests of the corporation;" (ii) "acts with the
intent to violate applicable positive law;" or (iii) "intentionally fails to act in the face of a known
duty to act, demonstrating a conscious disregard for his duties."
Because the legislature has also recognized the intermediate category (exculpation) that
provision distinguishes between intentional misconduct and a knowing violation of the law. We
uphold the Courts chancery definition as a legally appropriate but not limited definition of bad
faith.
Rules : Two categories of actions that arguably constitute bad faith:
1. Subjective bad faith: where the fiduciary conduct is motivated by an actual intent to do harm.
2. Fiduciary actions taken solely by reason of gross negligence and w/o any malevolent intent
(including a failure to inform oneself of the material facts).
-There is a difference between bad faith and a failure to exercise due care.
-Ordinary negligence is insufficient to constitute a violation of the fiduciary duty of care.
Reasoning : -The Court found that the directors are not required to be informed of every single
contingency (example: if Ovitz' left early). Instead, they have to be 'reasonably informed' in
order to meet the requirements of the duty of care.
The prenup: Disney could terminate for cause (Ovitz will not be owed any additional
compensation) If not let go for cause, termination: Disney will have to pay him remaining
salary + stock options (140 millions after 14 months of inept service).
No way to terminate for the for cause understanding of the contract.
Aspirational duty (1) but does need to be ideally performed (2).
Chancellor Chandler generally reviews the business judgment rule and duty of care.
At the end of the opinion, statement, duty of good faith is evolutionary, should not been
considered a violation good faith by that time (in 1995) but may be not the case anymore
(3).
Today if this case was coming to the court, the outcome should be opposite based upon
lack of good faith.
Process to hire: The process used to hire Orvitz and giving him the more benefit
advantages ever should not be followed to hire future directors. Should have kept the
board informed and involved nevertheless Einers actions were taken in god faith so did
not break his fiduciary duty.
The court reaffirmed that it as not the best scenario it was not an ideal governance, it is
not a good faith failure for guidance because intentional dereliction of duty, conscious
disregard for ones responsibilities, deliberate indifference and inaction in a face of duty
to act. Showing gross negligence is not enough to show bad faith.
For oversight failure it has to be more than good faith.

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The SC is afraid of a flood of litigation potentially if expands a big separate general

violation of good fait. Way of warning the plaintiffs lawyers. Do not try to smuggle every
violation under good care.
Duty of care and good faith must remain distinct. Highly consequences flow from that
statement.
Higher standard of liability if the board does not act.
Everybody thought that duty of good faith would have been linked to the duty of care.
Instead the courts decided to use it as an independent duty.
Then comes the stone v. Ritter
The duty of good faith is not a subsidiary of duty of care neither independent, it is
accessory to the duty of loyalty.
Duty of loyalty is significantly broader includes failure to oversee. Oversight is tucked in
duty of loyalty.
Failure to act affirmatively is a violation of duty of care if found grossly negligent.
Is the duty of good faith in cases like Caremark and Disney a response to Delawares
adoption of 102(b)(7) exculpatory provision? The court has not cut out his judicial review
and will police the boundaries and make sure that is article is narrowly interpreted.
Board in public companies have go to be serious of how they monitor they have to put
systems in place and make sure they are working if not courts will hold them liable.
Failure to engage in the specific role of monitoring, the legislature will not disarm the
courts to review.
Courts look at the context of the business they are dealing with because of the earnings
of Disney they found that the compensation of 140M was eminently reasonable.
How you assess fiduciary duties?
Do you look at the board as a whole or one by one?
Very little written about this. The choice between individual and collective assessment
might be outcome determinative.
Chancelor Allen adopted another view: In Van Gorkom look at the board as a whole, in
Moia expertise case look at the individuals. Not insignificant degree of tension between
the to Chancelor looked at the primary actions of one by one and look at the rest of the
group. In Disney case you might be surprised to the connections to Eisner and that the
court does not seem to consider such as head mistress of the school where his kids go.
Question: Could you could argue that Eisner was domenering like Van Gorkom. The
court does not reach the individual approach. The court has not formally opined of how
you do the analysis.
So they are going to assess both to show what is the reality.
After this decision, duty of good faith started to have significance.
Stone v. Ritter: Delaware SC affirmance of Caremark standard for indirect liability.
Standard for assessing a directors potential personal liability for failing to act in good
faith in discharching his oversight responsibilities.
Historical approach to the the duty of care : From Graham, through Caremark to Disney.
Then between Disney and Stone v. Ritter: Cede v.Technicolor (stand alone)

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In Stone v.Ritter, SC rejects the stand alone of the duty of good faith.
Graham : derivative action brought against the directors for failure to prevent violations
of federal anti-trust laws.
The plaintiffs claimed that the directors should have known.
The Court held that absent cause for suspicion there is no duty upon the directors to
install and operate a corporate system of espionage to gerret out wrongdoing which they
have no reson to suspect they exist.
Caremark (oversight liability): the board exercise a good faith judgment that the
corporations information and reporting system is in concept and design adequate to
assure the board that appropriate information will come to its attention in a timely manner
as a matter of ordinary operations. It does not require the directors to possess detailed
information about all aspects of the operation of the enterprise.
Only a sustained or systematic failure of the board to exercise oversight such as
an utter failure to attempt to assure a reasonable information and reporting
system exists will establish the lack of good faith.
Disney : failure to act in good faith requires conduct that is qualitatively different from
and more culpable that the conduct giving rise to a violation of the fiduciary duty of care
(gross negligence).
A failure to act in good faith may be shown where the fiduciary intentionally act
with a purpose other than advancing the best interests of the corporation where
the fiduciary acts with the intent to violate applicable positive law or where the
fiduciary demonstrating a conscious disregard for his duties.
Stone v.Ritter : Violation of duty of good faith: Failure to act in good faith is a violation of
the duty of loyalty, rather than a new and independent fiduciary duty.
Bad outcome not = bad faith. Board neednt guarantee effectiveness of
compliance systems.
Whats bad faith? Failure to act in good faith requires conduct that is qualitatively
different from, and more culpable than, the conduct giving rise to a violation of
the . . .duty of care (i.e., gross negligence) [citing Disney]
Oversight liability in Delaware now:
In order to prevail on a claim that the board breached its duty to monitor the
corporation, a plaintiff must prove that either
(a) the directors utterly failed to implement any reporting or information
system or controls to monitor the business, or else
(b) having implemented such a system or controls, [the directors]
consciously failed to monitor or oversee its operations thus disabling
themselves from being informed of risks or problems requiring their
attention.
In either case, imposition of liability requires a showing that the directors knew
that they were not discharging their fiduciary obligations, that is, that they were
demonstrating a conscious disregard for their responsibilities.
(scienter
element)

Why is Stone important? Suggests an increased scope for the duty of loyalty
beyond the traditional context of conflicts of interest/the self-dealing transaction.

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You can read Stone in two opposite directions:

1. extensive fiduciary duty and directors better watch themselves.
2. Reduces accountability by saying that good faith requires a showing of scienter. So
you can always prove there is no scienter.

Theoretically, duty of care could be subset of duty of loyalty

Consequences will depend on how DGF is defines as the new duty of loyalty
evolves.

The DGF is comprised of a general baseline conception and specific obligations that
instantiate that conception.
The baseline conception consists of four elements: subjective honesty, or sincerity;
nonviolation of generally accepted standards of decency applicable to the conduct of
business; nonviolation of generally accepted basic corporate norms; and fidelity to office.
Among the specific obligations that instantiate the baseline conception are the obligation
not to knowingly cause the corporation to disobey the law and the obligation of candor
even in non-self-interested contexts.
Some suggest that the Stone account describes the standard of review for the standard
of conduct above.
Evolution in good faith and oversight in Delaware:
Caremark, Disney, Stone v. Ritter
Good faith seems to move from (apparently) duty of care to element of fiduciary
duty triad to duty of loyalty

Duty to act lawfully

Miller v. ATT
Facts : Shareholders (plaintiffs) of American Telephone & Telegraph Co. (AT&T) brought a
derivative action against the corporation and most of its directors. The complaint alleged that
AT&T failed to collect a $1.5 million debt owed by the Democratic National Committee (DNC) for
services provided at the 1968 Democratic convention. The shareholders claimed that, in
addition to wasting corporate assets, the failure to diligently pursue collection violated federal
communications and campaign finance laws; specifically, ignoring the debt allegedly constituted
an illegal contribution to the DNC. The trial court dismissed the complaint, finding that
collections practices are protected by the business judgment rule absent allegation that the
conduct was plainly illegal, unreasonable, or in breach of fiduciary duty. The shareholders
appealed.
One of those cases that have to be settled.
Even if acting unlawfully was going to benefit the company, you still have to act lawfully.
There is a duty to follow the law. The courts in the corporate context, it is not a negotiable duty.
Was there a clear violation of section 18. 610?
You have to show scienter.
Why second-guess this business decision? Otherwise there would be no other resource ?
To put the company at risk of violating the law is too much.
At least two faults: anything that you do shall help the corporation on the short basis. A certain
kind of risk taken regarding compliance law is a fault. Criminal corporate liability.
Qui vole un oeuf, vole un boeuf.

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Criminal liability of directors and officers.

2 categories
1) criminal liability for acts performed by corporation manager or caused to be performed.
2) criminal liability for unlawful acts of employees under their control, even if the power was
not exercised (responsible-corporate-officer doctrine), even if the person is not the
person engaged in the illegal conduct undertaken. The person is not personally liable for
the wrongful act.
A corporate law norm basis when you cannot have it under tort law.
Intent of Congress: public health
Activities that are supervisory, oversight norms (Caremark) or the range of liability ought to
come from outside corporate law?

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DUTY OF LOYALTY
What is the possibility that people are going to misuse a power for a self-interest at the expense
of the company? It is not about promoting maximization profit behavior but self-abnegation.
How to limit those circumstances.
Who owes the duty of loyalty? Directors, officers of the company and sometimes controlling SH
of the company.
When you see a fact pattern that shows loyalty, conflict of interest, you cannot rely on
exculpation 102(b)(7)
Self dealing conflict of interests.
The moment they have their own interest, we doubt their ability to make business judgment that
are not coloured, not entire business judgment but entire fairness.
Very important: Violation of duty of care for the board of director and violation of duty of
loyalty for the self-interested.
1. When is it a self-interest transaction: broad definition, transaction between the corporation
and a person that has an influence decision making and has a greater personal interest than the
welfare of the corporation itself. It can be direct or indirect conflict of interest on the part of the
insider (director or officer)
-

Classic, most obvious form of conflict of interest: the director is a party to the transaction
along with the corporation and has a personal stake in the operation. A director sells his
house to the company, loan, using his own company to deal with the corporation, outside
lawyers and experts that are also members of board of directors.
Examples of self dealing : Interlocking: between two corporations that share directors.

What is self-dealing, conflict interest?

- Various categories: if the majority of the board is dominated, by one or more members of
the board self-interested parties.
Delaware SC: v.Loft about corporate opportunities.
Possible Approaches
Flat prohibition: The corporation cannot enter into any transaction with any person or
entity in which a director has a conflicting interest.
Shareholder ratification. The corporation can enter into conflicting-interest transactions
if the shareholders validate -- ratification or approval.
Director ratification. The corporation can enter into conflicting-interest transactions if
the disinterested directors approve.
Fair. The corporation can enter into conflicting-interest transactions if a judge finds the
transaction was fair.
When there is a conflict of interest and the court uses to assess the transaction fairness, is
that a risky proposition? A fairness inquiry involves costs, you pay for a court to determine
that the deal was fair. If the deal was only fair, when you have paid for an assessment of the
fairness, the cost of the deal becomes: the deal + the costs to determine it was a fair deal
(additional cost)

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How do you determine whats fairness, assuming that fairness is in range. What is it that
you are getting when the court is engaging? You are better not getting a self-interest
transaction but having a third party or the self-interest entering into competition to get the
transaction it will be a more market price. It depends how cleanly the market information,
there are transactions costs in access to resources as a matter of reality lead people to rely
outside f cash market economy, whether or not you think that disclosure is really sufficient to
assess the risk so that they can agree.
Evolution of the duty of loyalty.
At the beginning there was a prohibition of self-interested transactions that shifted to
approval by a disinterested majority of the board (increasing liberal standard).
Stages under which the transaction is going through to consider voidability.
The shift occurred regarding small companies that got loan not from banks but from
shareholders, directors.
The public held companies had access to non-conflicted resources.
1. How do we determine interest?
2. Whether the self-interested transaction is voidable completely or is fair sufficient to be
permitted?
3. What are the rules?
Gantler v.Stephens
Reversal (rare) of Chancery decision
Allows plaintiff to go forward
BJR presumption rebutted
Facts : The board of directors of First Nile Financial, Inc. (First Nile) put the company up for
sale in August 2004 and attracted interest from several firms.
The board of director retained a financial advisor and a legal advisor.
3 offers : from Farmers National Banc Corp. (Farmers) was ignored by Stephens the CEO,
after Farmers stated that it would not retain the First Nile board if its bid were accepted.
Cortland Bankcorp (Cortland) and First Place Financial Corp. (First Place) also made offers
and submitted due diligence requests. William Stephens (defendant), First Niles chairman
and CEO, did not inform the rest of the board of the due diligence requests. This caused
Cortland to drop out of the bidding and First Place to reduce its bid. Ultimately the board
rejected First Places offer and decided to pursue a privatization plan instead of a sale.
Because the privatization plan involved changes to shareholder rights, it required
shareholder approval.
The board of First Nile submitted a proxy statement to the Securities and Exchange
Commission (SEC) which disclosed that the each of the directors had a conflict of interest
with respect to the privatization plan because, by virtue of their positions, they could
structure the plan to their own benefit. The shareholders nonetheless voted in favor of the
privatization plan.
A group of dissident shareholders (plaintiffs) brought a derivative action against several First
Nile directors (defendants), including Stephens. The complaint alleged that the directors
breached their fiduciary duty by rejecting a valuable opportunity to sell the company. Three
directors, constituting a majority that opposed the sale, were alleged to have had improper
personal motives in rejecting First Places offer. All wished to preserve their positions.
Director Kramer owned a heating and cooling company which did work for First Nile, which

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would presumably be lost in the event of a sale. Director Zuzolo was a principal in a law firm
which likewise did work for First Nile.
The trial court granted the directors motion to dismiss the complaint, on the grounds that (1)
the business judgment rule shielded the directors from duty of care claims, and (2) the
shareholder vote ratified the boards actions and also served to shield the directors. The
dissident shareholders appealed the dismissal.
Reasoning : 1. A cognizable claim of disloyalty rebuts the BJR presumption. The entire
fairness standard (Blasius) must be applied by the courts.
Stephens as a director, Safarek as an officer, Zuzolo (passed away) and Kramer have
violated their duty of loyalty. (sabotage of the due diligence process and recommendation
the reclassification proposal to the SH for purely self-interested reasons).
Fiduciary duty of care explicitly extended to officers
3. A majority of the directors that approved the reclassification proposal lacked
independence.
4. SHs approval was required to amend the certificate of incorporation but the
Reclassification proxy contained a material representation, thus the SH was not fully
informed. The approving vote could not also operate to ratify the challenged conduct of
the interested directors.
5. Shareholder ratification limited when a fully informed SH approves a director action that
does not legally require SH approval in order to become legally effective.
Shareholder ratification limited
6. Because a SH was required to amend the certificate of incorporation that approving vote
could not also operate to ratify the challenged conduct of the interested directors.
Decision observes that 102(b)(7) exculpatory clause does not in its term apply to
officers: Even if you cannot find Gantler liable as a director you can still apply the
duty of loyalty on officers. It is applied more stringently on inside, in-house directors
(employees of the company) rather than outside directors. Very important to look at
the position.
Entire Fairness
Lewis v. S.L.&E (NY Courts)
Facts : Plaintiff and Defendant directors were brothers. Their father left each of his children
shares of SLE but only Defendants were shareholders of LGT. The siblings that had only SLE
shares agreed to sell their shares of SLE to Defendants at the June 1, 1972 book value. Prior to
that date, SLE, whose only asset was property, leased property to LGT. The lease expired in
1966, but Defendants, who were directors of both LGT and SLE, never entered into a new lease
nor increased the rent. During that time, property taxes increased from $7,800 to $11,000 per
year while rent stayed at $14,400 per year. Defendants testified that they did not seriously think
of SLE as a separate entity, but instead treated it as a shell for LGT. When the agreement for
the siblings to sell Defendants the remaining shares of SLE came due, Plaintiff brought this
action of waste by Defendant directors for allowing LGT to pay a low rent. Defendants
countered to for the specific performance of Plaintiff
to sell his shares, arguing that LGT paid a fair amount for property in that location.
Issue : The issue is whether Defendants have the burden to prove that there was no waste in
the transaction wherein there was a conflict of interest.

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Holding : Burden of proof on the directors.

In order to show the fairness: what would a market based transaction at that time had been. At
least in this, a showing of fairness that would depend on at that time marketplace.
Law & economic approach: it was not a market transaction approach, it was agreed between
the SH.
Requiring SLE to rent the land to a third party would have put LSG operating a tire dealership
out (LSG needed a place to operate its business).
Even the expert of the defendants said that the rent was too low.
Fairness on how to assess that it is a business opportunity (bikini stores buy coats from one of
the directors factory because the deal is very attractive).
In each case, outcome may differ.
Entire fairness definition : fair dealing and fair price
Fair Dealing:
when the transaction was timed
how it was initiated, structured, negotiated, disclosed to the directors
how the approvals of the directors and the stockholders were obtained
Fair Price:
relates to the economic and financial considerations of the proposed merger
all relevant factors: assets, market value, earnings, future prospects, and any other
elements that affect the intrinsic or inherent value of a company's stock....
Entire Fairness Delaware statements
Disclosure (even if fair)
The courts seem to be applying the fairness notion in a way that protects minority SH.
Is it the right the right approach when no creditors are harmed?
Talbot v. James (Iowa Courts)
Talbot sued James as an officer and director of the corporation for violation of his fiduciary
relationship to the corporation and the appellants as SH.
Lula Talbot owned a tract of land, from her husband. James proposed to use the land to build an
apartment complex. The parties agreed to form a corporation to construct and operate an
apartment complex: the Talbot received half of the stocks for their transfer of the land and
James the other half in consideration of his efforts.
James obtained the services of an architectural firm, obtained commitments for a mortgage.
The corporation was formed, a charter issued. James was elected president and the Talbots
were elected as directors.
At a meeting a resolution was adopted Lula Talbot transferred the land to Chicora Apts in
exchange of 10 shares (valued 44.000$) and James received 10 shares for the same value for
the commitment of FHA to insure a mortgage loan of 850.700$, certain contracts and
agreements which James had worked out and developed in connection with the architectural
and construction services and the use of finances and credit of James in order to make it
proceed with the project.
James Construction whose sole proprietor is James entered into a construction contract with
Chicora Apts: actual cost of the construction plus a fee of 20,000 $, without disclaiming to the
disinterested officers and directors.
The loan was obtained and the complex was constructed.

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The Talbots asked James to review the corporate records and were denied. An order was
obtained. The record showed that James personally received 25.025,31 from the proceeds of
the mortgage loan.
Whether James could enter into contract with Chicora Apts as a SH, officer and director?
The officers and directors stand in a fiduciary relationship to the individual SH and must make a
full disclosure of all relevant facts when entering into a contract with said corporation.
The Talbot did not know that James was the constructor.
Even he would have disclosed to be he constructor, he has not disclosed his entitlement to a fee
of 25.000$ and an allowance for overhead expenses of 31.589$. he did not disclose the profits
that he was receive under the terms of the contract.
In the minutes nothing is said about James being the constructor. Talbots wife wrote the
minutes.
It is inferable from the facts that James did not want the directors to discover how the funds of
the corporation has been disbursed and he received benefit.
It is true that he was allowed to sign a construction contract but he had to disclose the identity of
the constructor.
James as a director of Chicora Apts entered into contract with himself as sole proprietor of the
construction company without full disclosure of his identity and interests t the other officers and
SH.
The record revealed that the only service James rendered in connection with the construction
was supervisory. He was compensated for this service when he received half of the shares. He
was not entitled to any other compensation.
Dissent: The apartment complex was completed with the help of a resident manager, selected
by Talbot but approved by James, took charge of the management and operation of the
complex. All receipts being deposited by Talbot and all checks being written by Talbot. After
Talbot and his manager had been in charge, the corporation was virtually insolvent. James did
not agree and took charge of the operation and after a year the complex did well. Talbot
asserted a claim only after he was ousted from the management. He knew that a check of
15000$ had been drawn on the construction account for the benefit of James but waited to sue
James. The resolution of the board showed that the ten shares represented a value of 44000$
for James to cover his efforts during a two years period and the use of his credit throughout the
construction. The general supervision duties of a corporation president or a pre-incorporation is
one thing but a general contractor is another. There is uncontradicted evidence, that James
acted as a general constructor far above from the resolution or the pre-incorporation agreement.
Talbot admit that he did not know of any loss suffered by the Talbots or the corporation as a
general result of the general contract with James and even conceded that another contractor
would have cost more.
James should be allowed to retain an actual overhead.

Can you argue the deal was substantively fair?

Talbot would have to pay more if hiring another constructor, did not have to pay up front, and he
made the business work well
What would disclosure have done?
The question is to what extent does the disclosure need to be: only there is a conflict of interest
or more information. What would have happened if there has been disclosure? Nothing.
Fairness v. disclosure: which is the better rule and why?
In a lot of situation fairness of price is going to be a range in other situation it would not be clear
what the transaction is but there is a full disclosure, there is the possibility of private ordering
where both parties have the same et of information and engage into a negotiation to determine

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what they accept within the range of fairness value. The courts do not know to promote a
disadvantage a non-balanced information between the parties.
In Delaware: full disclosure
In Iowa: disclosure of the self interest conflict only
Note on the duty of loyalty
In the corporate context, fairness requires not only that the terms of the self interested
transaction be fair but that entering into a transaction is n the corporations interest.
Fill buildings: had leased premises to Wayne National Life insurance and sued for past-due
rent. The lease was a self-interested transaction because Fill was the principal SH and a
director of Wayne and the sole SH of Fill. Waynes corporate successor sought to avoid liability
under the lease on the ground that the lease was unfair. The burden to establish the fairness is
on the director and requires not only a showing of fair price but also a showing of the fairness of
the bargain to the interests of the corporation.
Here the price was fair but the corporation was in trouble and was warned against overexpansion, yet they entered into a long term lease at a time when the future of the corporation
was in question.
Note on associates of directors and senior executives
What if a corporation deals with an enterprise or individual with whom director or senior
executive has a significant relationship? The same rules should be applied put the problem is
remedy.
More scrutiny than regular transactions.
Sect 2. Statutory approaches
Relevant statutes
Cal. Corp. Code 310
DCGL 144
RMBCA 8.60-8.63 SUBCHAPTER F
NY Bus. Corp. Law 713
Cookies Food Products v. Lakes Warehouse
Derivative suit brought by a minority SH of a closely held corporation against the majority SH
Duane Speed Herrig and 2 of his family-owned corporations Lakes and Speed.
Plaintiffs alleged that that Herrig, by acquiring control of Cookies and executing self-dealing
contracts, breached his fiduciary duty to the company and fraudulently misappropriated and
converted corporate funds.
Cook founded Cookies to produce and distribute his original barbeque sauce. He persuaded 35
members of Wall Lake Iowa including Herrig and the Plaintiffs to purchase Cookies stock.
The business went down. Herrig held only 200 shares and was the owner of an auto parts
business, Speed Automotive and Lakes Warehouse distributing, a company that distributed
auto parts from Speeds.
Cookies board of directors approached Herrig with the idea of distributing the companys
products. It authorized Herrig to purchase Cookies sauce for 20% under wholesale price which
he could the resell at full wholesale price. Herrig began to market and distribute the sauce to his
auto pats customers and to grocery outlets from Lakes trucks.
Cookies formalized an exclusive distribution agreement with Lakes. Cookies was responsible for
preparing the product. Lake assumed all costs of warehousing, marketing, sales, delivery,

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promotion and advertising. Cookies retained the right to fix the price the sales price of its
product and agreed to pay Lakes 30% the gross sales for these services.
By 1985, annual sales reached 2.400.000$.
As sales increased, Cookies board of directors amended and extended the original distribution
agreement to give Lakes an additional 2% of gross sales to cover freight costs, then to allow
Herrig to make long-term advertising commitments. The board also amended the agreement
that year to allow Cookies to cancel the agreement with Lakes if Herrig died or disposed of the
corporations stock;
Cook decided to sell his shares. Herrig became the majority SH. He replaced 4 of the 5
members of the Cookies board with members he selected.
First, under Herrigs leadership, Cookies board extended the term of the exclusive
distributorship agreement with Lakes and expanded the scope of its service., increased to
compensate Lakes at the going rate for use of its nearby storage facilities.
Second, Herrig took an additional role in product development on top of his director and
distributor role and developed the recipe of a taco sauce less expensive to produce. Herrig
began to receive a royalty fee for his taco sauce recipe (3% of the gross sales of the barbeque
sauce and a flat rate per case).
Third, the board approved an additional compensation for Herrig of 1000$ a month as a
consultant fee and then increased the compensation. The exclusive distribution agreement was
again amended with an a-increase of 2% of the gross sales.
SH were not happy because the corporation was a closely held corporation (SH have no access
to buyers for their stock at current values that reflect the companys success) and no dividends
were distributed. The corporation had to repay a loan before declaring dividends.
The SH claimed that Herrig has breached his fiduciary duties to the corporation and the SH
because he fully negotiated for these arrangements without fully disclosing the benefit he would
gain. The sums pay to Herrig and his companies have grossly exceeded the value of the
services rendered.
fiduciary duties: Herrig as an office and director of Cookies owes a fiduciary duty to the
company and its SH. Must serve in a manner believed in good faith to be in best interest of
corporation. Herrig owes a fiduciary duty only once he became a majority SH. The duty derives
from the prohibition against self-dealing that inheres in the fiduciary relationship. One may not
secure for oneself a business opportunity that in fairness belongs to the corporation. Proper
circumstances transact business strictest good faith with full disclosure of the facts and to
the consent of all concerned.
3 sets of circumstances:
the fact of such relationship or interest is disclosed or known to the BD which authorizes or
ratifies the contract without counting the vote of the interested director.
the fact of such relationship or interest is disclosed or known to the BD entitled to vote and they
authorize such contract or transaction by vote or written consent.
The contractor transaction is fair and reasonable to the corporation.
The court added another requirement fro the directors to show good faith, honesty and fairness
in self-dealing.
burden of proof: on Herrig

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standard of law: Corporate profitability should no be the sole criteria. Fair price and fairness of
the bargain to the interests of the corporation. The court requires disclosure just of the
conflict of interest (in agency it requires disclosure of all the facts). Fairness requires disclosure.
1. Who is going to bare the risk of the self-dealing transaction? Directors can ask questions
but they may not know what to ask. Duty of care of the directors.
2. deniable of equitable relief: all members of the board were well aware of Herrigs dual
ownership in Lakes and Speed.
Dissent: The court should have looked at whether these matters of self-dealing were fair to the
SH. Herrig failed on his burden of proof by what he did not show (local going rate for distribution
contract, storage fee, fair market value of his services). The evidence shows that the fair
market value of his services is considerably less than what Herrig actually has been paid
(110.865 v. 730.637).
Different types of rules when at discussion is a real estate value or human value (manager
value)?
Note on the effect of approval of self-interested transactions by disinterested directors.
The transaction should nevertheless be subject to some review for substantive fairness: by
virtue of their personal relationships, directors are unlikely to treat each other with the degree of
wariness they would apply to third parties. Review of the fairness of the process by which the
transaction was approved(objective and impartial).
Must of the statutes do not preclude such an inquiry when the transaction has been approved
by disinterested directors.
Approval by disinterested directors will not prevent courts from reviewing self- interested
transactions for obvious unfairness.
Intermediate test between judgment rule and a full-fairness test.

Whats the standard the court applies?

How does the court assess fairness?
What degree of disclosure does the court require?

Delaware 144(a): self dealing self harbor

No self-dealing transaction (defined in 144(a)) shall be void or voidable
solely for this reason, or
solely because the director or officer is present at or participates in the meeting
of the board or committee which authorizes the transaction or
solely because the director/officers vote is counted for such purpose

IF
1) material facts as to relationship or interest and as to transaction are dislcosed or are
known to the board or committee and the board or committee in good faith authorizes
the contract or transaction by the affirmative votes of a majority of the disinterested
directors, even though the disinterested directors be less than a quorum; or
2) the material facts as to the directors or officers relationship or interest and as to the
contract or transaction are disclosed or are known to the stockholders entitled to vote
thereon, and the contract or transaction is specifically approved in good faith by vote of
the stockholders; or
3) the contract or transaction is fair as to the corporation as of the time it is authorized,

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approved or ratified, by the board of directors, a committee thereof, or the

What constitutes adequate disclosure?
What has to be disclosed is all of the relevant facts: full disclosure
Fair
Decision made in good faith

How do you define disinterest?

When is a board member disinterested?
When is a board member independent?

When is the board not neutral?

Board not neutral if:
1) a majority of the board is interested;
2) a majority of the board is affected by another directors or controlling
shareholders self-interest;
3) a majority of the board is dominated by an interested director or controlling
shareholder; or
4) an interested director manipulates the decision-making process by failing to
disclose material information to an otherwise disinterested majority of the board.
Common or interested directors may be counted in determining the presence of a
quorum at a meeting of the board of directors or of a committee which authorizes the
contract or transaction

Key issues:
1) disclosure
2) disinterest
3) effect of disjunctive phrasing of statute in judicial review. How much judicial is there?
Sutherland v. Sutherland (Delaware courts)
What is the extent of private ordering on self-dealing transactions?
Derivative suit and double derivative complaint filed by a 25% SH of a closely held corporation
with the support of her brother also 25% SH.
Dardanelle is a closely held family owned corporation operating retail lumber yards and stores.
Sutherland Inc (Souhtwest) is a wholly owned subsidiary of Dardanelle.
Martha is a SH of Dardanelle, trustee and beneficiary of a trust by which she is the beneficial
owner of 17% of Dardanelle common stock. Her children are the beneficiaries of other trusts
that own approximately 8% of the common stock of Dardanelle.
Perry is the brother of Martha. Perry and his children own 25% of the common stock of
Dardanelle and controls a trust which owns all of the voting preferred stock of Dardanelle.
Todd is the twin brother of Perry. No equity interests in either corporation.
Mark is the cousin of the Sutherland siblings.
BD of Dardanelle and Southwest: Perry, Todd and Mark
Perry: President and CEO of both companies
Todd: officer on both companies
Dwight Sr. gave 25% of Dardanelles common stock to each of his children: Martha, Dwight Jr,
Perry and Todd.

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After Dwights death, the shares of preferred stock were transferred to a trust for the wifes
benefit.
Perry and Todd have nevertheless voting control over Dardanelle and Southwest because Perry
is the trustee for Normas trust and Todd has allied himself with Perry.
Todd and Perry control the board of both companies.
Martha was a director of Souhtwest. Dardanelle the sole SH of Souhtwest called for an annual
meeting for Southwest at which the number of directors was reduced to 3.
Martha filed a suit for breach of fiduciary duty on behalf of Dardanelle; waste and breach of
fiduciary duty on behalf of Southwest.
Todd and Perry have used the companies corporate funds and assets for personal benefit: pay
for personal flights, personal tax and accounting services provided by Dardanelles affiliate, use
for personal vacations of a facility, club memberships, expensive hotels as well as the
decision to buy a new corporate aircraft and maintain continuing ownership whereas that aircraft
serves no legitimate business purpose. Todd and Perry approved their own employment
agreements. Spent 750000$ to defend against Marthas section220 action, and improperly
amended bylaw to include a limitation of liability.
What is the limit of private ordering ?
Disinterest and independence
In Delaware disinterest: the court focus on financial and familiar interests
Independence: something to do even if the director does not have is there any evidence that
this decision is controlled by another part, the director is basically a tool of the interested
person. Are these directors in a position to freely exercise their duty of care? What is the test
to use? When is the board not neutral?
Oracle Derivative Litigation
Oracle shareholders brought a derivative suit claiming company insiders knew
December 2001 earnings would fall short of expectations, so they sold their stock insider
trading.
The Oracle board constituted a special litigation committee composed of two eminent
Stanford professors. The SLC said the suit should be dismissed.
Legal standard
The SLC must convince me that
(1) Its members were independent
(2) They acted in good faith
(3) They had reasonable bases for their recommendations
If the SLC meets this burden, I can grant its motion or in my judicial business judgment allow
the suit to proceed.
To cleanse: purger
DGCL 144(a)
(a) No contract or transaction between a corporation and 1 or more of its directors or
officers, or between a corporation and any other corporation, partnership, association, or
other organization in which 1 or more of its directors or officers, are directors or officers, or
have a financial interest, shall be void or voidable solely for this reason, or solely because
the director or officer is present at or participates in the meeting of the board or committee
which authorizes the contract or transaction, or solely because any such director's or
officer's votes are counted for such purpose, if:
(1) The material facts as to the director's or officer's relationship or interest and as to the
contract or transaction are disclosed or are known to the board of directors or the
committee, and the board or committee in good faith authorizes the contract or transaction

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by the affirmative votes of a majority of the disinterested directors, even though the
disinterested directors be less than a quorum; or
(2) The material facts as to the director's or officer's relationship or interest and as to the
contract or transaction are disclosed or are known to the shareholders entitled to vote
thereon, and the contract or transaction is specifically approved in good faith by vote of the
shareholders; or
(3) The contract or transaction is fair as to the corporation as of the time it is authorized,
approved or ratified, by the board of directors, a committee or the shareholders.
(b) Common or interested directors may be counted in determining the presence of a
quorum at a meeting of the board of directors or of a committee which authorizes the
contract or transaction.
Elements:
- No contract or transaction
- Between one or more of directors or officers,
- Self interested, self-dealing transactions are not prohibited simply because of the conflict of
interest but they are voidable
- Voidability will be eliminating when majority fully informed SH or directors or fairness
144(a) when 144(a) does not apply then the regular common law of duty of loyalty applies. It
does not make such a difference because under common law they seem to track the provisions
as set forth in 144(a).
144(a)(1): fully informed vote by disinterested directors, full disclosure
Ex: BD with 20 members only one disinterested: it is OK as long as he approves under 144(a)
(1)
Questions:
So where is the independence business coming from?
Delaware courts have defined independence to mean that a director's decision is based on
the corporate merits of the subject before the board rather than extraneous considerations
or influences. Aronson v. Lewis
Said to be a highly fact-dependent inquiry
SH SUITS
What is SH derivative action?
Demand excusal actions: Before bringing a derivative action, the sh has to make
demand on the board to assert the claims on behalf of the corporation (or to show why
demand would be futile.)
Is the decision of the board of directors based on the merits of the transaction applying their
own business judgment rather than extraneous considerations and influences?
Are there patterns the courts follow when applying to the facts, how the court makes the fact
decision?
What the template seems to be developing at?
SH derivative action: SH is representing the interest of the corporation, he is steeping into the
shoes of the corporation.
This is happening when SH thinks that the BD does not do what they should.
SH given the opportunity to assert the claim on behalf of the corporation
The SH has to ask the BD to assert the claim but sometimes because all the members of the
BD are interested, it would be futile

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The SH goes to the board and ask the board to bring the action. It is a matter of business
judgment when the board is not interested. There is no reason to second guess their decision
not to bring the suit but sometimes a minority of the board is conflicted somehow, the board will
create a special litigation committee (Ebay) The BD will delegate the task to decide whether to
bring the suit to the special committee.
The plaintiff has the burden of proof to show the independence, but if there is a special
committee the committee has the burden of proof.
Whether or not the developments apply only to only special litigation context, which bare the
burden of showing its own independence or can we broadly make a claim?
Special committee can be appointed in merger context (Zappata v. Meldanado): 2 steps
analysis to evaluate t: independence and good faith of the members and allows the court itself
to use its own business judgment to decide whether the suit should be continued or terminated.

In Delaware, directors are independent even if they receive substantial fees, are friends
of the CEO, serve on the board of non-profits that receive substantial contributions from
the company (or its foundation), and if they are in the same economic strata as Bill
Gates.

What if the directors get a lot of fees? No even if large fees. If he is getting a material income
stream from a company that will make them less dependent. The court looks at the fees other
corporations are paying for the same transaction. The court does not look subjectively on
whether the material income is abnormal regarding the specific person.
Should we think of independence as reliability or something else?
No other personal ties to the company except the fees the company is paying the director. You
will be more or less reliable to the BD to keep your seat and your fees. Delaware courts assume
the way of the mere impact of directors fees. Bill Gates defense. All of these directors are rich
so the fees are not that relevant. (Beam Martha Stewart: 60000$)
Examples of how DGCL deals with various independence-challenging matters
Fees dont per se compromise independence
courts recognize that material income stream can undermine
independence
But if fees, for example, are within usual and customary range, then no
impact on independence even if they are subjectively material to the
director and despite dependence on CEO
Ralph Brown (Race to the Bottom) mentions the Bill Gates defense: rich
directors are always independent!
Business relationships only if material
What if the directors have business relationship with the corporation: only if material.
What about personal relationship: this shows a contract (between Oracle special litigation
case v.) Delaware want to believe that the directors act is influenced by personal
relationship. Eisner was considered disinterested. The court does not want to consider what
is personal business.
Personal relationships: Oracle vs. Beam approaches
What about personal relationship: this shows a contract (between Oracle special litigation case
v.) Delaware want to believe that the directors act is influenced by personal relationship. Eisner
was considered disinterested. The court does not want to consider what is personal business.

Charities (see Goldman Sachs)

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What about corporations gives donations to companies. It seems to be fine under Goldman
Sachs approach.
No reasonable doubts shown re: independence despite the following:
Goldman director served as Chairman/CEO of ArcelorMittal, to which Goldman
provided financing
Goldman invested at least $670 million in funds managed by another director
Goldman made significant contributions to non-profits where 4 Goldman directors
had significant contacts
Goldman gave $200,000 to a university where one of the directors served as
President.
Arent these folks likely to be reliable supporters of management?
Reliable supporters of management
Even if a board member is otherwise independent, should the fact that s/he is likely to be a
reliable supporter of management be enough to undermine independence for safe harbor
purposes? Demand excusal contexts?
More searching if transaction is with controller (see Americas Mining)
When there is a controlling SH/Director, Delaware Courts are not nearly deferential.
See, e.g., Ebay: 1) defendant directors owned enough stock to control the corporation and the
election of directors, including the non-defendant directors on the SLC; 2) non-defendant
directors owned options worth millions that had not vested and would not vest unless they
continued to serve as directors of eBay.

Strine in the oracle Strine looks carefully at the independence of the SLC not only in
terms of economic interest, but more functionally.
You can distinct the cases: one is about burden of proof.
In Disney, the personal relationship does not count (Disney and Martha Stewart) even if
donations.
Causation is hard to show in this kind of context.
The SC distinguishes Oracle (special committee) has the burden of proof
What about charity and the relationship the court looks at (Goldman). Should reliable support
undermine independance. Different kinds of context.
Different approach in the federal context (SOX, SEC) and Delaware (must more fact analysis),
which one is better?
Martha Stewart
MS Living Omnimedia
Supreme Court distinguishes Oracle:
Unlike the demand-excusal context, where the board is presumed to be independent, the SLC
has the burden of establishing its own independence by a yardstick that must be like Caesars
wife -- above reproach.
-- Allegations that Martha Stewart and the other directors moved in the same social circles,
attended the same weddings, developed business relationships before joining the board, and
described each other as friends even when coupled with Stewarts 94% voting power, are
insufficient without more, to rebut the presumption of independence.
Americas Mining v. Theriault
SLC: Special Litigation Committee
Derivative SH suit against Americans mining subsidiary of Southern Perou
Classic 144 self dealing transaction
Copper company

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Delaware court approves what the chancery court does.

Attorneys fees award: 350 millions dollars
Bainbridge welcome matt to the attorneys is now a red carpet. Bainbridge is more directors
oriented thinking they should be let alone to do their work because of their expertise they are
less harmful than SH.
What was wrong with the process of the special committee they did not see the possibility not to
make the deal, they has a control mind set because they thought of making the deal only.
The court will look stringently at the independence of its processes whether it was well
functioning if it can go away from the deal. Why did the court second guess the process? Was it
really to be noticed is that the price was bad. Because the price was so bad the process had to
be controlled because otherwise the result is inexplicable. May be it is only a footnote case but
it can be like oracle that if there is something smelly in the substance of the deal, the courts are
not going to defer. Is that a real rule of law or is it a Hamlet theory (does something smell for an
independence assessment?)
We do not know how important it is going to be.
The court was very sensitive to the price but it is not going to happen every other day
How to read this case broader: It is true that when there is a special committee that seems to be
independent, the court will review with a business judgment rule. Here, it looks good but the
court did not buy that the process did function worked the way it was supposed to, there is no
other thing than the weird price. The group had a controlled mind set.
When entire fairness, burden shift: transaction approved by a well functioning independent BD
or approval vote of fully informed SH.
Here the board did only looked at making the deal.
Del. Sup. Ct. affirms $2 billion + judgment and $300 million + in legal fees for plaintiffs
counsel.
Bainbridge: the welcome mat for plaintiffs lawyers in Delaware is now a red
carpet.
Controlled mindset
When the court will assess independence of the board by looking behind the curtail?
Assessment of the independent board notion
2 ways to challenge the independent board idea:
- Bainbridge: all that is give you is increasing tension, Need of expertise not necessarily
independence.
Focus is put on the wrong structural argument
-

There is no definition of independence in Delaware court

Delaware 144(a)
The term Independence is nowhere in 144(a)(1) only talk about interest.
The 144(a) claim will be in a derivative suit, refers to Lewis case, that talks about
independence.
Second way to get non-voidability is by bringing to SH disinterested vote: full disclosure like
under 114(a)(1). Talbot v. James sort of disclosure not Cookies. (a)(1) is more convenient than
(a)(2) because it is less expensive and easier to speak to other members of BD than to SH.
Litigation focus a lot more about what the SH knew rather than the legitimacy of their votes. If
you have a controlling SH the controller can manipulate the process, so whether their votes
were sufficiently clean.
144(a)(1) the litigation is about disclosure but also independence. We need a majority of
disinterested directors. And look heavily at the independence of the directors, in SLC the burden
is on directors.

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Are the courts precluded from judicial review of the decision once a majority of SH fully informed
has voted for the transaction? If you read 1, 2, 3 disjunctively.
144(a)(3): fairness analysis
Standard of review if disinterested sh or dir approval?
Waste
Lewis v. Vogelstein (p. 753)
Possible approaches:
No review: voting extinguishes claim
Minimal review: waste standard; smell test
Ordinary review: business judgment review
Process review: substantive fairness of the process (disclosure and voting)
Stringent review: entire fairness, with burden on defendants to justify self-dealing
transaction.
Burden shift: entire fairness review, but with burden on plaintiff to prove unfairness
Burden reduction: defendants burden, but lower
Delaware law muddy
Various of the above appear in Del. jurisprudence
Entire fairness review used in Delaware when director is also controlling shareholder
Cases say fairness review is not precluded even if safe harbors are met
But review appears to be less stringent if 144(a)(1) and (2) have been satisfied
Transactions involving controlling shareholder
Entire fairness standard
Why?
Lewis v. Volgenstein: What is the standard of review of self-dealing transaction when they have
been approved under (1), (2) or (3)?
Strine: no substantive review so long as fully informed economic SH vote for it, courts should
not involve into self-economic determination.
But some favor a judicial review when the case smells: disclosure, manipulation of the process,
is there a waste here, is there something irrational? Burden reduction.
In Delaware, when director is also controlling SH, entire fairness comes in. worry that the
controlling SH will influence the vote of other SH
Degree of stringency of the review does seem to vary.
IF the disinterestness of the directors is proved and if it a SLC or demandal excuse action then it
is a 99% case of the case, that the judicial review is relatively deferential looks like business
judgment review.
144(a)(2): the court might just use a waste analysis but will do heavy inquiry disclosure. What it
was that the SH were told. The SH have to be fully informed.
Once you have a controlling SH in the mix, the court is extremely is concerned of the
manipulative coercive effect on the SH who can appoint directors who are their puppets and
mess with the proxy process. The standard of review is going to be entire fairness. The most
that the self-dealing SH can get is the burden shift is there is a showing of disinterest and
independence.

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You can be deemed to be a controlling SH even if you have less 51% of the shares (de jure
control) in large publicly held corporation far far less than 51% is necessary of having a de facto
control. It can be significantly less can indicate that there is a controller in the mix. It can be 7%
depends on the facts.
EXAM

Whats so worrisome about freeze-out transactions with controlling

shareholders?
In freeze out transactions, there is a stringent standard of judicial review because of the
risk of coercion.
The level of review of you have a SLC case ends up being much more extensive with
regard to independence as opposed to 144(a)(1) that has less stringent review.
The existence of SLC flips the burden of proof.

310 - California
310: statutory variation in self harbor (California): disclosure + approval of disinterested SH
majority approval of directors + just and reasonable : this is not business judgment rule, it
looks more like fairness
More opening for judicial review
Possibility of corrupted decision making
ILI does not give up some kind of fairness review.
There is got to be some kind of fairness review but not necessarily very stringent review
if disinterested vote of majority of directors. Plaintiff still has the burden showing that the
transaction was inadequate or unfair or the directors were independent.
RMBCA deals with them in a much more bright line kind of approach.
The way it is divided to separate out a very specifically set of directors conflict of interest
in transactions (subchapter f): particularly defines are dealt with subchapter f.
Attempt to codify self-interest transactions. Judicial review is removed when sanitization
of the direction by director or SH approval. (8.6.2 and 8.6.3.). Subchapter f is very
controversial because it cuts judicial review.
State and federal law approaches on independence.
Effect of SOX on state fiduciary duties.
The attitude of the CEO about transparency, diversity will have a real influence on how the
board and management operate. CEO is the locus of real governance today.
SOX has chosen to place direct obligations on officers. Prohibits the corporation to grant loans
to officers. Preemption of state law but state law allows as long as they satisfy 141(a) and (2)
but not for publicly held corporations.
Certification requirements
Federal congress has got his foot in the door in fiduciary land.
State law is going to become dialogic with federal law. You always have to keep in mind the
existence of federal law.

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COMPENSATION
Elements of compensation
Short term components: Salary, bonus, other annual compensation
- Annual salary is fixed in advance nd generally does not have an incentive component
associated with it. Exception: future increase determined by current firm performance
- Annual bonuses are typically tied to measures of firm oerformance, often based on
accounting information.
It provides the executive with a minimum level of income prior to any performance
standards or targets being met.
Long term components: restricted stocks and stock options (equity compensation)
- Severance pay and other benefits (e.g. pensions) via contract
Perks: corporate jets, corp. programs matching personal charitable contributions
Executive compensation controversy
Populist argument re: Income inequality
Economic argument re: whether shareholders are getting their moneys worth

Stock options:

Tyson Foods Inc

Tyson adopted a stock incentive plan granting the board the permission to award class A
shares, stock options or other incentives to employees, officers and director of the company.
Tyson gave the power to compensation committee and compensation sub committee complete
discretion to enforce the plan, but instructed that they were to consult with and receive
recommendations from Tysons Chairman and CEO. The committee granted stock options to
key Tyson directors and executives.
Plaintiffs alleged that at all relevant times the Plan required that the price of the option be no
lower than the fair market value of the companys stock on the day of the grant.
Plaintiffs allege that compensation committee spring-loaded the options (granted the options to
executives before the release of material reasonably expected to drive the shares higher)in 4
instances:
- announcement of the acquisition of Tysons Pork Group by Smithfield Foods. The shares
jumped after the announcement from 15$ to 17,50$.
- Announcement of cancellation of the acquisition of IBP, shares jumped from 11,50 to
13,47
- Announcement of doubling the fourth-quarter earnings more than expected :
- Announcement that the earnings were to exceed Wall Street expectations: from 13,33 to
14,25.
Issue: Whether a director acts in bad faith by authorizing options with a market value strike
price as he is required to do so by a SH-approved incentive option plan, at a time when he
knows those shares are actually worth more than the exercise price?
Analysis: sole authority to grant option rested in the Compensation committee. A committee of
independent directors enjoys the presumption that its actions are prima facie protected by the
business judgment rule.
To overcome the presumption where a director is independent and disinterested, it must be
demonstrated that no person could possibly authorize such a transaction if he or she were
attempting in good faith to meet their duty.

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A director who intentionally uses inside knowledge not available to SH in order to enrich
employees while avoiding SH-imposed requirements cannot be said to be acting loyally in good
faith as a fiduciary.
1. the plaIntiff must allege that options were issued according to a SH approved employee
compensation plan.
2. The plaintiff must allege that (a) the director that approved the spring-loaded or bulletdodging options (grant stocks to employee after the bad news announcement)
possessed material non public information soon to be released that would impact the
companys share price and (b) issued the options with the intent to circumvent otherwise
valid SH-approved restrictions upon the exercise price of the option.
Plaintiff have alleged that the compensation committee violated a fiduciary duty by acting
disloyally and in bad faith with regard to the grant of options.
Tyson II
The complaint alleged that the stock options were to be issued at no less than a fair market
price on the date of the grant but the proxy materials made a distinction between incentive
stock options with a fair value market price restriction and non qualified options that may be
exercisable at any price.
Defendants allege that the challenged stock options were non qualified options.
Issue: Whether the grants were of incentive or of non qualified options?
Tysons publicly-filed statements and the SH approved plan contradict the allegation that the
plan required the price to be no lower than the fair market value of the companys stock on the
day of the grant.
Why is the compensation discussion in the duty of loyalty section of the book?
Compensation set by the board for:
1) Management (CEO et al) compensation
2) Directors
Ryan v. Gifford
Backdating : company issuing stock options to an executive on one date while providing
fraudulent documentation asserting the options were issued earlier.
Facts : Plaintiff Ryan filed a derivative suit against D for breach of duties of care and loyalty by
approving/accepting backdated options that violated the shareholder-approved stock option
plan.
-Technology company board granted stock options for purchase of shares of common stock to
D.
-Maxim contracted and represented that that exercise price of options would be no less than fair
market value of companies common stock on the date of the grant,
-P is a shareholder, alleges that 9 grants were backdated (all on the lowest trading days of the
years in question). The timing was too fortuitous to be mere coincidence.
Analysis : The complaint alleges bad faith and breach of fiduciary duty and therefore rebutt the
BJR. Such a breach may be shown when the boards acts intentionally in bad faith or for
personal gain.

BUSINESS JUDGMENT RULE

The business judgment rule is a presumption that in making a business decision

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the directors of a corporation acted on an informed basis, in good faith and in

the honest belief that the action taken was the best interest of the company.
Show board breached either FIDUCIARY DUTY OF DUE CARE or its FIDUCIARY
DUTY OF LOYALTY in connection with a challenged transaction (may rebut
business judgment rule).
-Acts taken in bad faith breach the duty of loyalty.
Bad faith may be shown where:
1. the fiduciary acts with the intent to violate applicable positive law.
2. the fiduciary intentionally fails to act in the face of a known duty to act,
demonstrating a conscious disregard for his duties.
3. Any action that demonstrates a faithlessness or lack of true devotion to the
interests of the corporation and its shareholders.
What does executive compensation has to do with fiduciary duty. Most classic kind of self
interested transaction; they vote on their own pay.
You would think that the standard of review is entire fairness, it is not even business judgment
rule it is only waste standard.
How come the review is waste? People disclose how much they are being paid, at the same
time that it is a self interested transaction, it is an ordinary decision.
A lot of the compensation packages for executives is not just cash it is a combination of cash
and stock options.
Standard of review
Delaware: Waste: very deferential standard
Recent cases: Deference to boards even for severance packages for general releases and past
service
Public vs. closely held corporations
In closely held corporations. The smaller group is the SH the less disinterested they are. The
compensation is likely to involve a very significant fraction of the corporations earnings
Courts are particular interested to protect the SH. There is also taxation reason for paying in
compensation rather than dividends. The courts are afraid that compensation is issued in
disfavor to the SH.

New developments
Increase in performance-based pay and compensation schemes tying compensation to
performance. It depends on a lot of elements such as the type of

industry

But note: Designing appropriate compensation scheme is a complex issue

Different views on proper way to measure pay/perfomance connection;
differences in peer groups chosen for benchmarking purposes
the challenge for compensation committees is to improve
compensation program design with the goal of being able to convincingly
demonstrate that executive pay correlates with management success at
achieving long-term strategic and operational corporate objectives.
Increasing complexity of executive pay discussion in proxy statements
New factors affecting: proxy advisory services and new compensation-related regulation
(particularly requiring disclosures)

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Federal regulatory developments

Enhanced SEC compensation disclosure rules
SOX clawback provisions
Dodd-Frank provisions
Say-on-pay votes
Provisions pending SEC rulemaking

Say-on-pay
Movement pushed by academics like Lucien Bebchuk
Dodd-Frank Wall Street Reform and Consumer Protection Act (2010): requires U.S.
public companies to provide shareowners with a non-binding vote to approve the
compensation of senior executives.
SEC implementing rule, adopted on Jan. 25, 2011, requires say-on-pay votes to
approve the compensation of the named executive officers (NEO) at larger
companies at least once every three years. The SEC granted smaller companies
a two-year exemption.

New litigation approaches include

Suits for breach of fiduciary duty
14(a)(9) proxy non-disclosure suits grounded on say-on-pay
Say on pay controversial
Bainbridge
Ineffective at best, reduces share value at worst
Invites 14(a)(9) suits with potentially expansive disclosure requirements
Increases power of proxy advisory outfits
Increases blackmail for settlements
Bebchuk
Minimum way of policing board tendencies to give ridiculous handouts to their executive
suite friends
Giving shareholders voice in business decisions where board always faces conflicts of
interest

What are likely impacts of negative say-on-pay votes?

Negative press for company, damaging its image
Distraction to board and management
Signal to top managers that compensation opportunities will be limited, so they
might look elsewhere
May affect pay of all of the top management team

What is impact of SOP on board behavior?

Depends:
See Oracle (no vote re: $78 million Ellison compensation had no appreciable
effect) vs. Citigroup (Vikram Pandit exit after board decision to increase his pay
rebuked by shs) and Stanley Black & Decker (after no vote on CEO pay, board
reduced his compensation by 63%)

Impact
Engagement of board with major SH and attempts to educate them to the compensation
approach.
Attention to ISS and Glass Lewis views and recommendations

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Excessive or non aligned pay?

Some of studies is there a reduction of excessive following the say on pay vote?
One study found that SH do not care in a kind of absolute sense, whether there is a correlation
between what the managers are doing and the performance. But the moment the company
underperforms with regard to the market then it leads to CEO no vote. It is going to curve from
non excessive to non aligned. Clearly with the ratio disclosure.
Regulatory approaches to compensation
SEC compensation disclosure rules
Effects: strong support of SH for existing pay practices
SECs proposed CEO pay ratio rule
US public corporations to disclose: 1) the median of the annual total
compensation of all employees of the issuer except the CEO, 2) the annual total
compensation of the CEO; and 3) the ratio of the two figures
Stimulate greater management attention to SH and more dialogue between SH
and managers
Remaining initiatives under Dodd-Frank (see Aguilar comments)
Director compensation -- new developments
Hedge fund shareholder bonuses to directors
Sometimes in the millions of dollars
Generally criticized
E.g., Bainbridge: if its not illegal, it should be!
Dissident director compensation bylaws
Some companies have adopted bylaws designed to discourage such bonuses
As recommended by Martin Lipton et al
But, ISS recommendation of withhold vote w/r/t director election in co. that adopted such
bylaws

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USE OF CORPORATE ASSETS - CORPORATE OPPORTUNITY DOCTRINE

VIOLATION OF DUTY OF LOYALTY
Three often overlapping situations when it arises:
Use of corporate assets
Opportunities closely related to the corporations business
Noncompetition principle
Corporate opportunities
Unlike self-dealing, theres no transaction with company.
Director, officer, or controlling sh takes the opportunity unilaterally.
Would prohibition against usurping corporate opportunities be a rule for which most
parties would bargain? It is very different than self-interested transaction because here
the company does not beneficiate from any interest, it is only unilateral.
Corporate opportunities analysis:
Step 1: rule of recognition is this a corporate opportunity?
Step 2: if it is, is there a defense?
In these types of cases, the only thing that you need to do is define if it is a corporate
opportunity, which is not a simple task (Salmon case, hotel case form the beginning of the
semester). But there are several tests to figure it out.
Courts think that corporate opportunities are things that need to be negotiated by insiders and
not regulated. What the Court thinks are the archetypal business relations that should be
considered normal?
What is the rule to define Corporate Opportunity?
Corporate expectancy vs. line of business?
What happen if the Corporation rejected the opportunity?
Is Disclosure necessary?
Hawaiian International Finances, Inc. v. Pablo (P. 780)
Facts : Pablo served as the president of Hawaiian International. He has a real estate agency
license as well and advised Hawaiian International as to the availability for purchase of two
parcels of land in California. Acting on Hawaiian Internationals behalf, Pablo agreed to
purchase the land. However, Pastor also arranged to take a portion of the commissions to be
received by the sellers brokers. Pablo did not disclose the commissions to the directors of
Hawaiian International until several months after the transaction had closed.

Issue : Did Pablo breach his fiduciary duty to Hawaiian International?

Holding : Pablo breached his fiduciary duty.

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Reasoning : The acceptance of undisclosed benefits arising from a transaction involving a

corporation may amount to a breach of the fiduciary duty owed to that corporation even if the
benefits do not result in any harm to the corporation. Pablo cannot circumvent the settled law by
claiming that Hawaiian International would have been prohibited from receiving any
commissions from the sale by virtue of not being a licensed real-estate broker. A corporate
officer cannot invoke ultra vires in order to obtain a share of the profits from a transaction. Pablo
should have disclosed the commission to Hawaiian International so as to allow the corporation
to make an informed decision as to the purchase price.
Could the Company do this deal without a real estate agent? No, they dont have a license.
Would the Company had to pay a realtor to do this job ?Yes
So, why is this a Corporate opportunity?
Pablo needed to disclose the opportunity. Not because the corporation was going to get this
money, but because Pablo used a corporate asset.
If you take a secret profit, a kick-back (like in the agency cases).
Forkin v. Cole
Use corporate assets to secure a personal debt.
Cole, who controlled HPDI Corporation, mortgaged the corporations property as security for a
personal loan. Although Cole argued that the corporation suffered no material loss, the court
found that he had en- cumbered the HPDI asset.

In these 2 cases, there was no harm to the corporation, but in both cases there were profits.
Tests:
1. Interest or expectancy (Lagarde v. Aniston) very protective of the entrepreneur and not
of the Corporation. The test least used today, it is the oldest. Today in Delaware, this
case will have not come out the same way. In this case, the Court says that it was wrong
that the shareholders bought a % of the corporation when the corporation had a contract
to buy those shares.
2. Line of Business (Guth v. Loft) violating fiduciary duty. The Court used this case to
establish the key factors of corporate opportunity. It is the precedent of a corporation that
manufactured candies, sodas, syrups, etc. Loft was buying coca-cola from the coca-cola
company. Guth was furious; so he bought the patent form Pepsi and start manufacturing
their own cola soda. So it is because of Guth terminate the coca-cola agreement and
now obligate Loft to buy the soda from Guth. Is the business about making cola syrup?
About manufacturing soda? What is the line of business? The Court said Pepsi is out of
the line of business. The court came with the argument of how Pepsi came to Guth, and
it was because he was the President of Loft. Reasonable with its aspirational needs of
expansion. Another view is to ask if this is the kind of business that will not require you to
hire a new amount of people and wont distract you from your original business.

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3. Fairness test (introduced by Prof. Ballantine) a) Is the opportunity special or unique

value? B) Was the opportunity presented to the officer due to his official position? C)
Was the company actively pursuing the opportunity, and if so, had it abandoned its
effort? D) Was the offer explicitly made responsible for acquiring such opportunities for
the company? E) NOTE: This is a 7 prongs test that not a lot of courts use.
Fairness test -- Ballantine
1. Is the opportunity of special or unique value, like patents or real estate, or is it
necessary for the corporate business or expansion?
2. Was the opportunity presented to the officer due to his official position?
3. Was the company actively pursuing the opportunity and, if so, had it abandoned its
effort?
4. Was the officer explicitly made responsible for acquiring such opportunities for the
compnay?
5. Did he utilize corporate funds or facilities to obtain or develop the opportunity?
6. Did taking the opportunity place the officer in a position adverse to the corporation?
7. Did the corporation have the ability, financial or otherwise, to take advantage of the
opportunity?
4. Miller v. Miller a 2-step test. This case mixed the line of business with the fairness test.
First step: determine whether the opportunity is in corporations line of business
If yes, then second step: determine whether the fiduciary violated his duties of good faith
and fair dealing to the corporation in taking it. As to the second step, the defendant has
the burden of proof.
Minority shareholders of Miller (a family business that manage human waste) started a
derivative action against corporation. The corporation was unable to meet the
requirements of an agreement with the government. So, some of the shareholders open
a partnership to do this work for the Gov. that was obvious that the corporation was not
able to provide. The opportunity was taken under fair market price. Miller sells them
supplies, and rent them space, everything under fair market value. The court said that
taking this opportunity form the corporation is fair as long as there is no harm to the
corporation.
None of this standards are good enough for the Maine Court when they decided Northeast
Harbor Golf Club, Inc. v. Harris. They use the ALI standard.
Facts : While serving as a director of Northeast Harbor Golf Club, Harris purchased several
parcels of land adjacent to the Golf Clubs property. Harris disclosed each transaction to the Golf
Clubs board of directors, and she stated in each instance that she had no particular plans to
develop the land. The directors declined to take any formal action in response to the purchases.
When Har- ris expressed the desire to develop the land as residential subdivisions, the directors
argued that she had breached her fiduciary duty to the Golf Club by failing to notify the directors
of the opportunity to purchase the land.
Issue : What must a director do to avoid liability for the improper taking of a corporate
opportunity?
Holding : A director must at least notify the corporation of an opportunity from which the director
might profit personally at the corporations expense.

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Reasoning : Although different courts have adopted different tests for what constitutes a
corporate opportunity, the basic purpose of each test is to ensure that a director does not
pursue personal gain at the corporations expense. As set forth in the American Law Institutes
Principles of Corporate Governance, a director should disclose to the corporation any
opportunity that might set the directors personal interests at odds with the interests of the
corporation. In order to avoid liability for breaching her fiduciary duty, Harris must convince the
court that she afforded the Golf Club a meaningful opportunity to consider and reject purchasing
the parcels of land at issue.
It is a balancing test, that require:
Different levels: directors vs. executive officers
Require presentation and disclosure
Formal rejection by disinterested directors, shareholders, court
ALI Principles of Corporate Governance
5.05 Taking of Corporate Opportunities by Directors Senior Executives
(a) General Rule. A director or senior executive may not take advantage of a corporate
opportunity unless:
(1) the director or senior executive first offers the corporate opportunity to the
corporation and makes disclosure concerning the conflict of interest and the
corporate opportunity;
(2) the corporate opportunity is rejected by the corporation; and
(3) (A) the rejection of the opportunity is fair to the corporation; or
(B) the rejection is authorized in advance following such disclosure, by
disinterested directors, or, in the case of a senior executive who is not a director,
authorized in advance by a disinterested superior, in a manner that satisfies the
standards
of
the
business
judgment
rule;
or
(C) the rejection is authorized in advance or ratified following such disclosure, by
disinterested shareholders, and the rejection is not equivalent to a waste of
corporate assets.
ALI Principles of Corporate Governance
(b) Definition of a Corporate Opportunity. For purposes of this Section, a corporate
opportunity means:
(1) any opportunity to engage in a business activity of which a director or senior executive
becomes aware, either:
(A) in connection with the performance of functions as a director or senior executive, or under
circumstances that should reasonably lead the director or senior executive to believe that the
person offering the opportunity expects it to be offered to the corporation; or
(B) through the use of corporate information or property, if the resulting opportunity is one that
the director or senior executive should reasonably be expected to believe would be of interest
to the corporation; or
(2) any opportunity to engage in a business activity of which a senior executive becomes
aware and knows is closely related to a business in which the corporation is engaged or
expects to engage.
It is open to Court review but not to the entire fairness approach. This is the law in Maine, not in
Delaware. In Delaware the law is Broz.

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Facts : Broz simultaneously served as a director for two corporations. First, he was the sole
stockholder of RFB Cellular, Inc. (RFBC), which provided cell-phone service in the Midwest.
Second, he was a director of Cellular Information Systems, Inc. (CIS), which was a competitor
of RFBC. CIS knew of Brozs relationship to RFBC at all times.
In April 1994, Mackinac Cellular Corporation approached Broz to discuss the possibility of
selling to RFBC a license that would allow RFBC to expand its coverage. Broz promptly
disclosed the offer to several directors of CIS, each of whom expressed that CIS had neither the
resources nor the plans to purchase such a license. After CIS made clear its lack of interest,
Broz acquired the license for RFBC in November 1994.
Between April 1994 and November 1994, PriCellular, Inc. acquired CIS. PriCellular
subsequently sued Broz on the ground that he had breached his fiduciary duty to CIS by failing
to consider that a potential purchaser of CIS might be interested in the license.

Issue : Is the director of a corporation required to disclose a potential conflict of interest not only
to the corporation but also to parties that might have a future interest in the corporation?

Holding : The director of a corporation need only disclose potential conflicts of interest to the
corporation itself.

Reasoning : The acquisition of CIS by PriCellular was still purely speculative when Broz
disclosed the availability of the license to CIS. Broz obtained confirmation that CIS had no
interest in purchasing the license. Trial testimony estab- lished that the entire board of CIS
believed that the corporation was finan- cially incapable of making such a purchase. Having
ascertained CISs inten- tions, Broz had no obligation to anticipate eventualities such as
PriCellulars acquisition of CIS.
In ALI if you dont disclose, there is no way you get review.
In Delaware, you may choose not to disclose. They look at the line of business, they look at the
line of business, if the Corporation would have entered into the business, how the opportunity
came?
3 defenses in the corporate opportunity:
1. Legal restriction. You can always try to create a new corporation or get around the
restrictions.
2. Refusal to deal. They hate the corporation so much, that they will never make business
to them. Will courts recognize extra-economical reasons? For example, they will never
contract with the company because the company is racist.
3. Financial incapacity. This is also doubtful, because why if it is such a great opportunity
the company doesnt get a loan? But courts like to use this financial incapacity to give
entrepreneurial opportunity.

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How has the burden of prove?

How do you distinguished if the opportunity came not because of his official capacity.
Ebay shareholders
Significant re: question of director independence
The Delaware Court of Chancery held that accepting shares that would otherwise be issued in
an initial public offering (IPO) may amount to a breach of the fiduciary duty. During a secondary
offering of eBay, Goldman Sachs issued shares of the company to the defendants. Because the
price of eBay stock skyrocketed, the defendants made immense profits on the shares within
days or hours of receiving them. Although the court doubted that ac- cepting such shares
interfered with any corporate opportunity, it nonetheless found that the defendants conduct
amounted to a breach of their fiduciary duty. The court held that the defendants had an
obligation to provide an accounting of personal profits derived from transactions involving the
corpo- ration.
Question of director independence. Case where they rewarded Goldman Sachs. Again, how do
you define the line of business?
Should the rules be different in small companies that in big public corporations? Is it different
because most of these small companies do not have independent directors, does this affect?
Can you imagine the standards the Court
MFW shareholder litigation (TWEN page). Standards of review in controlling shareholders
transactions.
The question in this case is if it will be review by the BJR or entire fairness. If a Special
Committee existed then the entire fairness standard will apply but the burden of prove will shift
to the plaintiff.
Here you have a Special Committee that cleans the deal and a majority of the minority
shareholders that ok the deal as well.
Chancellor said that this type of case has never been approached by the Delaware SC. A case
where you have both, a Committee and the majority of minority shareholders.
If SLC truly independent, and if transaction with controller is approved by wellinformed majority of the minority vote (and maybe if controller has promised no
tender offer), then standard of review should be business judgment rule (not
entire fairness with burden on defendant or entire fairness with burden switched
to plaintiff if independent SLC, per Kahn v. Lynch)
DUTIES OF CONTROLLING SHAREHOLDERS
NON-SALE OF CONTROL CONTEXTS

What about sale of control?

Should controller have any duties to the minority SH?
Why would control be sold at a premium: you are going to pay more than
what the market is because you obtain the control.
Should you share the premium with minority SH.

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Zahn v. Transamerica Corporation

Facts : A-F was a tobacco company that had as its principal asset leaf tobacco which they
bought in late 1942 and early 1943 for $6,361,981. By April of 1943 the value of the tobacco
was about $20 million. Defendant, a holding company, was the majority shareholder which
entitled them to control nearly every aspect of A-Fs operations. Defendant converted all of their
Class A stocks to class B stocks, and then called for a redemption of outstanding Class A stocks
at $80.80 per share. The companys charter allowed for the redemption, but the timing of it was
suspicious because right after the redemption Defendant liquidated A-F. As a result, owners of
Class A shares lost out on what Plaintiff valued to be a $240 per share return. Plaintiff redeemed
some Class A shares, so Plaintiff sought equitable relief to turn in outstanding shares at $240
per share and sought the difference between the $80.80 and $240 for the redeemed shares.
Defendant argued that they followed the corporate c
harter when they voted for the redemption.
Issue. The issue is whether Plaintiff is entitled to equitable relief for a decision made by the
majority shareholder that was otherwise allowable under the corporate charter.
Holding : The court differentiated between a decision made by a shareholder and a director,
and determined that the Plaintiff was entitled to equitable relief if, as Plaintiff maintains, the
directors were acting on Defendants behalf when they decided to redeem Class A shares.
Defendant is entitled as a shareholder to vote their interests, but their capacity as director (if the
directors are acting as an extension of the majority shareholders) is limited because they owe a
fiduciary duty to every shareholder.
Synopsis of Rule of Law. Unlike a director, a shareholder, majority or otherwise, is entitled to
vote in a manner that is most beneficial to their interests.

What was the corporations hidden asset?

How did Transamerica take advantage of it?
What were the boards options?
What should the board have done?
Should it have refused to call the Class A stock?

Sale of office.
Director cannot sell its seat at the board, it is illegal. Because even if you are
a SH controller, and you can elect new members of the BD, you still have to
call SH for vote (whether wait for annual meeting or call for a special
meeting). It depends whether or not the new SH has control.
Duty to investigate
Gerdes v.Reynold
Ordinarily it is not a violation of duty to share its controlling stocks but in the
case there is such a gigantic premium and the fact that the sale is on
installment basis. Why it is worried? If they pay on installment it raise
suspicion that they are going to liquidation and pay it with the liquidation
price. Here because the company only owns shares in other companies that
you can buy on the open company, there is nothing extra that would justify

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such an important premium all the more than the price is paid on
installments.

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