Business Organizations Outline

NOTE: Entities don’t act because they are legal fictions; instead, employees of an entity act. Thus,
don’t underestimate individualized incentives of employees to make certain decisions (don’t want to
look bad).

I. AGENCY LAW
A. WHO IS AN AGENT?
1. Agency The label the law applies to a relationship in which:
a. By mutual consent (formal or informal, express or implied)
b. One person or entity (agent)
c. Undertakes to act on behalf of another person or entity (principal)
d. Subject to the principal’s control
2. Rest (Second) of Agency § 1 “Agency is the fiduciary relation which results from the
manifestation of consent by one person to another that the other shall act on his behalf
and subject to his control, and consent by the other so to act.”
3. Agent one who has agreed with another person (principal) to act on his behalf and
subject to his control.
a. A Nonservant Agent is one who agrees to act on behalf of the principal but is not
subject to the principal’s control over how the task is performed.
b. Agents owe a fiduciary duty to their principal.
4. Creation of the Agency Relationship
a. Restatement: Agency is the fiduciary relation which results from the manifestation
of consent by the principal to the agent that the agent shall act on the principal’s
behalf and subject to the principal’s control, and consent by the agent to so act.
b. Creation of Agency necessarily requires two steps: (1) Manifestation by the
Principal, and (2) Consent by the Agent.
i. When the agent manifests consent to the principal’s request, the
agency exists, even though the principal may initially be unaware of
the manifestation.
c. Objective Standard for Determining Consent The law looks not to subjective
intent, but to objective manifestation of such consent by looking to words and
conduct of agent and principal.
d. If two parties manifest consent to the type of business or interpersonal relationship
the law labels “agency,” then an agency relationship exists. The legal concept
applies and the label attaches regardless of whether the parties had the legal
concept in mind and regardless of whether the parties contemplated the
consequences of having the label apply.
i. Parties may expressly state their agreement does not constitute an agency
(particularly in regards to franchise agreements) and courts may recognize
such provisions; however, such clauses are not dispositive and will not be
enforced if the parties actions are to the contrary.
e. Agency is consensual, but not necessarily contractual; thus, an agency can exist
even though the principal provides no consideration.
i. Gorton v. Doty (1937)—D allowed the school football team to use her car
in transporting the football team to a game, with a condition precedent that
the football coach drive the car, but there was no consideration. P was in
the car when it was in an accident and sued P on an agency theory.
o HELD: The evidence sufficiently supported the finding that the
relationship of principal and agent existed. P designated the driver,

1
 making it a condition precedent to using the car; thus she consented
that the coach should act for her and on her behalf in driving the car
to and from the game. The coach consented to be an agent by
driving the car.
 D’s request that the coach drive the car is the manifestation
by the principal for the coach to act on her behalf by driving
her car—because she volunteered the car
 Coach consented to be the agent by driving it.
 Coach is acting on her behalf in her wanting to do something
nice for the team.
o DISSENT: There is a total lack of evidence to support the allegation
that D is the principal of the coach. More than “mere passive
permission” is needed to create an agent.
o How can you avoid Liability in this Case? Get automobile
insurance that covers passengers.
f. CONTROL:
i. Consent and Control To create an agency, the reciprocal consents of
principal and agent must include an understanding that the principal is in
control of the relationship. The control need not be total or continuous and
need not extend to the to the way the agent physically performs, but there
must be some sense that the principal is in charge.
ii. Control as a substitute for establishing agency status—When a creditor
exercises extensive control over its debtor’s business, that control can
establish an agency relationship.
o A. Gay Jenson Farms Co. v. Cargill, Inc. (1981)—D was a
creditor to Warren and the recipient of 90% of Warren’s grain (13
year long-term contractual relationship). D also exercised extensive
control over Warren’s financial decisions and operations, and
disbursement of funds. When Warren went bankrupt, 86 Ps, to
whom Warren owed $2 million, sued D.
 ISSUE: Was there ACTUAL AUTHORITY between Cargill
(principal) and Warren (agent)?
 HELD: D, by its control and influence over Warren, became
a principal with liability for the transactions entered into by its
agent, Warren. A creditor who assumes control of his
debtor’s business may be liable as a principal for the
acts of the debtor in connection with the business. This
is determined by looking at the circumstances as a whole.
By directing warren to implement its recommendations, Carill
manifested its consent that Warren would be its agent.
Warren acted on Cargill’s behalf in procuring grain for Cargill
as part of its normal operations, which were totally financed
by Cargill. Further, an agency relationship was established
by Cargill’s interference with the internal affairs of Warren,
which constituted de facto control.
 Rest. (sec.) Of Agency—
• Safe Harbor Period—“A security holder who merely
exercises a veto power over the business acts of his
debtor of preventing purchases or sales above
specified amounts does not thereby become
principal.” Pt. before which the agency is created.

2
 • “However, if the creditor takes over management of
the debtor’s business either in person or through an
agent, and directs what contracts may or may not be
made, he becomes a principal, liable as a principal for
the obligation incurred thereafter in the normal course
of business by the debtor who has now become his
general agent. The point at which the creditor
becomes a principal is that at which he assumes de
facto control over the conduct of his debtor, whatever
the terms of the formal contract with his debtor may
be.”
 Danger in this Line of Reasoning: Bank loans to
businesses—in Minn. Don’t renew the loan because if you go
too far in trying to give advice, there might be an agency
relationship. This situation is scary because there is no
bright line test.
 What can one do to avoid such liability? Don’t get so
involved. Create a partnership.
 What could the farmers have done? Want cash. Want
payment before delivery of grain. Ask Cargill to write a
check.
 This is the most extreme case you can find.
o Lease Cost Avoider (LCA)—Should the responsible party be the
person with the lowest cost of avoiding the loss?
 This is the question you should ask in each case in
order to determine whether the outcome was the most
economically efficient.
o Going-Concern Value—Every business has some relationship with
their customers and suppliers and bankruptcy dissolves this
relationship.
o Look at planning a problem on p. 13 (Make or Buy Question)—
Note that Bankruptcy is the worst possible option—you want to
avoid this! You could take over Warren (failing company) by
increasing control or write the farmers to tell them that they were not
liable for purchases made by Warren (problem because they have
control). There is risk from either choice; in certain circumstances
both could fail.
iii. Control as an element of servant status—Whether the principal has a
right to control the physical performance of the agent’s tasks determines
whether the agent is a servant or non-servant.
iv. Control has a consequence—As a consequence of agency status, the
principal has the power to control the agent (even if the agent has not
consented to give the principal limited control; however, the agent must
manifest a recognition that serving the principal’s interest is the primary
purpose of the relationship).
g. Agency Contracts can change the rights and duties that exist between agent and
principal, but they cannot abrogate the powers that agency status confers on each
party to the relationship:
i. Principal always has the power to control every detail of the agent’s
performance.
ii. Agent may have certain powers that bind the principal
iii. Both principal and agent have the power to end the agency at any time.

3
5. SOLE PROPRIETOR SHIP
a. Sole Proprietorship a business owned directly by one individual, called a sole
proprietor, who has direct ownership of the assets used in the business. It is
usually not thought of as an organization in the legal sense.
b. Open Account (or trade account)—Personal obligation of sole proprietor (sp) to
seller—regardless of how much SP owes, she personally owns any goods, even
those that have not been sold to customers.
c. Secured Creditor—One whose claim is secured by specific property, and who has
first claim to the proceeds of the sale of such property.
d. General Creditor—All other creditors.
e. Nonrecourse loan—a way to avoid personal liability for business debts. The loan is
secured by specific property and in the event of non-payment, the lender’s sole
recourse would be to sell the property and apply it to the debt.
i. A more convenient way to avoid personal liability may be to incorporate the
business.
f. In the event of bankruptcy no distinction is drawn between business and personal
debts.
g. The difference between the value of the business and the amount of the debt is her
equity in the business. However, there may be a difference between the book
value (more of a historical figure) and the market value.
h. Leverage—the financial consequences of the use of debt and equity. The use of
debt creates financial leverage for the equity. The greater the debt the greater the
leverage. The greater the leverage the greater the potential gains and losses for
the equity and the greater the risk of loss for the debt.
i. Effects of leverage result from the fact that:
o The debt holder (lender) has a fixed claim
o The return on investment or business financed by the debt is
uncertain
o The equity holder (the borrower) has a residual claim (the right to
whatever is left after the debt holder’s claim is satisfied)
ii. If the rate of return on the total investment (before interest) turns out to be
less than the rate of interest, leverage will work against the owner.
iii. “Breakeven Point”—occurs where the return on total investment is the same
rate as that paid on debt. There is no loss or gain from use of the borrowed
funds.
iv. Leverage creates risk and the greater the leverage, the greater the risk.
o RULE: The degree of RISK will depend on the total value of the
business as compared to the amount of debt. As the debt rises in
relation to the value of the business, the risk to the general
creditor rises. As the risk rises, the lender is likely to want
increasing control or a higher interest rate (higher return).
v. See p. 8 K&C for GREAT Example
i. Employment agreements—Transaction Costs (COASE) are not always justified in
negotiating individualized employment agreements because the default rules may
be satisfactory. However, lawyers may be able to provide knowledge of the
common law or statutory default rules and their view on its sufficiency or
appropriate modifications necessary.
i. There is a range of possibilities—Standard form to Taylor-made
j. Divergent interests and mutual interest must come together in a business deal—
Fairness and Integrity are very important.
6. Effects of Legal Right of Control over the Agent
a. Generally, as duration of an employment contract increases, the importance of

4
 control increases.
b. There is an important relationship between incentives and power to control. For
some employees, particularly those in higher-level management positions,
incentives can be provided that tend to align the interests of an employee with
those of the employer and to the extent that this happens the importance of control
to the employer diminishes.
c. Further, to the extent that specificity can be achieved, the importance of control
diminishes. If it is difficult to specify the desired output or performance, or to
observe or measure it, incentive compensation may not be feasible and control
may be important.
d. The extent to which the employer can find replacements affects control, incentives
and specificity.
e. Vicarious Liability
7. Organization within Firms and Across Markets—Can hire within a FIRM, meaning hire
an employee or can hire across a MARKET, meaning hire an independent
PERSON/COMPANY to work within your business.
a. “Make or Buy Decision” Do we make something in house or do we buy
something from an outside supplier? Every business deals with this decision.
b. Ex. Car manufacturer—
i. “In Firm”—build all part to a car and assemble the parts into the product
ii. “Across Market”—buy all parts from outside suppliers, and company only
assembles the final product.
c. COASE—The Theory of the Firm—Why is everything in the world not owned by
one giant company? If it is beneficial to vertically integrate your work, then why
don’t that keep going? What determines where we stop?
i. Answer—firms internally organize until it is cheaper to buy from outside than
to produce internally.
d. Relevant Variables in the Make or Buy Decision: risk, control, duration,
incentives, availability of objective tests of success, opportunities for stealing and
for cheating and shirking and other forms of self-dealing, and ability to predict the
future.
i. Cost/Benefit analysis of keeping an eye on monitoring costs of in firm v.
across market
8. Owners and Managerial Employees
a. Incentive-Based Compensation:
i. The owner may want incentive based salary to increase the manager’s
productivity
ii. Likewise, the manager may want an incentive-based salary according to
performance in order to receive greater compensation.
iii. The Compensation package may consist of a salary (fixed claim) plus a
bonus based on profits (residual claim). The presence of an element of
incentive compensation like a bonus based on profit shifts some of the risk
of the business to the manager. It aligns the manager’s objectives and
interests with those of the owner, and thereby allows the owner to be less
concerned with supervision, review and control.
o The better you can align the incentives of the agent and the
principal, the better business will be.
iv. BUT as the manager rewards become increasingly tied to the business, he
will become more concerned about control.
v. The negotiations of these contracts, however, can be potentially
antagonistic, and as a result, can be very costly.
b. **“Hypothetical Bargain”**—To a considerable extent it will be necessary to leave

5
 problems for resolution as they arise, relying on the proposition that by and large
the outcomes prescribed by law (DEFAULT RULES), in the absence of explicit
agreement, will be consistent with what the parties would have provided had they
tried to anticipate and resolve all conceivable issues.
i. Ex. Partnership voting—1 partner and 1 vote—Is this what your client would
want (agree to) if they were to lay out the issue in the contract.
ii. ESSAY ON EXAM—NO default rule and help client determine whether they
would be happy with the default rule if it was needed.
c. Employers may be reluctant to enter into long-term contracts with executives
because
9. Irreducible divergences of interest:
a. There is a divergency or conflict between the interests and goals of two employees.
The resolution of that divergency or conflict can produce an interesting exercise in
game theory or bargaining strategy.
B. LIABILITY OF PRINCIPAL TO THIRD PARTIES IN CONTRACT
1. An agent’s power to bind the principal to third parties and to bind third parties to the
principal is central to the agent’s ability to accomplish tasks on the principal’s behalf. Thus,
principals and third parties are legally bound to contracts with each other as if the principal
had directly acted—Attribution or Imputation
a. Power the ability to produce a change in given legal relation (between principal
and third parties) by doing or not doing a given act.
b. Qui facit per alium facit per se
2. Agents have the power to bind a principal through any one (or more than one) of the
following: (1) actual authority, (2) apparent authority, (3) inherent power , (4) estoppel, and
(5) ratification.
3. Attribution or Imputation is transaction specific and time sensitive. With the exception of
ratification, all attribution rules are applied exclusively as of the time that relevant
transaction occurred.
4. AUTHORITY—A principal may be bound by the acts of an agent under any one of the
following separate principles:
b. Actual Authority Agent’s act was authorized.
i. Two Kinds:
o (1) Express and
o (2) Implied
 Actual authority circumstantially proven which the principal
actually intended the agent to possess and includes such
powers as are practically necessary to carry out the duties
actually delegated. This focuses upon the agent’s
understanding of his authority—Whether the agent
reasonably believes because of present or past conduct of
the principal tat the principal wishes him to act in a certain
way or to have certain authority.
 In most cases the principal does not think of, far less
specifically direct, the series of acts necessary to accomplish
his objects, and implied actual authority fills in the gaps.
 But express manifestations of the principal can negate
implied authority.
ii. Creation of actual authority involves:
o An objective manifestation of the principal
o Followed by the agent’s reasonable interpretation of that
manifestation by the principal
o Which leads the agent to believe that it is authorized to act for

6
 the principal
iii. A manifestation that reaches the agent through intermediaries can still give
rise to actual authority.
iv. Silence can also indicate consent
i. Leading the agent to believe it is authorized to act for the principal
ii. “Zone of Endeavor”
iii. Objective Standard of Reasonable Belief of the Agent The agent is
authorized to do, and to do only, what it is reasonable for him to infer that
the principal desires him to do in the light of the principal’s manifestations
and the facts as the agent knows or should know them at the time he acts.
iv. Principal’s Control of Agent’s interpretation—A principal can always cut
back or countermand previously granted authority simply by making a
manifestation to the agent and seeing that the manifestation reaches the
agent. But in this situation, the principal may be breaching a contract with
the agent.
v. Irrelevance of third party’s knowledge—An agent can have actual
authority even though at the tie of the relevant occurrence the third party
neither knows nor has reason to know the extent of the authority.
o This is the direct opposite of apparent authority, where the third
party’s view is pivotal to the existence of such authority.
o The agent can have actual authority even though at the time of the
binding act or omission the principal is
 Only partially disclosed—the third party knows or has reason
to know that the agent is acting for another, but not who that
other is
 Totally undisclosed—the third party does not know or have
reason to know that the agent is acting as an agent.
vi. Binding the Principal—If an agent acting with actual authority makes a
contract on behalf of a principal, then the principal is bound to the contract
as if the principal had directly entered into the contract. In most
circumstances, the third party is likewise bound.
o Special rules for contracts involving undisclosed principals—
When the principal is undisclosed, the third party is sometimes
entitled to:
 Insist on rendering performance to the Agent (especially
when the contract involves personal services)
 Escape the contract entirely—Escape is possible if either:
• The contract between the third party and the agent
provides that it is inoperative if the agent is
representing someone else, or
• The agent fraudulently represents that the agent is
not acting for the principal; the third party would not
have entered into the contract knowing the principal
was a party; and the agent or undisclosed principal
knows or should know that the third party would not
have made the contract with the principal.
vii. Mill Street Church of Christ v. Hogan (1990, p. 14)—The elders of D hire
Bill to paint the church building. The elders discuss using Petty to assist with
the work, but when Bill explains that he needs help to finish, he is told that
Petty is difficult to get in touch with, leaving him with the impression that he
could hire whom ever. Bill hires Sam Hogan, who had helped him with
church maintenance before. Sam falls and is injured. The church claims

7
 there was neither express nor implied authority given to Bill to hire Sam.
o HELD: Bill Hogan had implied authority to hire Sam as his helper.
Reasons:
 In the past the church had allowed Bill to hire Sam or other
persons whenever he needed assistance.
 Even though the elders discussed hiring Petty, this was
never communicated to Bill, and Bill was left with the
reasonable impression to hire whomever
 Bill needed assistance to complete the job he was hired to do
as an agent.
 Sam believed Bill had the authority to hire him and to deny
him coverage would have been unfair—This is apparent
authority
o TEST: What is REASONABLE for the Agent and/or Third Party
to think that the principal wants him to do.
c. Apparent Authority if the principle engages in written or spoken conduct that
leads a third party to reasonably to believe that the principal has allowed given the
agent authority. The power to bind, not the right to bind.
i. However, if the third party knows that the agent has no authority to bind,
then apparent authority does not exist.
ii. This creates a contractual duty between the principal and the third party
because the agent had apparent authority.
viii. Reasonable person standard.
ix. Creation of apparent authority involves:
o An objective manifestation from the “apparent principal”
o Which somehow reaches a third party, and
o Which causes the third party to reasonably believe that the
“apparent agent” is indeed authorized to act for the apparent
principal.
x. Can co-exist with actual authority and can extend the actual agent’s power
to bind the principal beyond the scope of the agent’s actual authority
xi. Can also exist when no actual agency exists.
xii. Under the Restatement, the third party is not required to show it relied to its
detriment on the appearance of authority. However, many jurisdictions
require detrimental reliance (agency by estoppel)
xiii. For apparent authority to exist, the third party must be able to
point to at least some peppercorn of manifestation attributable to the
apparent principal and this must form the basis of the third party’s
reasonable belief that the apparent agent is actually authorized.
o THUS, the statements of the apparent AGENT CANNOT give rise to
apparent authority, UNLESS:
 The apparent agent is actually authorized to act for the
principal, and
 While actually authorized, accurately describes the extent of
its authority.
xiv. Types of Manifestations:
o A manifestation that reaches third party through intermediaries can
still give rise to apparent authority, and the intermediary does not
have to be an agent of the principal.
o Authority By Position the position given to an agent may create
apparent authority based upon business practices and local custom.
o Authority by position within an organization based upon a

8
 hierarchical structure and custom of certain titles.
o By acquiescing the agent’s conduct.
o By inaction (silence)—Requires the following criteria to be met:
 Someone must assert that the apparent agent has actual
authority (including the apparent agent)
 The apparent principal must be aware of those assertions
and fail to do anything to contradict them
 The third party claimant must be aware of: (1) the assertions
themselves, (2) the apparent principal’s knowledge of these
assertions, and (3) the apparent principal’s failure to
contradict the assertions, and
 It must be the apparent principal’s failure to contradict the
assertions that causes the third party to reasonably believe
that the apparent agent is authorized.
xv. Third Party’s Interpretation—Reasonableness requirement
o Mere belief is insufficient—must be reasonable, which is determined
by the same analysis as for actual authority given to an agent—
Objective
o Duty of inquiry on third party
o Apparent agent’s conduct cannot affect this belief.
xvi. An agent for an undisclosed principal can never have apparent authority
xvii. Lind v. Schenley Industries, Inc. (1960, p.16)—P worked for D and
was promoted to a new office. The president of D told P to speak with the
NY general manager, Kaufman, about compensation. After moving, P got a
letter stating that the company was working on an incentive-based plan, and
shortly thereafter he was informed by Kaufman that he would get a title of
district manage and later learns from Kaufman he would also get 1%
commission on the sales of men under him. P was never paid (4 years)
and D claimed that Kaufman lacked the authority to offer P commission
because only the president of the Co had this power. ISSUE: Was there
apparent authority?
o HELD: D can be held accountable for Kaufman’s action on the
basis of both inherent and apparent authority. There was sufficient
evidence for a jry to find that D had given Kaufman apparent
authority to offer P 1% commission of grass sales of the salemen
under him and that P reasonably had relied upon Kaufman’s offer,
even though the commission resulted in a higher salary that was
received by his superior Kaufman.
 the court explains that there was no express authority
because there was a statement in company policy that only
the President to make salary and promotion decisions.
However, this is not at issue because P believed that
Kaufman had authority.
o Least Cost Avoidance Answer An Employer was in a better
position to prevent this mistake than is an employee. It is too
time consuming the require employees to get confirmation from the
top of the latter every time.
o What could Lind have done to avoid the problem? Get the person
above Kaufman to confirm the promotion and salary increase.
o What could the Company Do to Avoid this Problem? Make it very
well known what the policy is—put it in a handbook, talk about the

9
 policy in a training session. They could better train their employees
as to promotion procedures. Maintain a policy that all arrangements
must be in writing—no oral modifications of employment contracts.
xviii. Three-Seventy Leasing Corporation v. Ampex Corp. (1976, p.22)—P
was solely owned by Joyce, who through Kays, his friend and a sales
representative of D, signed a lease for 6 computer core memories.
However, D never signed the document, but the Kays’s superior at D sent
an email to the office explaining that P was a new customer and that the Ks
would go through Kays. P subsequently signed a contract with EDS to
lease the memories. On November 17th, Kays sent a letter to Joyce, which
confirmed the delivery dates for the memory units.
o HELD: In the light of the circumstances surrounding these
negotiations, Kays had apparent authority to accept Joyce’s offer on
behalf of D, and the Letter to Joyce confirmed the acceptance of the
contract by D. Absent knowledge of such a limitation by third
parties, that limitation will not bar a claim of apparent authority.
o Ampex could have had a statement on the contract be more clear,
saying that without the signature of a contract manager, this contract
is null an void. Ampex could have better employee training.
o P could have called and asked for confirmation.
o LEAST COST AVOIDANCE? We want people in Ampex’s position
to do more to notify its customers of its acceptance procedures
because it is less burdensome to the company to communicate than
it is to put the burden on the customer to jump through hoops to get
confirmation.
o Note that this transaction involves two aspects. On one hand there is
the sale of the memories and on the other hand there is an
extension of credit. Whether a sales rep. would have the authority to
obligate the company on both agreements is a matter of industry
custom. Does the company have the duty to disclose this custom to
the customer.
xix. EXAM Questions:
o What could the employer have done to protect itself against the
problem in the case?
o What could the employee have done to protect himself?
o Cost Avoidance Question—who was in a better position to avoid the
problem? Look to effort, time, expense, etc.
b. Inherent Agency Power a general agent binds an undisclosed principal to
contracts that are within the usual scope of authority of agents of the same type,
even where the agent had neither authority nor apparent authority.
i. REST. (Second) of Agency § 8A—“ Inherent Agency . . . is the power of
an agent which is derived not from authority apparent authority or
estoppel, but solely from the agency relationship exists for the
protection of persons harmed by or dealing with a servant or other
agent.” (Nogales)
ii. Rest. (Second) of Agency § 8A (comment b) “Inherent Agency. . .
Here the power is based neither upon the consent of the principal nor upon
his manifestations. There are three types of situations in which this
type of power exists:
o (1) General agent does something similar to what he is authorized to
do, but in violation of orders. In this case, the principal may become
liable as a party to the transaction, even if he is undisclosed.

10
  A “general agent” is an agent authorized to conduct a series
of transactions involving a continuity of service.
o (2) Agent acts purely for his own purposes in entering into a
transaction, which would be authorized if he were actuated by a
proper motive.
o (3) Agent is authorized to dispose of goods and departs from the
authorized method of disposal.”
o “But because agents are fiduciaries generally acting in the
principal’s interests, and are trusted and controlled by him, it is
fairer that the risk of loss caused by disobedience of agents
should fall upon the principal rather than upon third persons.”
iii. This is not really agency—Professor thinks it is wrong
iv. This is a catchall doctrine based on fairness.
v. NOTE: Inherent agency with a disclosed principal is very similar to
apparent agency. Inherent agency with an undisclosed principal is very
different.
vi. In this situation, the agent has caused mischief while acting counter to the
principal’s wishes, but the third party is without blame.
vii. Enterprise Liability Places the loss on the enterprise that stands to benefit
from the agency relationship.
viii. It holds the principal responsible for:
o Certain unauthorized acts of an agent whom the principal has
entrusted with ongoing responsibility, and for
o Certain false representations of an agent or apparent agent.
ix. If the agent is a general agent—principal has authorized an agent to
conduct a series of transactions involving a continuity of service—with
actual authority to conduct transactions,
o The agent is acting in the interests of the principal, and
o The agent does an act usual or necessary with regard to the
authorized transactions,
x. Then the act binds the principal regardless of whether the agent had actual
authority and even if the principal had expressly forbidden the act.
xi. Does NOT apply if either:
o The third party knows the agent is acting without authority, or
o The agent is not acting in the principal’s interest.
xii. Rule for False Statements by an Agent—Agent’s false statements are
attributable to the principal if:
o The principal is disclosed or partially disclosed, and
o A true statement concerning the same subject would have been
within the agents actual or apparent authority.
xiii. Watteau v. Fenwick (1892, p.25)—Humble sold his beerhouse to D,
but Humble’s remained the manager and his name remained on the bar. D
gave Humbe authority to order only bottled ales and mineral waters, and D
was to purchase everything else needed. P sued to recover the price of
cigars purchased. P had no knowledge that Humble was not the owner or
that D owned the beerhouse—D is an undisclosed principal.
o HELD: Because of Humble’s position as manager, P’s lack of
knowledge at D’s ownership, and the fact that cigars would usually
be supplied to such an establishment, the court found that D was
liable to pay P. D was the principal of Humble, and as such D was
bound to pay P because P was unaware of Humble’s lack of actual
authority.

11
 o The court also compares the agency situation to the law of
partnerships. Partners are considered to be agents of the
partnership, with the power to incur obligations on behalf of the
partnership. All partners are liable, as principals, for partnership
obligations. Since agency rules relating to undisclosed principals,
and to the power of agents bind their principals, apply to
partnerships, a person who becomes a partner cannot escape
liability for partner’s debts by concealing his or her membership in
the partnership.
 This comparison is the opposite of what analysis normally
occurs.
o Professor has a problem with this because P is getting a windfall
because they never knew they were dealing with D; therefore, they
took the risk by dealing with the risky client.
xiv. Kidd v. Thomas A. Edison, Inc. (1917, p.28)—SKIPPED IN CLASS—
D hired fuller as an agent to engage P to perform at recitals for the purpose
of recording her voice and selling the recordings to dealers (new
technology). D planned to only have a recital when a dealer agreed to it.
Fuller was told to learn from the artists what fees they would expect and to
tell them that D would pay the railway fairs. Fuller was also told to execute
a contract with P. The problems is that P understood, and Fuller likely
communicated, an unconditional engagement for a singing tour, as was the
known custom.
o HELD: When an agent is selected, as was Fuller, to engage singers
for musical recitals, the customary implication would seem to have
been that his authority was without limitation of the kind here
imposed, which was unheard of in the circumstances. The mere fact
that the purpose of the recitals was advertisement, instead of
entrance fees, gave no intimation to a singer dealing with him that
D’s promise would be conditional upon so unusual a condition as
that actually imposed. Thu, because a principal is responsible for
the actions of his agent, D is liable.
xv. Nogales Service Center v. Atlantic Richfield Company (1980, p.31)—
NSC claims a breach of contract against ARCO. Tucker, a marketing
manager for ARCO told NSC that it must build a motel at its service station
and that in exchange (1) it would lend NSC $100,000 and (2) would give
NSC a 1 cent per gallon discount on all diesel fuel, and (3) make NSC
competitive. ARCO lent the money, but did not give the fuel discount or
make NSC competitive. NSC defaulted on the note and ARCO foreclosed.
ARCO claims that Tucker was outside of his authority and that the statute of
frauds barred any action on the alleged oral contract. ISSUE: Would it be
normal for Tucker to not have this kind of authority. ISSUE 2: There was no
instruction to the jury as to inherent agency and there was no objection to
that; thus, they could not bring that issue up on appeal (not worried about
the procedure)
o HELD: The instructions given to the jury only covered actual
authority. Inherent authority depends upon neither of these
concepts since it may make the principal liable because of conduct,
which he did not desire or direct to persons who may or not have
known of his existence or who did not rely upon anything which the
principal said or did. It is fairer to place the burden upon the agent’s
principal than upon the third persons.

12
  The court also looks to the fact that while the agent was not
acting with authority, inherent agency will be applied when
the agent was acting within the general scope of his business
5. Ratification
a. Ratification occurs when the principal affirms a previously unauthorized act,
validating the original unauthorized act and production the same legal
consequences as if the original act had been authorized.
b. Ratification releases the purported agent from any liability for having made an
unauthorized contract.
i. EXCEPTION: IF the principal ratifies only to “cut his losses,” then the
purported agent is not released from liability to the principal.
c. In practice argue ratification in the alternative to authority
d. Entitles the third party to the full benefit of the bargain and not just quantum meruit.
e. Ratification by implication No express affirmance, but actions that indicate an
affirmance. 2 Requirements:
i. Intent to Ratify
ii. Full knowledge of material facts.
f. 2 Necessary Requirements:
i. Preconditions:
o The purported agent must have purported (expressly or impliedly) to
act on behalf the purported agent in some transaction with a third
party.
o The purported agent must have acted without either agency
authority or agency power and estoppel must not apply
o At the time of the act the purported principal must have existed and
must have had capacity to originally authorize the act, and
o At the time of the attempted ratification, the third party must not have
indicated—either to the purported agent or to the purported principal
—an intention to withdraw from the transaction.
ii. Affirmance—the act of ratification (occurs at the manifestation)
o Making a manifestation that, viewed objectively, indicates a choice
to treat the unauthorized act as if it had been authorized, or
o Engaging in conduct that is justifiable only if the purported principal
made such a choice
 This includes failing to repudiate the act.
 Includes accepting or retaining benefits while knowing that
the benefits result from an unauthorized act
g. Whether or not ratification has occurred is a question of fact.
h. Principal’s Ignorance:
i. Rest—If at the time of the affirmance, the purported principal is ignorant of
material facts involved in the original transaction, and is unaware of his
ignorance, he can avoid the affect of the affirmance.
ii. Most courts treat the purported principal’s knowledge of the material
information as a recondition to ratification.
iii. The principal’s ignorance ceased to be a factor if the third party has learned
of and detrimentally relied on the principal’s affirmance.
i. Ordinarily, a purported principal’s affirmance binds not only the purported principal
but also the third party.
i. Third party can avoid affirmance in two situations:
o Changed circumstances that to materially hold the third party to the
contract would be unfair
o Conflicting arrangements:

13
  Third party learns that the purported agent acted without
authority,
 Relies on the apparent lack of authority, and
 Makes substitute, conflicting arrangements or takes some
other action
ii. Ratification, Adoption, and Novation
j. Botticello v. Stefanovicz (1979, p.36)—Mary and Walter acquired a farm as
tenants in common. Walter then leases the farm to P with an option to sell;
however Mary never signs the contract and never agrees. In fact, mary says that
she will not sell for less than a certain price. At no point does walter represent to P
that he was an agent of his wife, and at no prior point in time had he acted as her
agent. ISSUE: Is an agreement for the sale of real property enforceable when the
agreement has been executed by a person owning only an undivided half interest
in property?
i. HELD: This is an issue of Ratification by implication The fact that
one spouse tends more to business matters than the other does not, absent
other evidence of agreement or authorization, constitute a delegation of
power as an agent. And the facts do not support ratification. If the original
transaction was not purported to be done on account of the principal
receives its proceeds does not make him a party to it. Since Walter at no
time purported to be acting on his wife’s behalf, as is essential to effective
subsequent ratification.
ii. RULE: Marital status cannot in and of itself prove the agency
relationship.
iii. RULE: Status of jointly owning land does not make one the agent to
the other.
6. Estoppel (He thought this was too goofy to go over in class)
a. Rest. Imposes liability on a person for “a transaction purported to be done
on his account . . . to persons who have changed their positions because of
their belief that the transaction was entered into by or for him, if:
i. (a) he intentionally or carelessly caused such belief, or
ii. (b) knowing of such belief and that others might change their position
because of it, he did not take reasonable steps to notify them of the
facts [that there was no authority].
b. Unlike apparent authority, estoppel can apply even though the claimant can show
no manifestation attributable to the asserted principal.
i. Can arise from the asserted principal’s mere negligent failure to protect
against misapprehension.
ii. Case law confuses this distinction
c. Hoddeson v. Koos Bros. (1957, p.40)—P goes into a furniture store with her aunt,
and pays cash for a furniture set, which is to be delivered to her home at a later
date. She does not receive a receipt, and the furniture is never delivered. P and
her aunt are unable to identify the salesman who took the money, and D claims that
the salesman must have been an imposter.
i. HELD: There is no actual or apparent authority because there was no
manifestation by the principal. However, the court finds that where a
proprietor of a place of business by his dereliction of duty enables one who
is not his agent conspicuously to act as such and ostensibly to transact the
proprietor’s business with a patron in the establishment, the appearances
being of such a character as to lead a person of ordinary prudence and
circumspection to believe that the imposter was in truth the proprietor’s
agent, in such circumstances the law will not permit the proprietor

14
 defensively to avail himself of the impostor’s lack of authority and thus
escape liability for the consequential loss thereby sustained by the
customer. This falls under a theory of agency by estoppel.
7. Agent’s liability on the Contract
a. RULE: It is the duty of the agent to disclose that he is acting in representative
capacity and to provide the identify of his principal; otherwise, the agent is
personally liable on a contract entered into by him on behalf of his principal.
b. Atlantic Salmon A/S v. Curran (1992, p.43)—Ps seek to recover from D
individually for unpaid contracts, but D claims he was acting as an agent of his sole
proprietorship (Marketing Designs, Inc. (MD)), which was a dissolved entity at the
time the debts incurred. Also, Ps were never told about MD, but thought he was
operating on behalf of Boston Seafood Exchange, Inc, the name printed on his
business cards, advertisements and checks.
i. HELD: Unless otherwise agreed (DEFAULT RULE), a person purporting
to make a contract with another for a partially disclosed principal is a party
to the contract. It was not the plaintiff’s duty to seek out the identity of D’s
principal; it was D’s job to reveal it. It is not sufficient that the Ps had the
means, through a search of Boston’s city clerk records, to determine the
identity of D’s principal. Actual knowledge is the test. The duty rests upon
the agent, if he wants to avoid liability, to disclose his agency and not upon
others to find it.
o There is no hardship in this rule.
o Partially Disclosed Principal DEFAULT Rule—A person
purporting to make a contract with another on behalf of a
partially disclosed principal is a party to the contract and is
liable on the contract.
o Fully Disclosed Principal Default Rule—If it is a fully disclosed
principal, then the agents liability is released.
ii. NOTE: One of the reasons to be incorporated is so that your personal
assets don’t get snagged.
iii. Ps could have gotten a credit check to protect themselves.
C. LIABILITY OF PRINCIPAL TO THIRD PARTIES IN TORT
1. Respondeat Superior—
a. A doctrine imposing strict, vicarious liability on a principal when:
i. An agent’s tort has caused physical injury to a person or property,
ii. The tortfeasor agent meets the criteria to be considered a “servant” of a
principal, and
iii. The tortuous conduct occurred within the servant’s “scope of employment.”
b. Applies to negligent and intentional torts
2. Servant v. Independent Contractor
a. Servant (Rest. of Agency §§ 1 and 2) Master/Servant Relationship Exists where
the servant has agreed:
i. To work on behalf of the master, and
ii. Be subject to the master’s control or right to control the physical conduct of
the servant.
b. Independent Contractor A nonservant who provides services or undertakes
tasks for others.
i. 2 Forms:
o Agent-type one who has agreed to act on behalf of another, but
not subject to the principal’s control over how the result is
accomplished.
o Non-Agent-Type One who operates independently and simply

15
 enters into arm’s length transactions with others.
c. Rest. 10 Factor Test:
i. The extent of control which, by the agreement, the master may exercise
over the details of work
ii. Whether or not the one employed is engaged in a distinct occupation or
business
iii. The kind of occupation, with reference to whether, in the locality, the work is
usually done under the direction of the employer or by a specialist without
supervision
iv. The skill required in the particular occupation
v. Whether the employer or the workman supplies the instrumentalities, tools,
and the place of work for the person doing the work
vi. The length of time for which the person is employed
vii. The method of payment, whether by the time or by the job
viii. Whether or not the work is part of the regular business of the employer
ix. Whether or not the parties believe they are creating the relation of master
and servant
x. Whether the principal is or is not in business
d. Major Issue: Oil companies often deal with Organization within the Firm v.
Organization Across Markets
i. 1) Firm—sell gas and oil through stations owned and operated through
company employees
ii. 2) Markets—Sell gas and oil through independently owned stations.
iii. When personal injury to third parties results from the negligence of station
personnel, the court must determine whether the operator of the station was
an employee (servant) or independent operator (independent contractor).
iv. Point of next cases—There are a number of ways for a business to organize
a business in order to sell its products. Companies make these decisions in
the way that they believe is the most efficient and the most profitable.
v. ISSUE: At what point will you allow the accident victim to sue the main
business entity supplying goods to a store? Does the putative principal
have enough control over the putative agent so that the putative principal
should be liable for the putative agent’s tortuous actions?
e. Humble Oil and Refining Co. v. Martin (1949, p.48)—Ms. Love drops her car off
at a service station owned by Humble, but run by Schneider. The car rolls off the
property and hits the Martins in the back. Humble asserts that the service station
was an independent contractor.
i. HELD: Humble is responsible for the operation of the station, which
admittedly it owned, as it did also the principal products there sold by
Schneider under the so-called “Commission Agency Agreement” between
him and Humble which was in evidence. The facts that neither Humble,
Schneider, nor the station employees considered Humble as an
employer/master; that the employees were paid and directed by Schneider
individually as there boss and that a provision of the agreement expressly
repudiates any authority of Humble over the employees, are not conclusive
against the master-servant relationship, since there is other evidence
bearing on the right or power of Humble to control the details of the station
work as regards Schneider himself and the employees he would hire.
Basically, the agreement required Schneider to do anything Humble might
tell him to do.
ii. FIXING THE PROBLEM TO TURN OUT LIKE SUN: One way to make this
case turn out like SUN is to not require reports to the headquarters, but

16
 instead may it less formal and more friendly by sending an agent to offer
“suggestions” and to get information informally from the branch/store.
Another way is to change the termination requirements Humble is the
only one who may terminate at will, but in SUN, the termination right was
mutual.
f. Hoover v. Sun Oil Company (1965, p.50)—P is injured as a result of his car
catching on fire while at Barone’s service station, owned by Sun. The station sold
mostly Sun products and maintained mostly Sun equipment. Barone had extensive
contact with Sun, and he had attended the Sun school. However, Sun did not have
control over the daily operations of Sun’s business. Barone determined his own
hours of operation and had the option of other products. He was also had no
reporting requirement to Sun. The name of the station also had Barone’s name.
i. HELD: Barone was an independent contractor. The service station, unlike
retail outlets, is a one-company outlet and represents to the public,
throughSu’s national and local advertising that it has Sun-quality service
and products. The lease is only that between landlord tenant and
independent contractors because Sun had no control over the details of
Barone’s day to day operations. There close areas of contract only arose
out of their mutual interest in the sale of Sun products and the success of
Barone’s business.
ii. TEST: Control over day-to-day operations of business.
g. Policy Questions:
i. Why not just make the agent get an insurance policy that would indemnify
the principal if sued for actions?
h. BELT AND SUSPENDERS—Don’t just depend on the law being in your favor; also
form a contract in your favor to cover yourself. Each alone is fine, but you really
need them both to protect yourself.
i. Murphy v. Holiday Inns, Inc. (1975, p.53)—P was slipped and fell on a puddle of
water at the Betsy-Len’s hotel, operating under a franchise agreement with D. D
was empowered to regulate the architectural style of the buildings and the type and
style of furnishings and equipment, and attend basic training. Betsy-Len’s was also
permitted to use the trade name, trademarks, etc. However, D was given no power
to control daily maintenance o the premises and no power to control business
expenses or demand a share of profits, or discipline and supervise employees.
i. RULE: When an agreement, considered as a whole, establishes an agency
relationship, the parties cannot effectively disclaim it by formal consent in a
contract. The relationship depends upon what is.
ii. HELD: The License agreement contains the principal features of a
franchise contract with regulatory provisions that gave D no control or right
to control the methods or details of doing the work. Therefore, no principal-
agent or master-servant relationship was created. The purpose of the
provisions was to achieve system-wide standardization of business identity,
uniformity of commercial service, and optimum public good will, all for the
benefit of both contracting parties. The regulatory provisions did not give D
control over day-to-day operations of Betsy-Len’s
iii. Franchisor sells the brand name and quality control, but franchise
contracts do not really fit normal agency law—the franchisee does act
on behalf of the franchisee to some extent, but not to any great extent.
Basically, the Franchisor makes only $450 per Month for 100 rooms at a
location, while the franchisor makes $30,500 a month in gross revenue.
iv. NEED premises liability insurance, so provide this in the contract!
Because going to court to determine who pays in INEFFICIENT!

17
 v. How much freedom does the franchisee have to run the business? Quite a
bit because it is an extreme remedy to revoke a franchise and it is difficult to
develop a financial penalty that is equivalent to their violation.
o A provision for arbitration could be helpful, but expensive to draft.
3. Tort Liability and Apparent Agency
a. The Apparent principal is liable to a third party if:
i. A person has actual or apparent authority to make statements
concerning a particular subject
ii. The person makes a misstatement of fact concerning the subject,
iii. A third party relies on that misstatement, and
iv. The third party suffers physical harm as a result
b. Rest.—“One who represents that another is his servant or other agent and thereby
causes a third person to justifiably rely upon the care or skill of such apparent agent
is subject to liability to the third person for harm caused by the lack of care or skill
of the one appearing to be a servant or other agent if he were such.”
c. Miller v. McDonald’s Corp. (1997, p.58)—P sues McDonalds Corp. when she bits
into a sapphire while eating a Big Mac at a franchise restaurant. The licensing
agreement signed with the franchise owner required that the location be operated
in a manner consistent with the McDonald’s system—this included use of trade and
service marks, wearing uniforms, keeping certain booking records, business
practices, and service policies and standards, and using only McDonald’s food,
cooking methods, menus and paper items. Failure to comply could result in
termination of the franchise. Trial Court granted Summary judgment for McDonalds
because they did not own or operate the restaurant.
i. HELD: Summary judgment reversed because a jury could find that
McDonald’s retained sufficient control over the franchise daily operations as
to create an agency relationship. A jury could also find that the plaintiff
believed that all McDonald’s restaurants were the same because she
believed that one entity owned and operated all of them, or at least,
exercised sufficient control that the standards she experienced at one would
be the same as she experienced at the others.
ii. “If, in practical effect, the franchise agreement goes beyond the stage
of setting standards, and allocates to the franchisor the right to
exercise control over the daily operations of the franchise, an agency
relationship exists.”
iii. Rest. §267 “One who represents that another is his servant or other
agent and thereby causes a third person justifiably to rely upon the care or
skill of such apparent agent is still subject to liability to the third person for
harm caused by the lack of care or skill of the one appearing to be a
servant or other agent as if he were such.” This means that McDonalds has
to hold out (do something to indicate) that the franchise restaurant is his
agent.
o Issues in regards to Franchisor/Franchisee: (1) Whether the
putative principal held the third party out as an agent and (2)
whether the plaintiff relied on that holding out.
o The centrally imposed uniformity is the fundamental basis for the
court’s conclusion that there was an issue of fact whether the
franchisors held the franchisee out as the franchisor’s agent.
d. Look at problem on p. 62—Like Best Westerns—Note, you can’t guarantee that a
court will not find that there is an agency relationship, no matter how many
precautions you take.
4. Scope of Employment

18
a. Basically, conduct must be of the same general nature as that actually authorized
or incidental to the conduct authorized.
b. Rest.—A servants conduct is within the scope of his employment if:
i. It is of the kind he is employed to perform
ii. It occurs substantially within the authorized time and space limits
iii. It is actuated, at least in part, by a purpose to serve the master, and
iv. If force is intentionally used by the servant against another, the use of force
is not unexpected by the master.
c. Rest. Factors to Consider:
i. Whether or not the act is one commonly done by such servants,
ii. The time, place, and purpose of the act
iii. The previous relations between master and servant
iv. The extent to which the business of the master is apportioned between
different servants
v. Whether or not the act is outside the enterprise of the master or, if within the
enterprise, has not been entrusted to any servant
vi. Whether or not the master has reason to expect that such an act will be
done
vii. The similarity in quality of the act done with the act authorized
viii. Whether or not the instrumentality by which harm is done has been
furnished by master to servant
ix. The extent departure from the normal method of accomplishing an
authorized result; and
x. Whether or not the act is seriously criminal
d. Can be within the SOE even if it was expressly forbidden by the principal, tortuous,
or constitutes a minor crime.
e. Master’s control over servant does not influence the SOE
f. Traveling
i. Commuting—not normally SOE
ii. “Special errand exception and necessary travel —SOE
iii. “Frolic and Detour”—not SOE
g. Ira S. Bushey & Sons, Inc. v. U.S. (1968, p.62)—A U.S. coast guard Vessel was
stored in a dry-dock owned by P. One of the Coast Guards sailors, Lane, comes
back drunk one night, turns the valves and floods and injures the dry-dock.
i. RATIONALE against Using Motive Test of Employee: Rest. §228 says that
conduct of a servant is within the scope of employment if, but only if it is
actuated, at least in part, by a purpose to serve the master. The Court
admits that this scope has been expanded; however, this court does not do
this. “It is not at all clear that expansion of liability in the manner here
suggested will lead to a more efficient allocation of resources. A more
efficient allocation can only be expected if there is some reason to
believe that imposing a particular cost of the enterprise will lead it to
consider whether steps should be taken to prevent a recurrence of the
accident—Accident Avoidance (costs)—how do you avoid such
accidents? What can you expect the future to look like depending upon
whom you put the responsibility—Government or Dry-Dock owner? Can
gov’t prevent drunken sailors asking questions or can the drydock owner get
insurance, etc?
ii. HELD for Foreseeability: BUT, the Court finds that the motive/incentive
test is inadequate. There is a deeply rooted sentiment that a business
enterprise cannot justly disclaim responsibility for accidents, which may
fairly be said to be characteristic of its activities. Ultimately, Lane was not
so unforeseeable as to make it unfair to charge the government with
19
 responsibility. What is reasonably foreseeable in this context is quite a
different thing from the foreseeably unreasonable risk of harm that spells
negligence. The employer should be held to expect risks, to the public
also, which arise out of and I the course of his employment of labor.
Here it was foreseeable that crew members crossing the dry-dock might do
damage, negligently or intentionally.
o NOTE: Many courts have rejected the foreseeability argument and
kept the intent o the agent’s actions.
h. Manning v. Grimsley (1981, p.68)—D plays for the Baltimore Orioles and throws a
baseball at a heckling fan. ISSUE: Can P sue the Orioles for damages as an
agent?
i. HELD: A jury could reasonably have found that such conduct had either the
affirmative purpose to rattle or the effect of rattling the employee so that he
could not perform his duties successfully. Moreover, the jury could
reasonably have found that Grimsley’s assault was not a mere retaliation for
past annoyance, but a reasponse to continuing conduct, which was
presently interfering with his ability to pitch in the game if called upon to
play.
ii. RULE: Where a plaintiff seeks to recover damages from an employer
for injuries resulting from an employee’s assault what must be shown
is that the employee’s assault was in response to the plaintiff’s
conduct which was presently interfering with the employee’s ability to
perform his duties.
5. Statutory Claims
a. Servant concepts also influence the reach of statutes in: (1) Discrimination in
employment, (2) unemployment compensation, (3) worker’s compensation, (4)
social security, and (5) payroll taxes.
b. Arguello v. Conoco, Inc. (71, 2000)—Ps are a group of African American and
Hispanic customers of Conoco who were subjected to racial discrimination while
purchasing gasoline and other services. All three instances occurred at stores that
Conoco claimed were independent stores in Texas. They sue under §1981 makes
it a violation of law to disallow someone to make contracts. In one incident, there is
a company owned store, an the employee Smith, acts out in a violent manner.
i. HELD for Agency relationship between Conoco and Conoco Branded
Stores: Court finds no agency relationship therefore they cannot be liable
for damages to Ps.
o RULE: In order to impose liability on a defendant under §1981 for
the discriminatory actions of a third party, the plaintiff must
demonstrate that there is an agency relationship between the
defendant and the third party.
ii. HELD for Scope of Employment: The court rejects the presumption that
because Smith behaved in an unacceptable manner that she was obviously
outside the scope of her employment. Smith’s position as a clerk and
her authorization from Conoco to conduct sales allowed her to
interact with Ps and put her in the position to commit the racially
discriminatory acts. Thus, summary judgment should not be granted.
6. Liability for Torts of Independent Contractors
a. According to some authorities, the principal is not liable for an independent
contractor’s intentional torts, UNLESS
i. The principal intended or authorized the result or the manner of
performance, or
ii. The principal owed a duty to the injured party to have the agent’s task

20
 performed with care.
b. Some cases that impose liability rest on a finding of control, while others assert that
the principal ratified the wrongful act by not terminating the independent contractor
c. Majestic Realty Associates, Inc. v. Toti Contracting Co. (1959, p.75)—Ps own a
building and the city hires D to tear down some buildings to build a parking deck.
However, D does not use proper procedures for demolishing the buildings, and part
of the demolished building falls on Ps’ building.
i. HELD: On exception to the general rule is that liability may be imposed on
the landowner who engages an independent contractor to do work which he
should recognize as necessarily requiring the creation during its progress of
a condition involving a peculiar risk of harm to others, unless special
precautions are taken, if the contractor is negligent in failing to take those
precautions. Such work may be said to be inherently dangerous. Becaue
the current NY statute is that the razing of buildings in a busy, built up
section of a city is inherently dangerous. Therefore, it fits the exception and
makes the city liable.
ii. GENERAL RULE: Ordinarily where a person engages a contractor who
conducts an independent business by means of his own employees,
to do work not in itself a nuisance, he is not liable for the negligent
acts of the contractor in the performance of the contract.
iii. EXCEPTIONS: (a) where the landowner retains control of the manner and
means of doing the work which is the subject of the contract, (b) where he
engages an incompetent contractor, or (c) where the activity contracted for
constitutes nuisance per se.
iv. Professor thinks this is a good decision.
D. FIDUCIARY OBLIGATION OF AGENTS: Duty of Loyalty and Duty of Care
1. Duties During Agency
a. RULE: If a servant takes advantage of his services and violates his duty of
honesty and good faith to make a profit for his services and violates his duty
of honesty and good faith to make a profit for himself, then he is accountable
for it to his master because the servant has unjustly enriched himself by
virtue of his position (this is true even in the absence of a fiduciary relationship or
actions within the scope of employment).
i. Meaning the assets he controls and his position plays the predominant part
in his ability to obtain the money.
ii. It matters not that the master has not lost any profit or suffered any damage,
nor does it matter that the master could not have done the act himself.
iii. Reading v. Regem (1948, p.80) (Professor Doesn’t Think this case is
important—Didn’t go over)— D accompanied a lorry from one part of Cairo
to another, and he got it because he was a sergeant in the British army, and
while in uniform, escorted these lorries through Cairo. He was violating his
duty in doing so and the military took possession of the Money. HELD:
There was not, in this case, a fiduciary relationship and P was not acting in
the course of his employment; however these are not essential causes of
action. The uniform of the Crown and the position of the plaintiff as a
servant of the Crown were the only reasons why he was able to get this
money, and that is sufficient to make him liable to hand it over to the crown.
b. Duty of LoyaltyAn employee is an agent of the principal, and as such owes
a fiduciary duty to the principal. Under this fiduciary duty to the Principal,
the agent is bound to exercise the utmost good faith and loyalty so that the
agent did not act adversely to the interests of the principal by securing or
acquiring any private interests of his own. The agent is also bound to act for

21
 the furtherance and advancement of P’s interest.
i. General Automotive Manufacturing Co. v. Singer (1963, p.83)—P
employed D as a skilled mechinist-consultant and manufacturer’s
representative to be the general manager. ISSUE: Whether D breached
his contract of employment with P and violated the duty of loyalty, which he
owed to P and his fiduciary duty of general manager thereof during the
existence of such employment by engaging in business activities directly
competitive with P, by obtaining orders from a customer for his own
account. D claims P incapable of doing the work requested by these
customers; however, he did not inform P of the customer’s orders and
instead did the work and kept the profits.
o HELD: As general manager, D was P’s agent and owed a fiduciary
duty to P. D violated the fiduciary duty he owed to P by failing to
disclose all the facts related to the other orders. Therefore, he must
pay P the profits earned from his sideline business.
o Disgorgement (REMEDY) DEFAULT RULE for Agent’s Breach of
Fiduciary Duty of Loyalty If one’s fiduciary duty of loyalty to an
employer is breached, the agent must account to the principal
for the profits made as a result of the breach.
 In this case, D gets a windfall because it was work that they
could not have done in the first place.
 Disgorgement is a harsh arrangement in order to deter
breaching a duty of Loyalty.
o Disclosure (SOLUTION) In most situations where there is a
breach of loyalty, disclosure of the situation would have
prevented the problem.
c. Duty of Care Duty of Care required is basically a reasonable person standard.
i. Negligent injury to third person
o Respondeat Superior—The principal is responsible for the agent’s
actions—DEFAULT RULE –it is what most people would do
o If the injured third person only sues the agent, agent may not be
reimbursed by the principal.
o If the injured third person sues the principal, the principal is entitled
to reimbursement from the agent.
o Insurance can take care of the problem
ii. Negligent injury to Employer
o Principal is entitled to recover from the agent because of the agent’s
carelessness.
o Insurance can take care of the problem.
iii. Incompetent business decision
o If the agent causes extreme loss by exercise of extremely bad
judgment in the operation of the business, the agent may be liable
for his own dereliction, unless the agent made a reasonable decision
that simply turned out badly.
o This makes it difficult for the state to develop a good default rule.
o Insurance will not be available in this case because it is difficult to
write policies about this rule.
iv. Inaccurate information
o Agent has a duty to supply principal with accurate information. If by
virtue of agent’s carelessness this information is seriously
inaccurate, principal may recover based on a theory of negligence or

22
 lack of due care.
o Self-Dealing (a violation of the duty of loyalty) actions may lead
the agent to provide inaccurate information.
o
d. CONTRACTS regarding such duties
i. Insurance for negligent injury to third persons
o Insurance policy is likely to be taken out by the principal.
o It is likely that the agent will insist that principal by protection for him,
or will insist on added compensation so that he can buy his own
policy.
o This is the idea of respondeat superior (default rule)—if most people
thought about this idea they would agree that the principal is in the
better position to compensate through insurance.
ii. Self insurance by employer (damage to employer)
o Self-insurer as to injuries arising from the business
o May execute an Indemnity Agreement under which principal agrees
to indemnify the agent for liabilities that he may occur; however,
principal may not want to insure “gross-negligence,” so this type of
agreement is difficult to word.
o Paul Newman Story—Private Investigator & Rent Harper
o When asking should the law enforce this agreement, then you
should ask the question: What is the harm of enforcement?
iii. Waiver of liability for Negligent injury to Employer
o If principal wants to be a self-insurer, the agreement may not be
enforceable.
o Professor doesn’t see why this would not be enforceable.
iv. Waiver of Liability for incompetent Business decisions
o Suppose the principal agrees to relieve agent of liability for even
seriously defective business decisions, but leaves open the
possibility that agent will be liable for what the principal regards as
an outrageously stupid or careless action.
o If this happens there may be a backlash of the agent’s behavior.
o There is a trade-off between the agent’s over-reaction, leading to the
adoption of conservative, costly, self-productive strategies that will
educe the returns from the business, and covering potential acts of
grossly-careless behavior.
2. Duties During and After Termination of Agency: Herein of “Grabbing and Leaving”
a. Town & Country House & Home Service, Inc. v. Newbery (1958, p.87)—P owns
a home cleaning company using mass production methods. It too P several years
to gather their client list. D worked for P for three years, then quit and formed own,
identical business, contacting same customers. P brought an action to enjoin D
from engaging in the same business at P and from soliciting its customers on a
theory of unfair competition. P claims that because its business is “unique, personal
and confidential,” D cannot engage in the business without breach of the
confidential relationship in which they learned trade secrets and customer lists.
i. ISSUE: Do you have a duty to not misappropriate trade secrets after you
leave an employment.
ii. HELD the Customer Lists are protectable and using them breaches
the duty of loyalty: Although appellants did not solicit P’s cusomters until
they were out of P’s employ, nevertheless P’s customers were the only
ones they did solicit. It would be different if these customers had been
equally available to P and D, but these customers had been screened by P

23
 at considerable effort and expense, without which their receptivity and
willingness to do business with this kind of a service organization could not
be known.
iii. RULE for Trade Secrets: Even where a solicitor of business does not
operate fraudulently under the banner of his former employer, he still may
not solicit the latter’s customers who are not openly engaged in business in
advertised locations or whose availability as patrons cannot be readily
ascertained but whose trade an patronage have been secured by hears of
business effort and advertising and the expenditure of time and money,
constituting part of the good will of a business which enterprise and
foresight have build up.
o Must take actions to maintain secrecy.
o Economic Trade-Offs prevent promotion of competition
iv. NOTE: Unfair Competition claims are business torts Difficult because
all benefit from competition (cheaper prices, better quality); however, the
party with the claim is impaired by such competition.
E. SPECULATION ON RELATIONSHIPS AMONG RISK, RETURN, CONTROL, DURATION, AND
SPECIFICITY
1. RISK AND RETURN
a. Attitudes towards Risk:
i. Risk Preferring
ii. Risk Neutral
iii. Risk Averse
b. Lottery Example: Each lottery ticket has a 1/1,000,000 probability of being the
winning ticket. The payoff of wining the ticket will be $1,000,000.
i. Expected Value (EV) of Any ticket = 1/1,000,000 x $1,000,000 = $1
ii. Maximum Amount a person would pay for a ticket:
o > $1—Risk Preferring (gambler)—will pay more than the expected
value
o $1—Risk Neutral—will pay expected value
o < $1—Risk Aversion—not willing to pay the expected value.
c. If looking at businesses larger than those that are an extension of a person, most
businesses will make decisions as if they are risk neutral.
d. Most people are risk averse in their major economic decisions—risk aversion.
Thus, people are willing to pay to achieve their desired safety and security. They
will only accept risk if they are paid to do so.
i. Because people don’t like risk they buy insurance.
e. Ex. If the expected rate of return on a first mortgage investment in a piece of
property, or a business, is 10%, the expected rate of return on the underlying equity
in that enterprise will be several points higher.
f. As risk rises, expected rate of return or required payment will rise. As a
result, the residual claim in any enterprise will have a higher expected rate of
return than a fixed claim in the same enterprise.
2. RISK AND CONTROL
a. “Control follows risk”
b. Probabilities must always add up to 1.
i. Prob. Payoff
ii. .25 0 0
iii. .60 100,000 60,000
iv. .15 10,000,000 1,500,000
v. EV= 1.560,000
c. Whoever bears the risk calls the shots.

24
 d. The holders of the equity (or residual) claim in a firm are more likely to be
interested in and have control of the firm than are the holders of debt, or the fixed
claim.
e. Equity investors will want to have the power to select the managers and to make
certain fundamental decisions.
3. DURATION AND SPECIFICITY
a. In a short-term relationship there may be relatively little need for elaborate rules
specifying rights and obligations and the cost of supplying such rules may seem
high in relation to their expected value. The rules established by common law and
statute (DEFAULT RULES), though perhaps simple and basic, may seem
adequate.
b. As duration of the relationship increases, the likelihood of changes in
circumstances seriously affecting the relationship increases and the need for
spelling out the consequences of those changes in circumstances may increase.
c. Must consider value of transaction with the costs of negotiation of tailor-made
provisions.
4. DURATION AND CONTROL
a. There may be reasons to expect specificity (private rule elaboration) to increase
with duration of employment; however, at some point the process must end.
b. Constraints on specificity may require generalized participation in control of the
enterprise.
c. COASE (above)
5. DURATION AND RISK
a. As the duration of an investment or relationship increases, certain risks associated
with that investment or relationship may increase, though other risks may decrease.
b. Long-term employment contract may reduce the employee’s risk of
unemployment; at the same time, as the employees skills become specific to the
firm or as other barriers to relocation evolve, such a contract may make the
employee’s fortunes dependent to some significant degree on the success or
failure of the firm.
6. RISK AND CONTROL—OWNERS AND EMPLOYEES Control Is associated with
risk, which is in turn associated with ownership and ownership alone.
F. DISTINGUISHING AGENCY FROM OTHER RELATIONSHIPS

II. Partnerships
A. What is a Partnership and Who are Partners?
1. A creature of contract and of statute.
2. UPA § 9—Partnership—An association of two or more persons to carry on as co-
owners a business for profit.
a. A partnership arises when two or more persons manifest an intention, which can be
by word or conduct
3. Uniform Partnership Act (1914)—1/2 States
4. Revised Uniform Partnership Act (1997)—1/2 States
5. § 18 of UPA key language is “subject to any agreement between them”
6. Determining who is a partner is important because the rule of partnership law makes each
partner potentially liable for all of the debts of the partnership.
7. Partnership:
a. An unincorporated business, intended to make a profit,
b. Which has two or more participants, who may be either individuals or entities,
c. Each of whom brings something to the party, such as efforts, ideas, money,
property, or some combination,
d. Each of whom co-owns the business

25
 e. Each of whom has a right to co-manage the business, and
f. Each of whom shares in the profits of the business.
8. Element Considered when determining the existence of a partnership
a. Intent of the Parties
b. Right to share in profits
i. Not necessary to have actual profits
ii. Difference in profit sharing and revenue sharing
iii. RUPA § 220(c)(3) A person who receives a share of the profits of a
business is presumed to be a partner in the business, unless the profits
were received in payment:
o Of a debt by installments or otherwise
o For services as an independent contractor or of wages or other
compensation of an employee
o Of rent
o Of an annuity or other retirement or health benefit to a beneficiary,
representative, or designee of a deceased or retired person
o Of interest or other charge on the loan, even if the amount of
payment varies with eh profits of the business, including a direct or
indirect present of future ownership of the collateral, or rights to
income, proceeds, or increase in value derived from the collateral; or
o For the sale of the goodwill of a business or other property by
installments or otherwise.
c. Obligation to share in losses
i. While this increases the co-management and co-ownership aspects of the
relationship, neither the UPA nor the RUPA mentions loss sharing as a
prerequisite. They instead treat it as a consequence of partnership
d. Ownership and control of the partnership property and business
i. Uniform Partnership Act, § 18 “The rights and duties of the partners in
relation to the partnership shall be determined, subject to any agreement
between them, but he following rules: . . . (e) All partners have equal rights
in the management and conduct of the partnership business.”
e. Community of power in administration
f. Language of the agreement
g. Conduct of the parties toward third persons
h. Rights of the parties on dissolution and appearance.
i. UPA, § 31 “Dissolution is caused: (1) Without violation of the agreement
between partners, . . . (b) By the express will of any partner when no
definite term or particular undertaking is specified.”
i. Limited Liability Companies are taking over as the primary form of small
business organization. However, courts have borrowed partnership laws in order to
set the boundaries for LLCs. Will most likely take over partnerships eventually.
9. PARTNERS COMPARED WITH EMPLOYEES
a. Fenwick v. Unemployment Compensation Commission (1945, p.91)—P
operated a beauty shop and employed Chesire as a cashier and receptionist, with a
salary of $15 per week. Chesire wanted a salary increase, and P offered to sign an
agreement that he would pay her more money if the income of the shop warranted
it. The agreement called their relationship a partnership and allowed her to receive
20% profit, if warranted. However, P retained full control of the operations, all
obligation of loss, etc. Additionally, the parties intent was only a pay increase.
i. HELD: Under all these circumstances, giving due effect to the written
agreement and bearing in mind that the burden of establishing a
partnership is upon the one who alleges it to exist, a partnership has

26
 not been established because the essential element of co-ownership is
lacking. The agreement between these parties was nothing more than one
to provide a method of compensation for work performed. She had no
authority or control in operating the business, she was not subject to losses,
and she was not held out as a partner.
ii. This case is almost the opposite of the Cargill case.
10. PARTNERS COMPARED WITH LENDERS
a. Martin v. Peyton (1927, p.96)—Important to Professor b/c Classic Case-Professor
draws significant comparisons between Cargill and Marin —Hall, a partner in
KN&K, made a trustee/lender agreement with friends, Ds. Ds loaned $2,500,000 to
KN&K in liquid securities to use for collateral. In exchange, KN&K gave Ds KN&K
securities (that were too speculative to give as collateral to banks) and 40% of the
profits of the firm until the loan was paid off (not to exceed $500,000 or less than
$100,000), as well as an option to join the firm. Because P only accuses Ds of an
actual partnership, the court does not look at conduct of parties. ISSUE: Are they
coowners in the business for profit?
i. HELD: Looking at the three agreements as a whole, no partnership existed.
It is quite true that even if one or two or three like provisions contained in
such a contract do not require this conclusion, yet it is also true that when
taken together a point may come where stipulations immaterial separately
cover so wide a field that we should hold a partnership to exist. The
question of degree is often the determining factor, and that degree
has not been reached.
o $1,000,000 life insurance policy on Hall’s life belongs to the Trustees
—this does not create a partnership and is not imply an unusual
association because trustees knew only Hall and new firm had
almost gone into bankruptcy due to unsafe speculation.
o Advising, inspecting, and maintaining power to veto highly
speculative or injurious business is a proper precaution to secure a
loan, provided the trustees cannot initiate actions.
o Assignment of interest in firm, prohibiting loans to members (no
“draws) are nothing but proper security for a loan when the firm may
dissolve at any time,
o Option is somewhat unusual, but not determinative.
ii. Indenture A mortgage of the collateral delivered by the debtor to the
trustees to secure the performance of the agreement.
iii. NOTE: Hall was not their agent because they had no right to control Hall.
Whereas in Cargill there was actual control.
iv. MORAL: High Return, High Risk
v. Basically, by adding together a bunch of minor issues you get something
important.
b. Expected value example on p. 100, note 2
i. $20 million in debt with only $12 million in assets.
ii. Offer to invest $1 million in order to have a 1/40 chance in getting $20
million in return.
iii. EV = 1/40 x 20M/1m = $500,000
iv. Bad investment because investment costs $1 million, but the return is only
$500,000.
c. Government Sponsored Entities (GSEs)—Freddie Mac and Fannie may—Hold
worthless mortgages ($5 trillion dollars) because they gave loans to people who
couldn’t afford them. Fannie may and Freddie mac were taking these long shot
bets (as the one above) because the money was coming from the public.

27
 d. Southex Exhibitions, Inc. v. Rhode Island Builders Association, inc. (2002,
p.101)—P’s predecessor in interest (SEM) and D entered into an Agreement in
1974, calling themselves “sponsors and partners.” However, the agreement
provides that SEM will produce home shows conducted at the providence civil
center and pay and indemnify D for all the costs (P incurs 100% of losses). In
return, D will not use any other company. The two parties will split profits 55/45 for
a fixed term of 5 years, subject to mutual renewal. SEM’s President also
expressed that he did not want ownership of the show. Then SEM took control,
they indicated a desire to terminate the contract or renegotiate its terms. D simply
entered into another production contract and D sued, claiming a breach of the
fiduciary duty owed to partners.
i. HELD: A partnership was not created because one must look at the totality
of the circumstances, despite the legal labels assigned to an intended
relationship. The follow are the factors used to determine the lack of a
partnership:
o No sharing of losses (not determinative, but it helps!—This tips the
scale in this case)
o P did not conduct itself as belonging to a partnership—conducted
business in own name, rather than that of the partnership,
partnership never given a name, and never filed a partnership tax
return
o No ownership interest in tangible property “In the present
circumstances (involving intangible intellectual property), the
requisite mutual intent to convert intangible intellectual properties
into partnership assets may well depend much more importantly
upon a clear contractual expression of mutual intention to form a
partnership.
o Even though the UPA explicitly identifies profit sharing as a
particularly probative indicium of partnership formation, it does not
necessarily follow that evidence of profit sharing compels a
finding of partnership formation.
ii. Theory of the Case: D wrongfully dissolved the partnership and as a result,
P should receive damages as well as the right to the trade show.
B. The Fiduciary Obligations of Partners
1. Partners owe each other a fiduciary duty of loyalty. This duty can be divided into 2
Categories:
a. Issues relating to the conduct or interests of the partnership’s business—
selfishness not allowed without consent of other partners
b. Issues relating to differences of interests between or among partners—less strict
and less clear rules
2. Meinhard v. Salmon (1928, p.109)—MOST IMPORTANT CASE OF SEMESTER—
Concerns a joint venture rather than a partnership, but applicable to partnerships. D signs
a 20 year lease with Gerry, for the Bristol Hotel property and independently agrees with P
to obtain the necessary funds. P and D’s agreement provides that P will pay half the
moneys required to reconstruct the property into retail stores, and in return P will receive
40% profits for the first five years and 50% of the profits for the remaining 15 years. Each
party bore the losses equally, but D had the sole power of management. 4 months prior to
the end of the lease, Gerry offers an 80 year lease to D. D accepts the offer on his own
behalf, but does not inform P of the offer or of the agreement.
a. RULE: Joint adventurers, like copartners, owe to one another, while the
enterprise continues, the duty of the finest loyalty. Many forms of conduct
permissible in a workaday world for those acting at arm’s length are

28
 forbidden to those bound by fiduciary ties. A trustee is held to something
stricter than the morals of the marketplace. Not honesty alone, but the
punctilio of an honor the most sensitive, is then the standard of behavior.
i. Punctilio every point is nailed down and as it should be
ii. The question is why doesn’t every plaintiff get an award when there is a
breach of the duty of finest loyalty?
b. HELD: The two were coadventurers, subject to fiduciary duties akin to those of
partners (this sentence here is the key difference between the dissent and the
majority—Cardozo decides the case in paragraph 3, determining that the joint
venture was the same as a partnership, requiring a fiduciary duty) “The two were in
it jointly, for better or for worse.” (What is it that they were in jointly? Cardozo sees
it as extending beyond the original lease, whereas Andrews believed that it was
only the single lease). P and D were joint adventurers, placing a duty upon D to
concede his knowledge to P. The very fact that D was a in control with
exclusive powers to direction charged him with even more with the duty of
disclosure, since only through disclosure could opportunity be equalized.
Therefore, even though D was not guilty of purposely trying to defraud P, he
breached his fiduciary duty and the price of denial is an extension of that trust at
the option and for the benefit of the one whom he excluded.
i. “Pre-emptive privilege, or better yet, pre-emptive opportunity, that was thus
an incident of the enterprise, D appropriated to himself in secrecy and
silence. He might have warned P that the plan had been submitted, and
that either would be free to compete for the award. IF he had done this, we
do not need to say whether he would have been under a duty, if successful
in the competition, to hold the lease so acquired for the benefit of the
venture then about to end, and thus prolong by indirection its responsibilities
and duties. The trouble about his conduct is that he excluded his co-
adventurer from any chance to compete, form any chance to enjoy the
opportunity for benefit that had come to him alone by virtue of his
agency.”
ii. If there is an opportunity “ lacking any nexus of relation between the
business conducted by the manager and the opportunity brought him
is an incident of management,” then D would not have a duty to disclose
the information. It is a question of degree. Because in this case, the
subject-matter of the new lease was an extension and enlargement of the
subject matter of the old one.
c. REMEDY: Because the parties intended for D to manage the operations, the
number of shares to be allotted to P should be reduced to such an extent as may
be necessary to preserve to D the expected measure of control and dominion;
therefore, an extra share should be added to D’s half. P’s equitable interest is to be
measured by the value of half of the entire lease, and not merely by half of some
undivided part. Thus, P obtains 49% of the shares and D 51% of the shares.
i. The court is trying to make it easier for D to by P out because the two
obviously hate each other now.
d. DISSENT (ANDREWS): If this were a partnership, then he would be agree with the
majority outcome, and these two parties would owe a duty to disclose the
opportunity of a new lease. However, Andrews didn’t believe this was a
partnership and therefore, did not believe that these rules applied.
e. NOTE: The reason this case did not discuss the existence of a partnership are that
the Plaintiff did not give this line of argument.
f. Questions:
i. Why Didn’t Meinhard ask in 1922 what was happening with the lease?

29
 ii. Would this door swing both ways? Could Salmon have sued Meinhard if
the venture had failed and he needed money?
g. NOTE: Cited in over 1000 published state court opinions.
h. This case is full of good rhetoric.
i. HYPOTHETICAL BARGAIN / Parties Expectations had the parties wanted the
agreement to extend past the twenty years of the lease, then they would have
provided for an extension in their lease.
i. Should the case be decided based upon what the parties intended when
they entered into the agreement.
o Salmon’s strongest argument is that the plain language of the
agreement would tell the court the true intentions of the parties.
ii. OR should the case be decided based upon what most people would
hypothetically agree to/ expect to be true.
iii. Cardozo’s strongest argument is that this rule what most parties would have
contracted for at the outset.
3. BIG QUESTION: Should you allow parties to contract out of fiduciary duties?
4. If the rule supplied by law is inconsistent with what the parties would have wanted (as
suggested by Cardozo) then, as has previously been suggested, the parties will be forced
to engage in possibly costly efforts to shape a rule fitting their true intentions. If they fail to
do so through ignorance to do so, then the possibility of unfair outcomes arises.
a. There may be compelling, entirely legitimate economic considerations that require
a restrictive rule on the obligation to share information or opportunities.
b. The vagueness of the rule of fiduciary obligation may require the adoption of
express agreements that seem to go too far in denying any such obligation. And
greater precision may be impractical.
c. Investors confronted with such a provision might be willing to accept it if, and only
if, the promoters reputation is good—only if the promoter has a good record.
5. Sometimes the law reifies a corporation/partnership treats it as a single entity/unit,
separate from the the individuals.
6. RUPA § 404—General Standard of Partner’s Control
a. (a) The only fiduciary duties a partner owes to the partnership and the other
partners are the duty of loyalty and the duty of care set forth in subsections (b) and
(c)
b. (b) A partner’s duty of loyalty to the partnership and the other partners is limited to
the following:
i. to account to the partnership an hold as trustee for it any property, profit, or
benefit derived by the partner in the conduct and winding up of the
partnership business or derived from a use by the partner of partnership
property, including the appropriation of a partnership opportunity;
ii. to refrain from dealing with the partnership in the conduct or winding up of
the partnership business as or on behalf of a party having an interest
adverse to the partnership; and
iii. to refrain from competing witht eh partnership in the conduct of the
partnership business before the dissolution of the partnership.
c. (c) A partner’s duty of care to the partnership and the other partners in the
conducting and winding up of the partnership business is limited to refraining from
engaging in grossly negligent or reckless conduct, intentional misconduct, or a
knowing violation of the law
i. Business Judgment Rule (BJR)
o See Bane below and determine whether it would fit into this rule?—It
is a line drawing issue.
o How aggressive should courts be with the requirements of “gross

30
 negligence”?
o Coco-Cola Example
d. (d) A partner shall discharge the duties to the partnership and the other partners
under this act or under the partnership agreement and exercise any rights
consistently with the obligation of good faith and fair dealing
e. (e) A partner does not violate a duty or obligation under this Act or under the
partnership agreement merely because the partner’s conduct furthers the partner’s
own interest.
f. (f) A partner may lend money to and transact other business with the partnership,
and as to each loan or transaction, the rights and obligations of the partners are the
same as those of a person who is not a partner, subject to other applicable law.
7. A partner is prohibited from:
a. Competing with partnership
b. Taking business opportunities from which the partnership might have
benefited or that the partnership might have benefited or that the partnership
might have needed
c. Using partnership property for personal gain
d. Engaging in conflict-of-interest transactions
i. Can’t do business with a partner himself, a closely related member of the
partner’s family, an organization in which the partner has a material financial
interest, or any other person whose interests are adverse to the partnership.
8. REMEDIES for breach of Fiduciary Duty of Loyalty:
a. Disgorgement of profits gained through disloyal act.
b. Do not have to prove damages
c. Rescinding the contract
9. AFTER DISSOLUTION
a. RULE: A partner is a fiduciary of his partners, but not of his former partners,
for the withdrawal of a partner terminates the partnership as to him.
b. Bane v. Ferguson (1989, p.115)—ISSUE: Whether a retired partner in a law firm
has either a common law or a statutory claim against the firm’s managing council
for acts of negligence that, by causing the firm to dissolve, terminate his retirement
benefits?
i. HELD: Bane ceased to be a partner when he retired. The pension plan id
not establish a trust and even if, notwithstanding the absence of one, the
plan’s managers were fiduciaries of its beneficiaries, the mismanagement
was not of the plan but of the firm. There is no suggestion that the Ds failed
to inform Bane of his rights. Business Judgment Rule (BJR)—And even if
the Ds were fiduciaries of Bane, the business judgment rule would yield
them from liability for mere negligence in the operation of the firm.
o The Business Judgment Rule is a line-drawing judgment—Looking
to the RUPA above, would it fit under this limitation on “gross
negligence.”
ii. NOTE: If there were fraud, then it would be a duty of care, but in this case
there is no breach of duty of care, but merely negligent mismanagement.
iii. NOTE: Bane is not a partner, but an individual with a contract.
iv. NOTE: It is incredible difficult for a plaintiff to win a Duty of Care Claim.
10. GRABBING AND LEAVING
a. Fiduciaries may plan to compete with the entity to which they owe allegiance,
provide that in the course of such arrangements they do not otherwise act in
violation of their fiduciary duties. However, a partner has an obligation to
render on demand true and full information of all things affecting the
partnership to any partner.

31
 b. Courts will look to the ABA committee of Ethics and Professional Responsibility,
stating that any notice explained to a client that he or she has the right to decide
who will continue the representation, for general guidelines as to what partners are
expect from each other concerning their joint clients on the division of their practice.
i. In sending the letter you should not recommend your own employment.
Should be very objective and explain to them the options.
c. Meehan v. Shaughnessy (1989, p.1989)—Ps terminated their relationship with Ds
to start their own firm, MBC because they wanted more money for the work they
were doing. In a cross-claim, Ds claimed Ps breached their duty of fiduciary duties,
breached the partnership agreement. At the time of leaving, Ps had 6% and 4.8%
of the firm’s interest. They recruit other members of the firm while still working and
refuse to give names of the clients they were taking with them. Also, the sent one-
sided letters on firm letterhead to former clients and referring council requesting
those individuals come with them.
i. HELD: The logistical arrangements to establish a new firm were
permissible; however, they breached their fiduciary duties by unfairly
acquiring consent from clients to remove cases from Ds. Through their
preparation for obtaining clients’ consent, their secrecy concerning which
clients they intended to take, and the substance and method of their
communications with clients, obtained an unfair advantage over their former
partners in breach of their fiduciary duties. Also, the content of the letter
sent to the clients was unfairly prejudicial to Ds because it was onesided.
ii. NOTE: Ingenious provisions in the Partnership agreement “A voluntarily
retiring partner, upon the payment of a “fair charge”, could remove any
matter in which the partnership had been representing the client who came
to the firm through the personal effort or connection of the retiring partner,
subject to the right of the client to stay with the firm.
o Ambiguity—is it always obvious whether the client came to the firm
through the attorney? What if he was one of several factors
inducing the client to come?
o What is “fair charge”?
d. The UPA default rules don’t work so well for law firms and other service
businesses.
11. EXPULSION
a. UPA § 31—“Dissolution is caused (1) Without a violation of the agreement
between partners. . . (d) By the expulsion of any partner from the business bona
fide in accordance with such power conferred by the agreement between the
partners.
b. RULE: If the power to involuntarily expel partners granted by the partnership
agreement is exercised in bad faith or for a predatory purpose, the
partnership agreement is violated, giving rise to an action for damage the
affected partner has suffered as a result of his expulsion.
i. The fiduciary relationship between partners to which the terms bona fide
and good faith relate concern the business aspects or property of the
partnership and prohibit a partner, to wit a fiduciary, from taking any
personal advantage touching those subjects.
c. RULE: Where the remaining partners in a firm deem it necessary to expel a
partner under no cause expulsion clause in a partnership agreement freely
negotiated and entered into, the expelling partners act in “good faith”
regardless of motivation if that act does not cause a wrongful withholding of
money or property legally due to the expelled partner at the time he is
expelled.

32
 d. Lawlis v. Knightlinger & Gray (1990, p.125)—P had an alcohol problem, and
when he finally to the firm in which he was a senior partner, the firm signed an
agreement with him to get him back on track. P then had a relapse and he gets a
second chance, with another program outline, which he follows. Nevertheless, the
partner vote 9 to 1 (P’s one vote as the 1) to expel him. P had agreed to the
procedure used to expel him.
i. HELD: P was expelled in accordance with the partnership agreement. The
partnership acted in good faith, therefore, there is no breach of duty. At the
time the partners negotiated the contract, they believed in the “guillotine
method” of involuntary severance as in the best interests of the partnership.
Therefore, there is no breach of duty in his expulsion because he voluntarily
agreed to the method. Their intent was to provide a simple, practical, and
above all, a speedy method of separating a partner from the firm if
necessary.
ii. NOTE: Would you agree to a no cause expulsion clause? Less trial, but
more efficient.
iii. What about Meinhardt? Mienhardt stretches in the opposite direction.
C. PROFESSOR NOTE: 1913, Art. I, § 8—According to Professor, the AIG loan from the
Government (bailout) is not constitutional.
D. The Entity and Aggregate Concepts
1. There is a strong tendency to reify corporations—refer to the entity and the individuals who
make up the corporation in the aggregate as one entity This is a less significant
phenomenon in partnerships because there is more of a tendency to treat partnerships as
entities separate and distinct from their owners.
2. The reification distinction has important legal consequences:
a. The business is treated as something separate from its owners, as having an
existence of its own, and
b. The assets are thought of as a bundle rather than as specific separate items.
E. Partnership Property
1. Under UPA, a partnership 3 Property Rights:
a. Rights in specific partnership property
i. Partnership tenancy possessory right of equal use or possession by
partners for partnership purposes (like a joint tenancy).
ii. This possessory right is incident to the partnership and the possessory right
does not exist absent the partnership.
b. Interest in the partnership
i. An undivided interest, as a co-tenant in all partnership property. That
interest is the partner’s pro-rata share of the net value or deficient of the
partnership. For this reason a conveyance of partnership property held in
the name of the partnership is made in the name of the partnership and not
as a conveyance of the individual interest of the partners.
c. Right to participate in Management.
2. Putnam v. Shoaf (1981, p.132)—P sells her ½ interest of her partnership interest to D.
After this transfer, they discover that the old bookkeeper had been embezzling money, and
P wants to intervene to recover funds paid by the banks.
a. HELD: Mutual ignorance does not warrant a reformation of the contract for sale of
the partnership interest, or warrant a decree in favor of the transferor for a share of
the value of the oil. Wheat would be the position of P, had the company failed,
leaving a sizeable deficit. Would she accept a partner’s share of the company’s
liabilities? NO. She did not have a specific interest in any specific assets fo the
company, either to retain or convey. All she had was a partner’s interest in a share
of the profits which she certainly intended to convey.
b. P could only sell all of her interest in the partnership. She could not sell a
33
 specific interest in the lawsuit, but not remain a partner.
3. Tenancy in partnership
a. UPA § 24—Extent of Property Rights of a Partner—“The property rights of a
partner are (1) his rights in specific partnership property, (2) his interest in the
partnership, and (3) his right to participate in the management.”
b. UPA § 25—Nature of a Partner’s Right in Specific Partnership Property—
i. (1) “A partner is co-owner with his partners of specific partnership property
holding as a tenant in partnership.
ii. (2) The incidents of this tenancy are such that:
o (a) A partner, subject to the provisions of this act and to any
agreement between the partners, has an equal right with his
partners to possess specific partnership property for partnership
purposes; but he has no right to possess such property for any other
purpose without the consent of his partners.
o (b) A partner’s right in specific partnership property is not
assignable except in connection with the assignment of rights of all
the partners in the same property.
o (c) A partner’s right in specific partnership property is not subject to
attachment or execution, except on a claim against the partnership.
When partnership property is attached for a partnership debt the
partners, or any of them, or the representatives of a deceased
partner, cannot claim any right under the homestead or exemption
laws.
o (d) On the death of a partner his right in specific partnership
property vests in the surviving partner or partners . . .”
c. UPA § 26—Nature of Partner’s Interest in the Partnership—“A partner’s interest
in the partnership is his share of the profits and surplus, and the same is personal
property.”
4. May not want the right to sell the ownership interest to be alienable because you are
responsible for the other’s actions.
F. Contributions, Accounts, and Returns
1. Capital contribution does not necessarily control the sharing of gain and loss, and shares
of gain may differ from shares of loss, depending upon the agreement.
2. “Draw” Cash distributions to partners. The amount of the draw of each partner is
determined by majority vote of the partners, and it may be more or less than the profit.
3. The effect of deducting depreciation from gross revenues at the partnership level will be to
allocate depreciation according to profit share—equally among all partners. However,
might be wise to agree initially to allocate depreciation in accordance with some other
formula for tax reasons, such as pro rata according to initial capital contribution.
4. A partner’s share of profit can be thought of as something he or she has earned and
reinvested in the firm.
G. Raising Additional Capital
1. “Dilution” the process of adjusting ownership shares to take account of additional
capital contributions and changes in the value of the business.
2. PROBLEM—Guy needs $10,000,000 to start a company. He puts in $1,000,000 and 40
partners invest the remaining $9 million. He comes up short and needs another $500,000
to complete the building. But if they sell the building now, they can sell it and get no
money returned. There is no provision in the partnership agreement covering the need for
additional capital. Must assume you are not acquainted with any of the other partners.
3. #1 shows problem of Transaction Costs and Free-Riders--COASE. This is part of the
problem dealing with Externalities.
a. Also demonstrates the Prisoners’ Dilemma—Problems with cooperation and

34
 coordination. You can cooperate or defect. Joint, maximizing outcome is for both
people to cooperate. But if someone defects, and there is an incentive to defect,
then it is difficult to make someone to cooperate, especially when there is no
penalty for failing to cooperate.
b. So, how do you draft an agreement to provide an incentive for investors to
cooperate and provide extra capital.
4. Pro-Rata Dilution—A provision addressing the issue of a possible need for capital. A
commonly used provision permits the managing partner to issue a call for additional funds
and provides that if any partner does not provide the funds called for her or his share is
reduced, according to existing formulas. The increase in th share of the profits and capital
of a partner contributing additional capital is determined with reference to the current value
of the business.
a. Answer to question at bottom of 137—Correct price is $500 each for 1000 new
points. Also look to page 87 in K&C
5. Ask partner to agree to be responsible for any shortfall.
6. Penalty Dilution—The partnership agreement might provide that if the managing partner
determines that additional funds are needed, new points will be offered to the partners at a
set price. If you don’t cooperate and give more money, your percentage of interest will be
diluted even more than in pro-rata.
a. Subject to abuse.
b. Without prior agreement, it may be impossible to reduce the percentage interest of
a partner; a change in the partnership share is a fundamental change that requires
consent.
7. Can also require partners to make loans to the partnership pro-rata, when called upon to
do so. The loans might bear a larger interest rate with no distributions to be made to the
partnership until the full amount of the loan and interest are paid.
a. Subject to abuse
8. 17 U.C. Davis Rev. 341 (1983)
9. LOOK TO K&C for more detail
H. Rights of Partners in Management (CONTROL)
1. 3 Basic Rules with Partnerships (absent contrary agreements):
a. (1) Control
i. UPA § 18(e)—in the absence of an agreement to the contrary, “all partners
have equal rights in the management and conduct of the partnership
business.”
o MAJORITY RULE= 1 partner, 1 vote
o ALTERNATIVE CONTRACTUAL AGREEMENTS—Could allocate
voting power based upon initial capital contributions OR delegate
decision making power to a small group.
o Professor says: Give all business decision power to the executive
committee.
ii. UPA § 18(h)—“Any difference arising as to ordinary matters connected with
the partnership business may be decided by a majority of partners.”
o Thus, if there are three partners and they disagree as to any
ordinary matter, the decision of the majority controls.
o ALTERNATIVE CONTRACTUAL AGREEMENTS—Instead of
looking making decisions based upon a majority of partners, could
require unanimous vote for important decisions. If a partnership of 5
or more, could require a 2/3rds vote.
b. (2) Agency,
i. UPA § 9 Every partner is an agent of the partnership for purposes of its
business, and the act of every partner for apparently carrying on in the

35
 usual way the business of the partnership binds the partnership.
ii. Agency can be limited by express terms of an agreement, but no limitation
is effective against a person doing business with the firm unless it has been
communicated to that person.
c. (3) Liability.
i. Each partner may be held personally liable for the full amount of any
partnership debt that is not satisfied from the partnership property.
However, this rule has been modified in many states.
ii. UPA § 15—joint and several liabilities in partnerships
2. Bromberg & Ribstein—The Treatise on Partnerships
3. National Biscuit Company v. Stroud (1959, p.140)—D advised P that he did not want
anymore bread; however, D’s partner, Freeman, called up P and told him to continue
delivering, which P did. D’s partnership dissolves.
a. HELD: Freeman was a general partner to D with no restrictions on his authority to
act within the scope of the partnership business. D could not restrict the power of
Freeman to buy bread, for such was an ordinary matter connected with the
partnership business, for the purpose of its business and within its scope, because
in the very nature of things D was not, and could not be, a majority of partners.
Therefore, freeman’s purchase of bread bound D.
b. You can require unanimous consent, agree that one party has overriding power,
etc. Ultimately when there are problems you have to dissolve the partnership.
4. Day v. Sidley & Austin (p.1977, p.146)—P was an underwriting partner in D’s Washington
office, and when the firm merged with another firm, D lost his position and the firm moved
the Washington office to the other firm’s location. Admission, severence, and participation
are voted on by all partners and there must be a majority vote. For an amendment need
3/4 ths vote.
a. HELD: There is no basis for fraud because P was not deprived of any legal right as
a result of his reliance on his statement. Having read and signed the partnership
agreements, which implicitly authorized the Executive committee to create, control,
or eliminate firm committees, plaintiff could not have reasonably believed that the
status of the Washington Office Committee was inviolate and beyond the scope
and operation of the Partnership agreement. Thus, since P had not right to remain
chairman of the Washington Office, a misrepresentation regarding his chairmanship
does not form the basis for a cause of action in fraud.
5. Continuation Agreements—An agreement containing a provision specifying that the
remaining partners will continue as partners under the existing agreement.
a. Under UPA, the partnership is technically dissolved when a partner leaves.
b. Under RUPA it is called dissociation.
c. When there has been siddociation, the partnership continues as to the remaining
partners and the dissociated partner is entitled, in the absence of an agreement to
the contrary, to be paid and amount determined as if on the date of dissociation,
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, plus interest from the date of dissociation.
I. Partnership Dissolution
1. Develop a Dissolution agreement BEFORE the partnership is created. Can talk
about it more clearly before a disagreement occurs.
2. Disolution of Contravention means wrongful dissolution.
3. UPA § 40—Rules for Distribution of Funds at Dissolution—“In settling accounts
between the partners after dissolution, the following rules shall be observed, subject to any
agreement to the contrary:
a. (a) The assets of the partnership are: (I) The partnership property, (II) the

36
 contributions of the partners necessary or the payment of all the liabilities specified
in clause (b) of this paragraph.
b. (b) The liabilities of the partnership shall rank in order of payment, as follows:
i. (I) Those owing to creditors other than partners,
ii. (II) Those owing to the partners other than for capital profits
o Partner gets any loan money returned. If there is not enough money
to repay the partner’s loan, then the partners must contribute their
pro-rata share of ownership (including the partner to be repaid) in
order to create that amount.
iii. (III) Those owing to partners in respect of capital,
o Partner gets back his original capital contribution
o In the absence of an agreement to the contrary, no partner will be
entitled to interest on his/her capital account.
iv. (IV) Those owing to partners in respect of profits.
o Partner gets his percent of profits remaining, if available
4. RIGHT TO DISSOLVE
a. Term established in contract: In certain cases, a partner may have reason to
want to dissolve the partnership, but if he does so, it will be deemed a wrongful
dissolution. In that case, he may seek a judicial dissolution. If a court dissolves the
partnership, the partner who is seeking to et out can not be sued by other partners.
This is a reason to take the route of judicial dissolution as opposed to merely
dissociating and causing a wrongful dissolution—Like staying in a Bad Marriage
b. A court may order the dissolution of a partnership where there are
disagreements of such a nature and extent that all confidence and
cooperation between the parties has been destroyed or where one of the
parties by his behavior materially hinders a proper conduct of the
partnership business.
i. Owen v. Cohen (1941, p.152)-- Owen, who had entered into an oral
agreement with Cohen whereby they contracted to become partners in the
operation of a bowling alley business, sought judicial dissolution of the
partnership because the agreement did not expressly fix duration and the
two were no longer able to get along.
o HELD: Where there are only minor differences and grievances that
involve no permanent mischief, a court should not issue a decree to
dissolve a partnership. On the other hand, one partner cannot
constantly minimize and deprecate the importance of the other, as in
this case, without undermining the basic status upon which a
successful partnership rests. Therefore, partnership is dissolved.
o GET IT IN WRITING!
o Courts have a lot of discretion in determining dissolution
o The reasoning of this case is similar to the “Doctrine of Unclean
Hands”—Cohen was acting inappropriately, so he was ruled against.
ii. UPA § 32—“On application by or for a partner, the court shall decree a
dissolution whenever:
o (a) a partner has been declared a lunatic in any judicial proceeding
or is shown of unsound mind,
o (b) A partner becomes in any other way incapable of performing his
part of the partnership contract.
o (c) A partner has been guilty of such conduct as tends to affect
prejudicially the carrying on of the business,
o (d) A partner willfully or persistently commits a breach of the
particular agreement, or otherwise so conducts himself in

37
 matters relating to the partnership business that it is not
reasonably practicable to carry on the business in partnership
with him,
o (f) Other circumstances render a dissolution equitable.”
 This provision is a safe harbor to prevent a party getting sued
for wrongful dissolution because we don’t want to force
people together who can’t get along.
iii. UPA § 801(5)— a partnership is dissolved “on application by a partner, by a
judicial decree that: (i) the economic purpose of the partnership is likely to
be reasonably frustrated; (ii) another partner has engaged in conduct
relating to the partnership business that makes it not reasonably practicable
to carry on the business in partnership; or (iii) it is not otherwise reasonably
practicable to carry on the partnership business in conformity with the
partnership agreement.”
c. A partner who has not fully performed the obligations required by the
partnership agreement may not obtain an order dissolving the partnership.
i. Collins v. Lewis (1955, p.155)—Lewis persuaded Collins to enter into a
partnership for the operation of a cafeteria for a term of 30 years. This
means that if either partner contravenes the partnership, he is not allowed
to participate in good will and is liable to the other for damages. Lewis also
agrees to give Collins a claim on his ownership (mortgage payable to bank
on demand) until Collins is completely repaid for Lewis’ portion of the loan.
And Collins ensures Lewis that he will make sure it does not negatively
affect Lewis. The venture failed to make money, allegedly because of
Collins’ lack of cooperation. Collins demands Lewis to make the business
profitable and he refuses to provide any more money to the venture. Also,
Collins and the bank attempt to foreclose on the mortgage.
o HELD: There is no such things as an indissoluble partnership only
in the sense that there always exists the power, as opposed to the
right, of dissolution. But legal right to dissolution rests in equity, as
does the right to relief from the provisions of any legal contract.
There is not a reasonable expectation of profit under Lewis’s
continued management, but Lewis was found competent to manage
and but for Collins’ conduct, there would be a reasonable
expectation of profit. Therefore, under these circumstances, no
dissolution may be granted.
o Collins right to foreclose on the mortgage depends upon whether or
not Lewis has met his basic obligation of repayment at the rate
agreed upon. Under the basic agreement of the partners, this extra
money was properly Collins’ obligation to provide. Upon his refusal
to pay it, Lewis paid it out of earnings of the business during the first
year of its operation. Thus, the court properly refused to allow
Collins to foreclose.
o NOTE: If this were a UPA case, might say that under § 32, it was not
reasonably practicable to carry on the business
o NOTE: Dissolution by judicial decree is rare. Even partners who are
locked in an irreconcilable dispute usually manage to agree to some
plan which enables one or all of them to exit gracefully, because
whatever settlement the feuding partners can reach is likely to be
more economical than court-ordered dissolution, a procedure which
typically requires the partnership to dispose of the property for
considerably less than its actual value.

38
 o Collins should have had a cap on how much money he would put
into the venture.
d. In the absence of an agreement to the contrary, a partner’s relationship with
other partners is terminable at the will of any partner, provided the partners
have not agreed to a definite period of time during which the partnership
should continue—UPA § 31(1)(b)
i. However, according to Traynor, this right must be exercised in good
faith. The good faith element is not in the UPA, but is added by Traynor.
Some courts have agreed with Traynor and others have not. If there is a
good faith limit, then it is not really at will. Additionally, cannot freeze out.
ii. Page v. Page (1961, p.160)—TRAYNOR— Business lost money for three
years, and as it started to make profit, P wanted dissolution. D tried to say
there was an implied term of partnership to last long enough to pay the loan.
o HELD: There was no implied term as to the duration of the
partnership (because there was no evidence of it), and so P had
right to dissolve. The understanding to which defendant testified
was no more than a common hope that partnership earnings would
pay for all the necessary expenses. Such a hope does not establish
even by implication a definite term or particular undertaking as
required.
o And although a partnership may dissolve at the express will of any
partner (UPA § 31), this power is held by a fiduciary and must be
exercised in good faith. Thus, if P acted in bad faith and violated
fiduciary duties by attempting to appropriate to his own use the new
prosperity of the partnership without adequate compensation to his
co-partner, the dissolution would be wrongful and the plaintiff would
be liable under UPA.
o A partner at will is not bound to remain in a partnership, regardless
of whether the business if profitable or unprofitable. A profit may
not, however, freeze out a co-partner and appropriate the business
for his own use.
o What could the Brother do in order not to breach is fiduciary duty?
Get a professional appraisal of the business/partnership, especially
if there is not a realistic market value because there are no bidders.
 Business Valuation Models many methods used by
appraisers in order to place a monetary worth on a business
in order to divvy up the proceeds at the time of dissolution.
• Book Value = Acquisition price - depreciation.
However, this number is an accounting artifact that
has no connection to market value.
• Freeze-Out Majority owners try to force co-partners
to sell their interests at a price lower than the true
price.
 If the partnership is dissolved, each of these brothers will get
50% of the partnership value after liabilities are repaid.
Chances are, however, is that the brother with more money
will buy the partnership. Therefore, more financially stable
partner will want to find a value of the business that is as low
as possible without violating his fiduciary duty and creating a
freeze out.
e. A well written partnership agreement should include:
i. Buyout Agreement (buy/sell agreement)—
39
 o Ex. One partner pays a percentage of the average of three
appraisals
o Ex. “I cut and you choose” approach make more accurate. Set
one price that he would be willing to take or to pay. One of more
popular ways.
o This is one of the most important things to remember for your
client! Buy/Sell agreements force people to think about what is fair
before they are placed in that position.
ii. Continuation Agreement—should contain a minimum of 5 things:
o Transfer of rights and obligations of dissolved partnership to
successor partnership
o Conversion of continuing partners’ rights in the dissolved partnership
to rights in the successor partnership
o Compensation of the dissociated partner for partner’s rights in the
dissolved partnership
o Indemnification or (if possible) the release of the dissociated partner
for debts of dissolved partnership
o Indemnification of the dissociated partner for debts of the successor
partnership.
5. CONSEQUENCES OF DISSOLUTION
a. 4 Primary Ways to “Wind Up” a partnership when dissolution/dissociation occurs:
i. “Going out of Business” Sale Shut down store and sell/liquidate all its
assets. This destroys all good will.
ii. Sale of Going Concern to Outsider Where good will is of significant
value, this is a more attractive alternative. Difficulties include:
o It may be difficult to find such a buyer because of the costs of
communicating information about the business to people who are
not familiar with it.
o Some of the values inherent in the business may exist only for its
present owners.
iii. Sale to Majority A purchase of the business, as a going concern, from
the partnership by the majority partners who wish to continue their
investment is the same as the sale above, only to insiders.
o The purchasing partners will be in a position that puts heavy strain
on the fiduciary obligation they owe, in their conflicting role as sellers
to the non-continuing partner.
o Courts are sensitive and will carefully review fairness.
iv. Sale to Minority The minority partner may find and wish to purchase the
partnership, either alone or with new partners.
b. Majority partners in a partnership-at-will may purchase the partnership
assets at a judicially supervised sale.
i. Prentiss v. Sheffel (1973, p.163)—After freezing Prentiss (15% owner) out
of the partnership’s management and affairs, Sheffel and a third partner
filed for dissolution, purchasing partnership assets at a judicially supervised
sale.
o HELD: Although Prentiss was excluded from management of the
partnership, the trial court found no indication that such exclusion
was done for the wrongful purpose of obtaining the partnership
assets in bad faith. Rather, it was the result of the inability of the
partners to harmoniously function in a partnership relationship.
Moreover, the participation of the majority partners in the sale

40
 increased the final sales price, enhancing the worth of Prentiss’
interest.
o NOTE on Freeze Outs: The UPA 18(e) says that all partners have
the rights to control; they get around this through the agreement that
they vote on percentages. We see the term “freeze out” again in this
case – this freeze out case law is somewhat vague. It seems less
important in this case than it does in other cases.
o Partners will tend to be the highest bidder if the partnership is sold
because they have greater knowledge of the business.
c. Disotell v. Stiltner (2004, p.166)—Real estate development went sour and D
seems like the one with the money. The trial court gave D the option to buy P’s
share at a precise figure (where did it come from?), but did not give P the option to
buy D’s interest. P argues that a partner who was not wrongfully dissolved can ask
for liquidation (UPA § 37).
i. HELD: Giving D option to buyout P is correct, but remanded to determine
figure. It is difficult to use tax appraisals to give value, so should come up
with a better manner of appraisal. Because the act did not prohibit the
buyout option it was not error to grant Stiltner the option ot buy out Disotell’s
partnership interest. It was error, however, to permit a buyout finding the
fair market value of the property, based on admissible evidence. In
remanding the case, the court should determine what each partner
contributed or took from the partnership assets and any differences
between services. Disotell was to contribute to the project and those he
actually contributed, but should not include the loan obligation. But should
take into account the personal use of the hotel property.
ii. Gap-Filling Where a term is missing within a written contract, the court
may search for a term that the parties would have agreed to had the
question been brought to their attention. Where there is no agreement
between the parties, the court should imply a term which comports with
community standards of fairness and policy rather than analyze a
hypothetical bargain. In considering what term is reasonable, the superior
court should consider the risks and obligations each party assumed.
iii. Profits allow for depreciation whereas cash flow does not.
iv. NOTE: Buyout figure should be covered in the agreement.
v. NOTE on § 38—Some hold that the statute require liquidation, while others,
such as this court, find that § 38 allows a buyout as a justifiable way of
winding up a partnership. This court explains that a buyout would reduce
the economic waste by avoiding the cost of appointing a receiver and
conducting a sale.
d. UPA § 38—“(2) When dissolution is caused in contravention of the
partnership agreement the rights of the partners shall be as follows:
i. (a) Each partner who has not caused dissolution wrongfully shall have
o II. The right as against each partner who has caused the dissolution
wrongfully, to damage for breach of the agreement
ii. (b) The partners who have not caused the dissolution wrongfully, if they all
desire to continue the business in the same name, either by themselves or
jointly with others, may do so, during the agreed terms for the partnership
and for that purpose may possess the partnership property, provided they
secure the payment by bound approved by the court, or pay to any partner
who has caused the dissolution wrongfully , the value of his interest in the
partnership at the dissolution, less any damages recoverable under clause
2a II of this section, and in like manner indemnify him against all present or

41
 future partnership liabilities.
iii. (c) A partner who has caused the dissolution wrongfully shall have:
o II. If the business is continued under paragraph 2b of the section
the right as against his co-partners and all claiming through them in
respect of their interests in the partnership, to have the value of his
interest in the partnership, less any damages caused to his co-
partners by the dissolution, ascertained and paid to him in cash, or
the payment secured by bond approved by the court, and to be
released from all existing liabilities of the partnership; but in
ascertaining the value of the partner’s interest the value of the
good will of business shall not be considered.”
 RUPA is not as severe.
 Significant penalty for wrongful dissolution because you lose
the good will in value of your share (difference between hard
asset value of firm and market value), and gets damages to
partnership subtracted from that amount.
e. Basics of § 38—2 Consequences of Withdrawal in Contravention of
Agreement:
i. (1) Wind up the business—Sell it as a going concern or liquidate its assets.
Then distribute proceeds according to UPA § 40.
ii. (2) Continue to Operate the Business
o Four Consequences of this decision:
 If the firm’s creditors are informed of the withdrawal, the
contravening partner is no long liable for any debts thereafter
incurred, but is responsible for those previously incurred.
 Contravening partner is entitled to be paid the value of his
interest, reduced by any damages for which he may be liable
by virtue of his breach of the partnership agreement.
 He continuing partners may use the partnership property and
need not pay the contravening partners the amount to which
he is entitled until the end of the agreed upon term.
 Continuing partners must post a bond to guarantee ultimate
payment to contravening partner and to protect him from
claims of creditors for pre-dissolution obligations.
iii. Pav-Saver Corp. v. Vasso Corp. (1986, p.173)—Dale is inventor and
Meersman is attorney that decided to form partnership, using Dales’s
patents. Agreement had some problems in the way it was drafted according
to Professor.:
-The agreement used the words “expiration of the partnership,” which
are not used in partnership statutes; had Dale used “dissolution”, he could
have gotten his stuff back because “expiration” does not have a UPA
definition and “dissolution” does have a definition.
-Should use the terms consistently throughout the agreement. When a
different term is used, the reader assumes that a different meaning is
intended.
-Also, don’t use the words “contemplated a permanent agreement”
because this does not tell you anything.
o HELD: Dale wrongfully dissolved the partnership (contravention),
and will not get his patents back, because taking them away would
hinder running the business. Additionally, Dale must write Vasso a
check.
o The court concludes, according to Professor wrongfully, that Dale’s

42
 unilateral termination was in contravention of the agreement. To
Professor, the liquidated damages clause provided for unilateral
termination. However, according to the Court, “the wrongful
termination necessarily invokes the provisions of the UPA so far as
they concern the rights of the partners. Upon PSC’s notice of
termination, Vasso decides to continue running the business (§
38(2)(b)). Thus, despite the parties contractual direction that PSC’s
patents would be returned to it upon the mutually approved
expiration of the partnership, the right to possess the partnership
property and continue in business upon a wrongful termination must
be derived from and is controlled by the statute.”
o DISSENT: The court should construe the contract as written,
meaning Dale should get his patents. The provisions in the contract
do not conflict with the statutory opinion to continue the business
and even if there were a conflict the provisions of the contract should
prevail. Professor believes this is much closer to the intentions of
the parties.
iv. Try to Draft a Better Contract for Dissolution to fix the problems with this
agreement.
v. NOTE: In drafting, remember in what state you are drafting the K—UPA
states, use “Dissolution” and RUPA use “Dissociation”
6. SHARING OF LOSSES
a. UPA § 18(a): States that partners split profits AND losses…they will “share
equally in the profits and surplus remaining after all liabilities…and must contribute
towards the losses.”
i. REMEMBER § 40(b) Three payment (after paying creditors and loans
made by partners), the partnership is obligated to pay what is owed to the
partnership in respect of capital. Therefore, if one partner is owed money
and the other is not, the one owed nothing must pay the partner who has a
right to the return of his capital investment.
b. Kovacik v. Reed (1957, p.179)—In an oral partnership agreement, Kovaick agrees
to put up the money for a remodeling project and Reed agrees to supply the labor
(but no money up front). The partnership doesn’t pan out and loses money and
Kovacik wants Reed to share equally in the losses. Reed refuses.
i. RULE: In a joint venture where one party contributes funds and the other
party contributes labor, neither partner is liable to the other for contribution
for any loss sustained.
ii. HELD: Kovacik attempts to invoke UPA § 40(b) dealing with the schedule of
payments upon dissolution. The court here finds that Reed’s labor
contribution was equal to Kovacik’s monetary contribution and therefore it is
an even loss. The general rule is that in the absence of an agreement to
the contrary the law presumes partners and joint venturers intended to
participate equally in profits and losses, disregarding how much they
actually contributed. However, the court finds that presumption only applies
to cases in which each party contributed capital. Here that was not the case.
iii. NOTE: The RUPA adheres to the UPA’s default rule that every partner
shares equally in the losses and specifically rejects the reasoning in
this case.
iv. Under the UPA and RUPA, Kovacik would have been entitled to ½ of his
capital returned.
v. Professor disagrees with this Default Rule. It is difficult to value the
services of the labor provider over the capital contributor. Therefore, the

43
 agreement should identify how the services will be valued upon dissolution
of the partnership so that he will not be liable to the capital contributor for
half of his contribution.
c. DRAFTING SOLUTION: In a two person partnership, where one partner
contributes cash or property and the other contributes services, the partners may
want to agree that the contribution of cash or property is treated as a loan subject
to a fair return and the contributor of services can be paid a salary. The agreement
may set that each of these payments may be deferred. Profits and losses would be
calculated and allocated between the partners, after deducting the interest on the
loan and the amount of the salary.
7. BUYOUT AGREEMENTS
a. VERY IMPORTANT TO PROFESSOR!
b. A buyout agreement is an agreement that allows a partner to end his relationship
with the other partners and receive a cash payment or series of payments or some
assets of the firm in return for his interest in the firm. It is a way to contract around
the UPA provisions which call for liquidation upon certain events occurring causing
dissolution.
i. An over-arching question is where will the money come from for the
buyout?
o Most of the time, the firm will take out life insurance policies on the
partners and pay premiums on the policy.
o When the partner dies, the policy proceeds go to the family to buy
out the partnership interest of the dead partner.
ii. Typically, a buyout agreement will be inherently fair because at the time of
the agreement, the partners do not know which side of the table they will
sitting on. (They don’t know if they will be the departing or remaining
partner.)
c. Buyout Agreement Checklist
i. Trigger Events—what event can cause the buyout agreement to kick in
o Death
 If there is not a buyout agreement, then the death of a
partner would cause the dissolution and windup of the
partnership.
o Disability—injury, chronic medical condition, etc. Explain what kind
of disability is included.
o Will of any partner—retirement, other opportunity, etc. Probably
want to do this.
ii. Obligation to Buy vs. Option to Buy—is there an obligation to buy or just
an option to buy?
o Firm—allow the firm buy you out
o Other investors—do you want to include that other people can buy
the interest and become partners in the business?
o Consequences of refusal to buy
 If there is an obligation
 If there isn’t an obligation
iii. Price
o This is a very difficult thing to come up with.
 Fair Market Value—the amount you would get if the
business is sold.
 But, if you don’t sell it on the open market, then how do you
determine the FMV?

44
 • You use other sources which are just substitutes and
in most cases are not going to be the FMV
o Substitutes for FMV
 Book value—an accounting number that is the original cost
of the assets minus depreciation
 Appraisal
 Formula
 Set price each year
 Relation to duration
iv. Method of Payment
o Cash
o Installments
 With interest?
v. Protection Against Debts of Partnership
vi. Procedure for Offering Either to Buy or Sell
o First mover sets price to buy or sell
o First mover forces others to set price
d. G&S Investments v. Belman—This partnership has a buyout agreement that is
triggered by death, insanity, resignation or retirement. One of the partner’s cocaine
use became such a problem that he was incapable of making rational business
decisions. The other partners sought a judicial dissolution and the right to carry on
the business by buying out the partner’s interest.
i. Rule: A partnership buyout agreement is valid and binding even if the
purchase price is less than the value of the partner’s interest, since
the partners may agree among themselves by contract as to their
rights and liabilities.
ii. HELD: Here, the court merely enforces the parties’ agreement in the
partnership agreement. The buyout agreement deals with a value based on
capital accounts—it is very straightforward. The court states that “It is not
the province of this court to act as a post-transaction guardian for either
party.” Professor LOVES this statement.
8. LAW PARTNERSHIP DISSOLUTIONS
a. Jewel v. Boxer This case involves a law firm which had no written partnership
agreement. The four partners in the law firm mutually decided to dissolve the
partnership and formed two new firms. Jewel and Leary filed suit stating that the
judgment awarding post-dissolution income on active cases at the time of
dissolution was in error.
i. Rule: Absent a contrary agreement, any income generated through the
winding up of unfinished business should be allocated to former
partners according to their respective interests in the partnership.
ii. HELD: Since there is no partnership agreement, the UPA default rules
apply. The court interprets the rule that “no partner is entitled to extra
compensation for services rendered in completing unfinished business” to
apply to those pending cases in the law firm that are part of the winding up
process. Therefore, the profit from those cases must be split among the
original partners.
iii. Professor says that it is just stupid for a law firm not to have a written
partnership agreement—“it is an invitation to litigation.”
b. Meehan v. Shaughnessy (earlier portion of case above)—This firm had a
written partnership agreement that provided for what would happen when a partner
left the firm and what would happen with pending cases. The departing partners

45
 could pay a fee to the firm for taking a case and then the case would be gone. This
partnership agreement winds up the partnership immediately.
i. Rule: Upon dissolution and division of assets, the express rights
provided by a partnership agreement control, even though different
from those rules provided in the UPA. Absent such an agreement, the
UPA default rules will apply.
ii. HELD: The UPA has provisions for what to do with a departing partner’s
interest in the firm (liquidation, sales, etc). However, the UPA is a set of
DEFAULT rules. It specifically states that partners may design their own
methods for dividing up assets and such an agreement will control.
iii. In this case, the partnership agreement minimized the impact of the
dissolution process—Professor found it brilliantly smart contracting.
J. Limited Partnerships
1. Consists of one or more general partners, plus one or more limited partners.
a. General Partners Personally liable for the debts of the firm and have the power to
act on behalf of the firm and to control it.
b. Limited Partners Do not participate in control, do not have the power to act for
the firm, and are not personally liable for the debts of the firm.
2. Uniform Limited Partnership Act (ULPA) and Revised Uniform Limited Partnership Act
(RULPA)
3. Rules are governing LPs are essentially the same are those for ordinary partnerships.
4. Most appealing for favorable federal income tax features.
5. Tax Reform Act of 1986 added a new provision affecting passive activity losses, which
drastically limited the opportunities for partners to take advantage of losses and
correspondingly reduced the use of limited partnerships for tax shelter investments.
6. Holzman v. De Escamilla—Hacienda Farms was formed as a limited partnership with
Russell and Andrews acting as limited partners. Bankruptcy was filed by the partnership.
ISSUE: Whether the two limited partners became general partners through their exercise
of control over the firm?
a. Rule: If a limited partner exercises control over the partnership business, he
becomes a general partner.
b. Limited partnership protection can be lost if there is participation or control
exercised over the business by the limited partners. To preserve personal liability
immunity, the limited partner must not assume any active interest in the partnership
affairs.
c. NOTE: In this case, the general partner was incorporated so there was no personal
liability. This is a common thing.
K. Limited Liability Companies
1. Two objectives of an LLC:
a. (1) Limitation of the liability of investors to the amount invested in the firm, and
b. (2) Avoidance of the double tax on corporate income.
2. Has the corporate characteristic of limited liability, but is treated as a partnership for
purposes of federal income taxation.
3. Vary from state to state.
4. Members may withdraw at will, generally with 6 months notice.
5. Dissolution is caused by a member’s death, withdrawal, bankruptcy, etc.
6. The withdrawing partner is not subject to the same risks of liability to existing creditors as
with a ordinary partnership.
7. Most common pay off rule provides for payment of the fair market value of the withdrawing
member’s interest, reduced by damages.
8. Benefit over limited partnerships because investors can participate in management
L. Limited Liability Partnerships

46
 1. LLPs are general partnerships for which the liability of the general partners is restricted. A
partner in an LLP is not personally liable for partnership obligations arising from
negligence, wrongful acts, or similar misconduct unless the such actions were committed
by the individual partner or a person operating under the partner’s direct supervision and
control.

III. CORPORATIONS
A. History
1. Derives from “Corpus,” meaning “body”
2. England
a. Royal Charter Corporation was a Tool / Extension / Concession of Government
b. A quid pro quo—the King got something in exchange for granting you a corporation
status a body with a separate legal identity.
3. America
a. This is a STATE law topic.
b. Until mid-19th century, it was rare for a business to ask for corp status. This is
because in order to function in the American economy at this time, you didn’t need
a big business. Partnerships worked fine because small business’ needs were
served easily in this way because there wasn’t a large need for capital.
c. The traditional idea of corporations changed with the development of Railroad
companies because you needed a tremendous amount of capital. To raise that
much money, it was nearly impossible to have that many partners.
i. NOTE: As the minimum capital needed increases, the partnership structure
becomes less effective and corporation structure becomes more effective.
ii. This attached somewhat of a scandal because of quid pro quo with
legislatures and grant of a corporation.
d. Paul v. Virginia (p.114 in K&C)—Facilitated the ability of a corporation
incorporated in one state to do business in another. This decision is a
transitional one because it first held that a corp. was not a citizen entitled to the
benefits and privileges and immunities clause of the Constitution. However, the
grant of incorporation fell within the field of interstate commerce, and as such a
state could only preclude a foreign corp from engaging in transaction within its own
borders if these transactions did not amount to interstate commerce.
Consequently, a second state to give full faith and credit to a legislature’s
grant a corporation certificate to a company.
e. 1896—New Jersey’s General Incorporation Statute—invited companies to
incorporate their companies.
f. Delaware takes the NJ statute and improves upon it.
g. Chartering Business NJ and Delaware were in a battle “chartering business” for
years. Delaware won! States are in competition with one another to charter
business.
i. State competition for chartering Business is either (either good or bad for
investors):
o “A race to the bottom” or
 Load up laws in favor of promoters (or managers) of
business and not laws that favor investors.
 Thrives on investor ignorance.
o “A race to the top”
 Load up laws in favor of investors and not in favor of
promoters. Investors have an advantage of
promoters/managers.

47
  This is the best idea because the promoter wants to sell
stock in a new corp and to get good investors you need to
promote a favorable environment for the investors to give
their money.
h. In 1913, Woodrow Wilson “REFORMED” NJ’s statute, and destroyed it.
B. A corporation is a particular set of rules for the organization of economic entities.
C. Corporation codes vary from state to state, but the basic rules are much the same.
D. Entity investors are called are called shareholders or stockholders and their ownership interests
are reflected in shares of the common stock of the firm.
E. The shareholders elect a boards of directors, who in turn select the officers who run the business.
F. Founders “incorporate” the corporation by filing certain documents with the appropriate state
agency and may chose to do so in any of the 50 states.
G. “Public Corporations” Large firms with many shareholders and with active trading of shares.
1. The shareholders in such corps do not expect to participate actively in the operation of the
business. They are passive investors; thus, the aggregation of individual savings permits
large-scale investment and large-scale operations by the corp.
2. Some federal regulations requiring disclosure of important facts relating to operation and
financial performance. Also prohibitions on “insider-trading”—trading by corporate officers,
directors, and employees on the basis of material, non-public information.
a. NY Stock exchange and NASDAQ also have regulations requiring minimum
numbers of independent directors.
3. “manager controlled”
H. “Closely Held Corporation” A corporation that has a small number of shareholders, generally
operates on a modest economic scope, and generally the people owning a substantial portion of
the total shares will occupy the top managerial positions or will be involved in a meaningful way in
the selection and monitoring of the people who do occupy those positions as well as in the
formulation of the corporate strategies and policies.
1. Shareholders are likely to be members of the board of directors.
2. No or little separation between ownership and control
3. “owner-controled”
I. “Startup Corporations” Important intermediate type of corp, typically financed by a venture
capital fund (VC).
1. VC The money in such funds comes from wealthy individuals or from institutions such as
pension funds and University endowments. Fund will be managed by savvy people who
invest the money in huge gains to make up fro the inevitable losers.
2. VC managers will bargain no only for a share of the gain if the venture is successful but
also for participation in control and for various protections.
3. VC is likely to insist on seats on the board of directors, a priority in case of liquidation, and
certain rights with respect to creating a public market for the shares of selling its shares in
the market.
J. Characteristics (accounting for success in organizing economic activity on a large scale)
1. Separate Entity
a. As a separate entity, it is the corporation, not the shareholders, that enters into
contracts, incurs debt, and files or is the defendant in lawsuits. The officers and
other employees act on behalf of the firm, subject to approval of the board of
directors as to major decisions. Shareholders have no powers to act on behalf of
the corporation.
2. Divisible ownership
a. Equity ownership is reflected in shares of stock of relatively modest value (rarely
more than $100). There are a large number of investors, each with a relatively
small investments.
3. Assets separated from Shareholders

48
 a. Assets of a corporation are held by the corporation. Shareholders cannot remove
from the corp their pro rata share of the corp’s assets. This protects the corps
stability and its creditors.
4. Limited Liability
a. Contractual obligations and debts incurred by employees of the corp are strictly
obligations ad debts of the corp, not of the shareholders (or the employees or
directors).
b. Shareholders risk losing the amount of their investment, but no more.
5. Indefinite Duration
a. The corp’s existence may be terminated as a result of insolvency, by merger into
another corp, by voluntary liquidation upon recommendation of the board of
directors approved by a vote of the majority of shareholders, or by judicial decree in
extreme circumstances.
6. Transferable and Tradeable Shares and Debt Obligations
a. The shares of stock of public corps are freely transferable and may be bought or
sold on established markets such as the NYSE. This means the shares are highly
liquid—the can be turned in to cahs by a quick phone call or a few keystrokes on
the internet.
b. In closely held corps, limitations may be imposed on transfer, by agreement among
the shareholders. In the absence of such agreement, shares are freely
transferable.
7. Centralized Control and Separation of Ownership and Control
a. The issue on which we will most closely focus
b. Shareholders elect the members of the board of directors, who in turn appoint the
CEO and other officers.
c. There is a separation of share ownership and control.
d. The shareholder power to elect directors may have little practical effect; boards
tend to be self-perpetuating, with new members often chosen by the professional
managers. Thus, the board and the professional managers have effective control.
e. Shareholders—elect
 Board of Directors—hires, monitors, & disciplines if necessary
 Officers
8. Berle and Means two men who wrote on and had problems with this separation of
control and ownership.. Professor thinks there is nothing wrong with it. It is just a feature
of a corporation.
K. Lawyers and laypersons tend to speak instinctively of a corporation as an it—to reify it—as if it has
an identity and an existence of its own. Corps should not be studied in this fashion because there
are many categories of people whose activities are coordinated within the firm.
L. Role and Purpose of Corporation
1. RULE: Shareholder Wealth Maximization is the Exclusive goal of Corporations
a. This means maximizing the corporation’s profits.
b. The traditional view is that he objective of a corp is to maximize wealth of
shareholders
c. This is the basic premise or tenant on which the entire analysis of corporate
governance by the law and economics movement is based.
d. OVERALL: According to Professor, 99 /100 times, courts will defer to
business judgment of the corporation.
2. A.P. Smith Mfg. Co. v. Barlow (1953, p.282)—The A.P. Smith Mfg. Co. manufactures and
sells valves, fire hydrants, etc. Its board of directors adopted a resolution, which set forth
that it was in the corporation’s best interests to join with others in the 1951 Annual Giving
to Princeton University and designated $1,500 be transferred to the university. The
stockholders of the corporation questioned this action. Issue: Whether this donation by

49
 the corporation was intra vires?
a. HELD: Giving money to a University is within the scope of the corporation’s power
because it was a modest amount given as an investment in the community and in
the future of the company.
b. Intra Vires—“within the scope” of the corporation’s powers (or the board of
directors powers).
c. Ultra-Vires—“outside the scope” of the corp’s power. A corp. charter is relatively
meaningless now, so this rarely comes up.
d. Rule: A state has reserved powers which permit it to revise, alter or repeal
corporate charters at any time.
i. Reserve Powers—states can “alter, revise or repeal” the corporate charter
at any time; here, New Jersey has passed a law allowing such donations by
corporations
e. This case deals with two issues—the power of a corporation to designate funds to
charities/philanthropic uses and the power of a statute to pass statutes that apply to
corporations incorporated prior to the enactments.
f. If they did so, no one would incorporate there.
g. Business Judgment Rule—the court found that such a donation was an implied
power of the board of directors; this is a business decision and management is in
the hands of the directors
i. Delaware General Corporate Law, § 122: “Every corporation created
under this chapter shall have power to…9) make donation for public welfare
or for charitable, scientific, or educational purposes…”
ii. Most state incorporation laws include this sort of provision and are typically
read as authorizing charitable contributions that aid in maximizing the
corporation’s profits.
iii. However, courts are extremely tolerant in accepting the business judgment
of the board of directors.
3. Dodge v. Ford Motor Co. (1919, p.288)—The Dodge brothers filed suit against Ford
Motor Co. after Ford decided not to pay any more special dividends and to instead re-
invest the money in the business. ISSUE: Whether Ford is required to pay the special
dividends to the shareholders or whether it can re-invest the profits in the company?
a. In this case, the Dodge brothers are minority shareholders (Ford had 58% and
Dodge Bros had 10%) and are creating their own car company—so Ford has an
incentive NOT to pay them special dividends (they will invest the money in a
competing company).
b. This case is RICH with history
i. Ford was really against the Rockefeller “big fat capitalists” and the “robber-
barons” and so he would never say that he was out to maximize profits.
ii. He even states that Ford Motor Co. should only make a “reasonable amount
of profits.”
c. Rule: A corporation’s primary purpose is to maximize the profits for its
shareholders and the powers of the directors are to be employed to that end.
i. Normally it is the directors decision whether to declare a dividend of the
earnings of the corporation, and to determine its amount. Courts of equity
will not interfere in the management of the directors unless it is clear that
they are guilty of fraud or misappropriation, or refuses to declare a dividend
when the corporation has a surplus of net profits which it can, without
detriment to its business and a refusal to doe so amounts to an abuse of
discretion that breaches the duty of good faith.
d. HELD: Ford ultimately loses and the court orders him to pay the special dividends
(which of course he got 50% of because he owned 50% of the shares).

50
 i. The court does say that he can build the plant (he wanted to build a plant to
expand the business).
ii. The thing is “judges are not business experts” and we really don’t want the
judge deciding these issues.
e. NOTE: If Ford had said something like Barlow, then he would have won.
f. QUESTION: Is there a difference between the company and the shareholders? To
Professor, the company is the shareholders.
g. NOTE: Professor doesn’t think the court should interfere into business
judgment.
4. Shlensky v. Wrigley (1968, p.293)—Wrigley, the majority shareholder and operator of the
Chicago Cubs, refused to install lights at Wrigley Field so that the club could hold night
games. Shlensky, a minority shareholder, filed a derivative suit to compel the installation of
lights (stating that the club was losing money by not having these night games).
a. Rule: A shareholder’s derivative suit must be based on conduct of the
directors which exhibits fraud, illegality or conflict of interest and not just on
a disagreement over a business decision.
b. HELD: Here, the court states that there is a lack of fraud, illegality or conflict of
interest—the minority shareholder just doesn’t agree with the directors’ business
decision. The court says, “We do not mean that we have decided that the
decision of the directors was a correct one. That is beyond our jurisdiction
and ability. We are merely saying that the decision is one properly before directors
and the motives alleged in the amended complaint showed no fraud, illegality or
conflict of interest in their making of that decision.
c. The court finds that it is not its place to determine whether or not the lack of lights is
a bad business decision absent those things.
5. Principles of Corporate Governance (American Law Institute),
a. This turned into what the law should be and not what the law was; therefore, never
called a restatement. Thus, this has not had much of an effect on corporate law.
b. § 2.01 Profit Maximization and Alternatives.
i. (a) A corporation should have as its objective the conduct of business
activities with a view to enhancing corporate profit and shareholder gain.
ii. (b) Even if corporate profit and shareholder gain are not thereby enhanced,
the corporate, in the conduct of its business:
o (1) Is obliged, to the same extent as a natural person, to act within
the boundaries set by law;
 Ex. do you need to tell your driver to follow the speed limit no
matter what?
o (2) May take into account ethical considerations that are reasonably
regarded as appropriate to the responsible conduct of business, and
 “may”—not required to consider ethical issues
o (3) May devote a reasonable amount of resources to public welfare,
humanitarian, educational, and philanthropic purposes.
 The board decides what is reasonable.
M. Formation:
1. Central step in the incorporation process is the filing with a state official (secretary of state)
of a document usually called the articles of incorporation or the charter.
a. Includes a nominal fee,
b. SOS issues a certificate of incorporation, evidencing the attached articles have
been filed with him or her.
c. Articles of Incorporation
i. Usually brief, with its contents closely tracking the requirements of the
incorporation statute of the jurisdiction of incorporation, which statute
51
 usually sets forth in very specific terms necessary for minimal contents of
these articles.
ii. Delaware Code § 102 Name, Address, purpose of the business, name of
incorporator, and specify classes of stock that can be issued and their
rights.
iii. Will often authorize the issuance of a maximum number of shares in each
class, and the Board of Directors may from time to time issue up to the
number specified for each class. The number of shares may be increased
only by a vote from the shareholders.
d. Corporation registration office is in the jurisdiction of incorporation.
2. Bylaws adopted by the Board of Directors
a. Cover number and qualifications of directors, committees of the board and their
responsibilities, quorum and notice requirements for meetings of shareholders and
directors, and titles and duties of the corporation’s officers.
3. Filing is a matter of notice.
a. Gives notice to the world of the corporation’s governance structure, and this can be
important in some instances.
b. Limited partnerships must also meet public notice requirements
c. Important for security interest reasons.
4. Concession Theory of the Incorporation State gives limited liability to
shareholders.
a. Not unfair because there are two kinds of creditors:
i. (1) Contract Creditors and
o Professor—The creditors choose to contract with the company,
despite the limited liability set up. Therefore, limited liability is not
unfair.
ii. (2) Tort Creditors.
o Limited liability may be unfair since these creditors don’t bargain to
be a creditor.
b. Therefore, a corporation’s limited liability is not must of a “Concession” by the state.
5. Amendment
a. Articles of Incorporation may be amended by a vote of the majority shareholders.
b. Modern corporate law has abandoned the “vested right” doctrine and replaced it
with procedural protection. Today, under most state statutes, proposed charter
provisions that adversely affect the legal rights of a specific class of stock will
require “class voting” the amendment must be adopted by both the majority of
all shareholders and by a majority of the adversely affected class.
6. Duration
a. Corporations have a perpetual or unlimited life.
b. May be dissolved upon a shareholder vote or, in extreme situations, by judicial or
other governmental order.
c. In the absence of an agreement to the contrary, or special circumstances justifying
judicial intervention, a minority shareholder has no legal power to terminate the
existence of the firm or to withdraw his or her capital. However, shareholders may
be more readily able than partners to sell their interests.
d. Shares of stock are freely transferable unless there is an express agreement to
the contrary in the articles of incorporation or bylaws.
e. A change in the identity of shareholders has no effect on the identity of the corp.
f. “Right of First Refusal” Each party can grant a right of first refusal to the other,
meaning if a party wishes to sell his or her shares to an outsider, the shares must
first be offered to the other existing shareholders at the price the outsider is willing
to pay.

52
 g. Buy/sell Agreement—also applies to corporations and shareholders.
7. Choice of law
a. Freely choose to form their corporations in any of the fifty states.
b. Internal Affairs Law—Regardless of where the corporation operates or where its
shareholders or assets are located, the laws of the state in which a corporation
is incorporated will apply to question concerning internal corporate
governance.
c. Those states that allow participants in the venture to greatest freedom to shape the
rules that will govern them are called “permissive.”
N. Promoters and the Corporate entity
1. “Promoter”—term of art referring to a person who identifies a business opportunity and
puts together a deal, forming a corporation as the vehicle for investment by other people.
a. A promoter’s activities includes arranging necessary capital, acquiring any needed
assets or personnel, and arranging for the actual incorporation of the business.
2. Fiduciary Duties
a. Agent of a principal that is a corporation—Stockholders can’t sue for damage to the
corporation. Therefore, the fiduciary duty is to the corporation and not to the
officers, stockholders, etc.
b. A promoter owes a fiduciary obligation to the corporation, like that of an
agent and principle. (but obligations to the corp. do not come into existence until
the corporation comes into existence.)
c. Problem on Page 200 in Case book:
i. Case 1: Demonstrates common law fraud.
ii. Case 2: Disgorgement remedy causes faithless agents to drop their profits.
Agent can satisfy his duty to his agent through full disclosure.
iii. Case 3: The Corporation becomes the real party in interest.
iv. Case 4: Sometimes the form of the transaction can prevail over the
substance of it. “There is more than one way to skin a cat.”
3. Liability of the Promoter to Third Parties: If the corporation has already been formed
and a promoter makes a contract in the corporation’s name, then there is normally
no issue in regards to liability. The corporation is liable and the promoter is not.
However, there are a number of situations when the promoter could be liable.
EXCEPTIONS:
a. Corporation not formed and not named in K If a promoter makes a contract in
his own name without referring to a not-yet-formed corporation, the promoter will be
personally liable, even if the promoter had the intent to assign the contract to the
corporation.
b. Contract in Corporation’s name without noting corporation has not yet been
formed When a promoter makes a contract that purports to be in the corps
name, but does not on its face disclose that the corporation has not yet been
formed as of the contract date, and the other party is not aware that the corp does
not exist, then the promoter will be personally liable on the contract, provided the
promoter was aware that the corp was not yet formed.
c. Promoter Believes Corp has been formed If the promoter believes the
corporation has been formed, but due to some technical defect, which he is
unaware of, the corp doesn’t exist at the time he signs the contract on the corp’s
behalf, then the courts have generally found ways to rule sympathetically toward
the promoter.
i. De Jure Corporation—When the defect is trivial, the court will forgive it and
treat the core as a de jure corp.
ii. De Facto Corporation—when the defect is more serious, the court will
apply the common law doctrine and treat the unincorporated business as
53
 incorporated calling it a de facto corporation and extending protection of
limited liability.
d. Contract indicates that a corporation is formed In this situation, the promoter
sets forth a contract that indicates to the other party that it is dealing with a
corporation yet to be formed, but which is intended to be formed. In this case, the
court must interpret the parties intent:
i. IF the corporation is never formed, the promoter is likely to be held
personally liable. The court will reason that the parties intended for
SOMEONE to be liable and in the absence of a corporation, it is the
promoter.
ii. IF the corporation is actually formed, but the contract is never adopted, the
promoter will also be held personally liable for the same reason.
iii. If the corp adopts the contract, the promoter is must less likely to be held
liable, but it still depends on the intent of the parties.
4. Southern-Gulf Marine Co. No. 9, Inc. v. Camcraft, Inc. (1982, p.202)—Camcraft sought
to get out of a contract with Southern-Gulf stating that Southern-Gulf had not been
incorporated when the contract was signed (trying to get out of the contract by a
technicality). Problem, at the time the K is signed, the Corp. does not exist, but he signs
as an individual and as president of the non-existent corp.
a. RULE: When a party has contracted with what he acknowledges to be and
treats as a corporation and has incurred obligation in his favor, that party is
estopped from denying the existence or legal validity of such a corporation
in order to escape those contractual obligations. (can’t use contract technicality
offensively)
b. HELD: The record discloses nothing indicating that the substantial rights of the
defendant were affected by Southern-Gulf’s de facto status. Southern-Gulf relied
upon the contract and secured financing. Camcraft likewise relied on the contract
and began construction of the vessel. Therefore, Camcraft is estopped to deny the
corporate existence of Southern-Gulf in this regard and the rule of construction
which adapts an interpretation in accordance with justice and fair dealing with
doubts resolved against the seller.
c. Solutions within Contract:
i. Term allowing Camcraft to stop construction if the corporation is not formed.
ii. Put a minimum capital requirement on the K so that when the capital on the
corp reaches a certain level, the individual is no longer liable on the K and
the corp becomes liable.
iii. Successor in interest provision for corp formed in a different jurisdiction
iv. Try to specify what happened if corp is not formed an dif it is formed what
happened if corp doesn’t adopted the K.
O. Piercing the Corporate Veil
1. EXAM: How do you help a client avoid getting its veil pierced?
2. General Rule: The law permits the incorporation of a business for the very purpose of
enabling its proprietors to escape personal liability.
a. The courts will disregard the corporate form, or, to use accepted terminology,
“pierce the corporate veil,” whenever necessary to prevent fraud or to achieve
equity.
b. EXCEPTION: Whenever anyone uses control of the corporation to further his
own rather than the corporation’s business, he will be liable for the
corporation’s acts upon the principle of respondeat superior applicable even
where the agent is a natural person.
i. “Alter Ego” Principle—100% owner is treating the corporation as an “alter
ego”—similar to agency law

54
 ii. Such liability extends not only to the Corporation’s commercial dealings but
to its negligent acts as well.
iii. If a corporation is a fragment of a larger corporate combine which actually
conducts the business, then only the larger corporate entity will be held
financially responsible
iv. If corporation is a “dummy” for its individual stockholders who are in reality
carrying on the business in their personal capacity for purely personal rather
than corporate ends, then the stockholder will be personally liable.
v. Walkovszky v. Carlton (1966, p.207)—Common practice as a taxicab
industry of vesting the ownership of a taxi fleet in may corporations, each
owning only one or two cabs. In this case, P was seriously injured, by one
of D’s cabs. D owns many corporations and holds only the minimum
insurance per cab.
o HELD: There is no valid cause of action. There are no allegations
that D was conducting business in his individual capacity. The taxi
owner-operators are entitled to form such corporations, and if the
insurance coverage required by statute is inadequate for the
protection of the public, the remedy lies not with the courts but
with the legislature. The enterprise does not become either illicit or
fraudulent merely because it consists of many corporations.
o NOTE: you have to be licensed to run a cab
o DISSENT: He argues that he doesn’t think that the Legislature
intended to require a taxi corp to only have the minimum amount of
insurance if they can afford more. Professor thinks this is ridiculous.
o Clear Legislative Statement Rule the reading of the statute is so
odd that we won’t read that meaning into the statute unless it is done
clearly.
vi. Three possible legal doctrines that a plaintiff might invoke in such situations:
o Enterprise liability—can get to other assets of other corporate
entities, but not to the personal assets of the owner.
o Respondeat superior (agency), and
 He is so involved in the operations that we should hold him
responsible under agency theory.
o Disregard for the corporate entity (piercing the corporate veil)
3. RULE: A corporate Entity will be disregarded and the veil of limited liability pierced when
two requirements are Met:
a. (1) Such a unity of interest and ownership that the separate personalities of
the corporation and the individual are or other corporation no longer exist
(maintain corporate formalities); and
i. Factors:
o Failure to maintain adequate corporate records or to comply with
corporate formalities
 Follow formalities of having Certificate of incorporation,
passing bylaws, having board of director’s meeting.
o Commingling of funds or assets,
 To Professor this is part of formalities don’t intermingle
corporate and personal funds.
o Undercapitalization—not enough capital to meet the normal
predicable costs of doing business.
o One corporation treating the assets of another corporation as its
own.

55
  Must act as if the corporation is separate from you.
b. (2) Circumstances such that adherence to the fiction of separate corporate
existence would sanction a fraud OR promote injustice (Corp. may not be
used to commit fraud).
i. “Promote injustice means something less than fraud. Ex.
o Some wrong beyond a creditor’s inability to collect would result
o Common sense rules of adverse possession would be undermined
o Former partners would be permitted to skirt the legal rules
concerning monetary obligations.
o A party would be unjustly enriched
o A parent corporation that caused a sub’s liabilities and its inability to
pay for them would escape those liabilities
o An intentional scheme to squirrel assets into a liability-free
corporations while heaping liabilities upon an asset-free corporation.
ii. Sea-Land Services, Inc. v. Pepper Source (1991, p.212)—D is clearly not
following corporate formalities, commingling business funds from various
corporations and his personal funds, and undercapitalizing the businesses.
D has a judgment against one of his corporations that dissolved. P tries to
get money from D personally and from his other corporations.
o HELD: Clearly shared control/utility of interest and ownership.
However, the court remands for a determination of whether not
awarding damages would “promote injustice” in the manner shown
above. On remand, found P was defrauded.
o Enterprise Liability situation
o “Reverse Piercing” when a person is found liable through veil
piercing of the corporation they own, additional companies owned by
the liable party may also be held accountable for the debts owned
and they may have their veils pierced because of their relationship to
the guilty party if the court orders the piercing by court order.
4. There is no respondeat superior between subagents/subsidiaries The “alter ego”
makes a parent liable for the actions of a subsidiary which it controls, but it does not mean
that where a parent controls several subsidiaries each subsidiary then becomes liable for
the action of all other subsidiaries.
a. Roman Catholic Archbishop of San Francisco v. Sheffield (1971, p.218)—
Skipped
5. A corporation owns all the shares of common stock of another corporation.
a. The first corporation is generally referred to as a “parent corporation” not liable
for the debts of the subsidiary, so the parent, like any other shareholder, is not
liable for the debts of the subsidiary, so the parent can undertake an activity without
putting at risk its own assets, beyond those it decides to commit to the subsidiary.
Corporate shareholder must be aware of the danger that if it is not careful, the
creditors of the subsidiary may be able to pierce the corporate veil of the
subsidiary.
b. The second is a “subsidiary”
c. When a corporation is so controlled as to be the alter ego or mere
instrumentality of its stockholders, the corporate form may be disregarded in
the interests of justice. This is determination is based upon a totality of the
circumstances.
i. In Re Silicone Gel Breast Implants Products Liability Litigation (1995,
p.222)—Bristol Beyers Squib is the parent corporation and owns 100% of
MEC as a subsidiary. Bristol also owns other subsidiaries. Someone sues

56
 for a breast implant leaking and try to hold Bristol liable.
o HELD: The court concludes that a jury could find that MEC was but
the alter ego of Bristol based upon the totality of the circumstances.
For example, 2 of the 3 directors were the same, they filed
consolidated federal income tax returns, used its own resources to
loan money, etc. Delaware courts do not necessarily require a
showing of fraud if a subsidiary is found to be the mere
instrumentality or alter ego of the stockholder.
ii. Totality of Circumstances Factors:
o The first 5 are not necessarily bad—Found in most subsidiary
situations.
 The parent and the subsidiary have common directors or
officers
 The parent and the subsidiary have common business
departments
 The parent and the subsidiary file consolidated financial
statements and tax returns
 The parent finances the subsidiary
 The parent caused the incorporation of the subsidiary
o The subsidiary operates with grossly inadequate capital
o The parent pays the salaries and other expenses of the subsidiary
o The subsidiary receives no business except that given to it by the
parent
o The parent uses the subsidiary’s property as its own
o The daily operations of the two corporations are not kept separate
o The subsidiary does not observe the basic corporate formalities,
such as keeping separate books and records and holding
shareholder and board meetins.
 Professor kind of says, SO WHAT? How is this fraudulent?
iii. This could be a case of Apparent Agency—Bristol Meyers was holding
itself out as the source of the breast implants because name was on the
product.
iv. Can’t complete plan around the avoidance of liability—can conform to
formalities to help.
6. Presser is the authority on this issue.
7. “Tax Shelter” Investments ones that show losses for tax purposes even though they
may be successful economically.
a. The tax advantage of the use of the limited partnership form of organization was
that the investors were able to claim their pro rata share of the losses of the
partnership on their individual tax returns, which is not possible for tax-shelter-type
investments if the corporate veil is used.
b. A variation on the basic limited partnership” a limited partnership with a corporation
as the sole general partner. No individual was liable for the debts of the
partnership.
c. It is often easier for a lawyer to form a corporation than for clients to respect the
form and thereby make it effective.
d. Frigidaire Sales Corporation v. Union Properties, Inc. (1977, p.229)—P enters
into a contract with Commercial, a limited partnership. Rs were limited partners of
Commercial. Rs were also officers of Union, the only general partner of
Commercial. Rs controlled the Union property and through their control of Union
they exercised day to day control and management of Commercial. Commercial
breaches the contract.
57
 i. HELD: Limited partners do not incur general liability for the limited
partnership’s obligations simply because they are officers, directors, or
shareholders of the corporate general partner. P was never led to believe
that respondents were acting in any capacity other than in their corporate
capacity. Because Rs scrupulously separated their actions on behalf of the
corporation from their personal actions, petitioner never mistakenly
assumed that Rs were general partners with general liability.
ii. Professor: This is the correct/fair outcome because to do otherwise would
result in a windfall because P knew what they were bargaining for when
entering into the contract.
P. DERIVATIVE LITIGATION
1. If a corporate official violates any of the duties he or she owes to the corportation, and the
board of directors fails to take appropriate action, American law recognizes the right of a
shareholder to sue in the corps behalf to redress the injury.
2. Typically involves a breach of the fiduciary duty of loyalty owed to the corporation,
resulting in damage to the corporation.
a. “Damage” Corporation’s financial situation is worse than it otherwise would be
and the price of the corporation’s stock is lower than it otherwise would be. Thus,
this indirectly affects the shareholders.
b. Necessary because of the separation between ownership and control
3. The lawsuit is the corporation’s right and any recovery from the action accrues to the
corporation.
a. In normal circumstances, questions of litigation strategy are decided by the
board of directors.
4. True defendants are the individuals who have wronged the corporation—officers, board of
directors, etc.
5. IF SUCCESSFUL Corp required to pay the plaintiff shareholder’s expenses because he
has benefited the corp.
a. This prevents the free rider problem that would otherwise exist.
b. In effect the law “taxes” all shareholders and thereby equitably apportions the costs
of monitoring the defendant’s conduct.
6. IF UNSUCCESSFUL Attorney/plaintiff bears the cost of the suit, not shareholders
7. Nuisance Action or Strike Suit
a. In reality suit typically brought by plaintiff’s attorney who owns a small amount of
stock.
b. Suit may be brought for its nuisance value because it is often more costly for the
defendant to defend the action than it is for the plaintiff’s attorney to bring it.
i. Often better in these situations to pay off the plaintiff shareholder so that
you can continue running the business.
c. Tendency for meritorious actions to result in Collusive Settlements real party in
interest tends to be the plaintiff’s attorney and this attorney has an economic
incentive to strike a deal, exchanging low recovery for high attorney’s fee award.
Sometimes even offer a non-monetary remedy (“put together an investigation
committee”). Look p. 208
i. In this case the shareholders loose out and the shareholder plaintiff gets a
greater benefit. This creates an agency problem because the shareholder
plaintiff owes a duty as an agent to the stockholders.
ii. This arises because both the Defendants and the nominal shareholder
plaintiff can pass the real costs of litigation onto the corp.
iii. To reduce the possibility of collusive settlements, judicial approval of
settlements reached in class and derivative actions is required in almost all
jurisdictions.

58
 d. To deter frivolous action, P often required to post a bond for defendant’s attorneys
fees to be paid if action is unsuccessful.
i. Cohen v. Beneficial Industrial Loan Corp. (1949, p.232)—Cohen owned
100 shares in Beneficial at $90 a share (this is .0125% of the total shares).
Cohen is complaining about mismanagement and fraud and brought a
derivative action. After Cohen initiates the suit, NJ passes a statute,
applicable to pending actions, making Ps with a small interests with
companies liable for posting a bond for the reasonable expenses of
attorney’s fees of the Defense if he fails to make good his complaint.
o HELD: P is a self-chosen representative and a volunteer champion
—Constitutional to require a bond to be posted. Furthermore, such
a law is a substantive rule of decision.
o RULE: A federal court with diversity jurisdiction must apply a state
statute providing security for costs if the state court would require
the security in similar circumstances.
o NOTE: There are remedies for these situations other than
Litigation. Reputation, to Professor, is more important to a person
than the fear of litigation—if a reputation is bad then no one will wan
to invest in the company.
e. Only shareholder who owned shares contemporaneously to at the time of the
wrong have standing to sue because subsequent shareholders not injured by the
wrong.
8. Business Judgment Rule—the corporation’s board of directors can successfully move to
dismiss the action on the ground that it has reviewed the action and deems it contrary to
the corporation’s best interest.
a. Problem because sometimes derivative litigation is a necessary monitoring
mechanism by which to police the conduct.
b. Procedurally, a plaintiff who wishes to commence a derivative action must
either first make a demand on the board of directors to bring the action or
demonstrate that demand was excused.
c. Delaware Strict Demand Rule gives the BOD the opportunity to do one of
several things.
o Take corrective actions or enter into a settlement with the D, thereby
avoiding the need for the lawsuit
o Bring the requested action
o Permit the P to proceed in its place, or
o Reject the requested action as not in the corp’s best interest.
ii. Generally, P seldom makes demand. Preferring to argue excused because
under Delaware Law, the making of demand concedes that a business
judgment test applies to the board’s decision to reject demand.
iii. In DE, Demand Rule strictly enforced, but American Law Institute ha
recommended that the demand required, demand excused distinction be
dropped and that demand be required in virtually all cases.
d. Excused Demand usually excused if the complaint alleged misconduct by ay of
the board’s members.
i. P must allege that a majority of the board personally benefited from the
challenged transaction or was otherwise subject to a legally disabling
conflict of interest.
9. Special Litigation Committee—Even if demand is excused, the plaintiff may still be
barred from proceeding because of the special litigation committee, consisting of director
who were not properly regarded as defendants.
a. SLC would hire outside counsel and carry out a thorough investigation.

59
 b. These committees almost always decide not to proceed with litigation and to
dismiss action.
c. Court vary in their standard of review applied
d. Justifications frequently given are plausible.
10. Eisenberg v. Flying Tiger Line, Inc. (1971, p.236)—Eisenberg is a shareholder of Flying
Tiger and filed suit against Flying Tiger to overturn a reorganization and merger. Eisenberg
argued that the reorganization would unfairly diminish his voting power and the voting
power of all other public stockholders by preventing them from directly influencing the
affairs of the operating company. The suit was brought as a class action suit. ISSUE:
Whether this suit is a derivative action or a class action direct law suit?
a. HELD: P was had a personal cause of action, not a derivative suit.
b. Rule: The class action suit is a representative action where the
representative of the class represents the issues of the entire class. The
derivative suit is an action in which the plaintiff represents the corporation.
c. This case is here to show that it can be difficult to determine if a suit is a direct suit
or a derivative suit.
d. TEST: The question to ask is whether the injury is a direct injury to the people
(shareholders) or an injury to the corporation (and only an indirect injury to the
shareholders).
e. The difference lies in the representation by the plaintiff.
11. Delaware 2 prong standard to be used in determining whether a stockholder’s claim is
derivative or direct:
a. (1) Who suffered the alleged harm, the corporation or the suing stockholders,
individually, and
b. (2) Who would receive the benefit of any recovery or other remedy, the corporation
or the stockholders individually.
12. Settlements and Attorneys Fees
a. If a action is settled BEFORE judgment, the corp can pay the legal fees of the P
and of the Ds.
b. If a JUDGMENT for money damages is imposed on the Ds, they will be required to
pay those damages and may be required to bear the cost of their defense.
c. EVERY state pushes these suits towards settlement.
d. RKO Case The officers loose a $100,000 contract because of bad contact.
When the derivative suit brought it is settled with $500,000 attorneys fees awarded
and a committee assigned to investigate. Show how willing courts are to approve
settlements.
i. Professor thinks this is funny!
e. NOTE: most important check on incompetent management if the risk of being
taken over.
13. Business judgment rule: How much judicial review do you want in the internal
organizations of a business?
a. Demand excused: Demand on the board is excused where it would be “futile.” In
general, demand will be deemed to be futile (and thus excused) if the board is
accused of having participated in the wrongdoing.
b. The requirements of demand on directors: Direct suits generally vindicate
shareholders’ structural, financial, liquidity, and voting rights. See Grimes v.
Donald. (Direct action when shareholder claimed directors’ abdicated statutory
control to CEO under terms of employment agreement). Derivative suits, on the
other hand, generally enforce fiduciary duties of directors, officers, or controlling
shareholders – duties owed to the corporation.
i. Delaware view: In Delaware, demand will not be excused unless P carries
the burden of showing a reasonable doubt about whether the board either:

60
 (1) was disinterested and independent; or (2) was entitled to the
protections of the INFORMED business judgment (i.e., acted rationally
after reasonable investigation and without self-dealing).
o Difficult to get: But Delaware makes it very difficult for P to make
either of these showings. For instance, he must plead facts showing
either (1) or (2) with great specificity. Also, it is usually not
sufficient that P is charging the board with a violation of the duty of
due care for approving the transaction; usually, a breach of the duty
of loyalty by the board must be alleged with specificity.
ii. New York: New York follows roughly the same rules as Delaware about
when demand will be excused. In New York, demand will be excused if (and
only if) the complaint alleges “with particularity” any of the following:
o “That a majority of the board is interested in the challenged
transaction.” (A director can be “interested” either because she has
a direct self-interest in the transaction, or because, although she has
no direct self-interest in the transaction, she has lost her
independence by being “controlled” by a self-interested director.)
o That the board “did not fully inform themselves about the
challenged transaction to the extent reasonably appropriate under
the circumstances.” In other words, a director who merely “passively
rubber stamp[s] the decisions of the active managers” does not
thereby exempt herself from liability.
o That “the challenged transaction was so egregious on its face that
it could not have been the product of sound business judgment
of the directors.”
c. Grimes v. Donald—Plaintiff is a stockholder and finds that the employment
contract that the company has with Donald is terrible. Grimes alleges that the
agreement is a breach of the board’s fiduciary duties because it failed to exercise
due care and committed waste. (The employment contract involved continued
payment to Donald, the CEO, after termination, medical benefits, etc.) Issue:
Whether the board’s rejection of the demand made by the shareholder was valid?
i. Rule: If a shareholder makes a demand on the board of directors to take
action and that demand is rejected, the board rejecting the demand is
entitled to the presumption that the rejection was made in good faith unless
the stockholder can allege sufficient facts to overcome the presumption.
o This case just reiterates that in Delaware, typically a plaintiff will not
bring a demand because the plaintiff will not want to waive the right
to an excused demand and admit that the board can make a valid
decision.
o Here Grimes made a pre-suit demand and his failure to plead
particularized allegations which would raise doubt regarding the
board’s decision to reject the demand meant that the board received
the protection of the business judgment rule.
d. Marx v. Akers—Plaintiff brought derivative action against board of directors of IBM
alleging a waste of corporate assets due to excessive compensation of IBM
executives and outside directors. ISSUE: Whether the plaintiff was required to
make a demand upon the board before pursuing litigation?
i. Rule: In New York, a demand is considered to be futile and therefore
excused if the complaint alleges with particularity that a majority of the
directors are interested in the transaction, that the directors failed to inform
themselves to a degree reasonably necessary about the transaction, and
that the directors failed to exercise their business judgment in approving the

61
 transaction.
o In New York, the legislature had not adopted a “universal demand”
policy so it is not the role of the court to enforce such a policy.
o Therefore, the court adopts a standard of futility for demands.
e. Alternatives (Insoluble problem) Germany: Must require a union worker
member to be on the board. Additionally, a bank representative must be present on
the board. This moves you towards a more political model versus a business
model.
14. The Role of Special Committees and Judicial review Courts do not simply rubber
stamp and independent committee’s decision not to pursue the suit. For instance, if P can
show that the committee was not really independent, or did not conduct even a reasonably
careful investigation, the court is unlikely to dismiss P’s suit based on the committee
recommendation. But the much more interesting question is whether, if the court is
convinced that the committee was independent and used appropriate procedures, the
court may nonetheless us its independent judgment about whether P’s suit has merit. On
this issue, courts vary widely. There seem to be two main positions, the New York position
and the Delaware position.
a. Majority / New York Rule: The New York approach makes it very difficult for the
plaintiff to overcome the independent committee’s recommendation that the suit be
terminated. The plaintiff is entitled to show that the members of the committee were
not in fact independent (e.g., that they were dominated by the controlling
shareholder who was accused of wrongdoing), or that the committee did not use
reasonable procedures in reaching its conclusion (e.g., its investigation was very
shallow). But once the court is satisfied with the committee’s independence and
procedures, the New York courts will not review the merits of the substantive
recommendation that the suit be dismissed.
i. The court will NOT attempt to make an independent determination of
whether the committee was correct in its conclusion that the probability of
recovery was low, the costs of proceeding with the suit would be high, etc.
Instead, the committee’s substantive recommendation that the suit be
dismissed, and the board’s approval of that recommendation, receive the
protection of the business judgment doctrine.
ii. Auerbach v. Bennett (1979, p.256)—A shareholder of GTE challenged the
decision by a board-appointed special litigation committee to terminate a
shareholder’s lawsuit. ISSUE: Whether further judicial inquiry is permitted
after a special litigation committee recommends dismissal of the derivative
suit?
o HELD: A court may properly inquire as to the adequate
independence of the special litigation committee members and the
reasonable appropriateness of its investigation, but the court may
not inquire into the substantive merits of the decision—such a
decision is protected by the business judgment rule. Thus, to accept
the assertions of the intervenor and to disqualify the entire board
would be to render the corporation powerless to make an effective
business judgment with respect to the prosecution of the derivative
action.
b. Minority / Delaware view: Delaware, by contrast, will in some situations let its
court review the substantive merits of the committee’s recommendation that the suit
be dismissed. The Delaware approach was articulated in the landmark case of
Zapata Corp. v. Maldonado, a case in which the Delaware Supreme Court tried
hard to reconcile the need for early termination of meritless actions with the need to
make sure that the independent committee does not simply rubber-stamp

62
wrongdoing by insiders.
i. Two-step test: Under Zapata, the court should use a two-step test to
determine whether the committee’s recommendation of dismissal should be
followed:
o (1) Step 1: The court should determine whether the committee
acted independently and in good faith¸ and whether the
committee used reasonable procedures in conducting its
investigation.
 If the answer to any of these questions is “no,” then the court
will automatically disregard the committee’s dismissal
recommendation, and will allow the suit to proceed. For
instance, if the committee members are shown to have been
dominated by a controlling shareholder, or to have been
motivated by their own self-interest (e.g., they are
themselves accused of wrongdoing by the plaintiff), or if they
conducted a shallow investigation, the committee
recommendation will be disregarded.
o (2) Step 2: Even if the committee passes all the procedural hurdles
of step one, the court may determine, bye “applying its own
independent business judgment,” whether the suit should be
dismissed.
 It is in this second step that the Delaware approach varies
sharply from the New York approach: whereas the New York
courts would never enter this second step at all (and would
always dismiss the suit if the committee passed muster
under step 1), the Delaware courts retain the freedom to
allow the suit to continue even though the committee acted
with procedural correctness. In other words, in Delaware the
committee’s recommendation that the suit be dismissed will
not be given the protection of the business judgment
doctrine.
 If the court feels that the suit has merit, and would probably
result in a substantial recovery for the corporation, the court
may allow the suit to go forward even though the committee
(acting with procedural correctness, independent, and good
faith) has recommended against continuation of the action.
ii. Only in “demand excused” cases: Apparently, it is only in cases falling
into the “demand excused” rather than “demand required” variety that the
court will use the two-step test of Zapata. If demand is required¸ and the
corporation responds by appointing an independent committee that then
recommends not continuing the suit, the court will apparently treat the case
just as it would treat a case in which the main board rejects the plaintiff’s
demand. In that situation, only the independence, procedural correctness,
and good faith of the committee, not the substantive merit of its decision,
will be reviewed by the court.
iii. Zapata Corp. v. Maldonado (1981, p.261)—Maldonado was a stockholder
of Zapata and brought a derivative suit against ten officers and directors
alleging breach of fiduciary duty. Maldonado did not make a demand stating
futility. ISSUE: Whether the committee has the power to cause the present
action to be dismissed?
o HELD: A court can review the decision by an independent litigation
committee to dismiss a derivative suit and should apply a two-step

63
 test. First, the court should inquire into the independence and good
faith of the committee and second, the court should determine,
applying its own business judgment, whether the substantive merits
of the committee’s decision are valid.
c. In Re Oracle Corp. Derivative litigation (2003, p.269)—Plaintiffs brought a
derivative action stating that the defendants breached their duty of loyalty by
misappropriating inside information and using it as the basis for trading decisions.
The plaintiffs also allege bad faith. Basically, four members of the board sold
Oracle stock prior to the release of news about the company and before the stock
price fell. The company appointed a special litigation committee to determine
whether the suit should be dismissed.
i. HELD: Drawing on a general sense of human nature, the court determines
the SLC has not met its burden to show the absence of a material factual
question about independence. I find this to be the case because the ties
among the SLC, the trading defendants, and Stanford are so substantial
that they cause reasonable doubt about the SLC’s ability to impartially
consider whether Trading Defendants should face suit.
ii. RULE: The burden of proving the independence of the special litigation
committee is on the special litigation committee and the SLC must show
that the committee members are capable of making a decision with only the
best interests of the corporation in mind.
iii. “Scienter” Intent
iv. “Fetishize”
v. Revenue “Guidance”—A pitch to a meeting of higher ups giving estimates of
future profitability.
vi. This judge is trying to get the Supreme Court to change the law.
vii. To Professor, the problem with this view is that no one could ever pass the
test because he sets forth such a demanding standard of independence.
o This case doesn’t seem like it benefits the shareholder and the
corporation. Rather it seems to undermine traditional
understandings of Delaware law that give clear and precise legal
rules.
viii. This opinion notes the Martha Stuart Case, which stated that the SLC must
establish its independence by a yardstick that must be “like Caesar’s wife—
above reproach.”

NOTE: Regime Uncertainty Gov’t is imposing itself into a formerly private business regime.

IV. Limited Liability Companies

A. EXAM ISSUE: Statutory Construction and Legislative Intent or Silence
B. INTRODUCTION:
1. LLC is an alternative form of business org. that combines certain features of the corporate
form with others more closely resembling general partnerships.
2. Investors called members
3. Liability shield for its members.
4. Allows somewhat more flexibility than the corp in developing rules for management and
control. LLC may be managed by its members or by managers who may or may not be
managers
5. Advantageous tax treatment—
a. no doubt tax on co. and on shareholders, as in corporations. Only LLC Is taxed
once on its profits.
b. Investors in an LLC can take account on their individual tax returns of any losses of

64
 the LLC as those losses are incurred
c. Greater freedom than corp in allocating profit and loss for tax purposes.
6. Paperwork and filing with state agency.
C. FORMATION:
1. Must first disclose LLC status
2. Statute normally provides a notice provision stating that filing the LLC with the proper
agency creates constructive notice to the world of the limited liability enjoyed by the
owners. However, it must first be disclosed to a third party that they are dealing with an
LLC; otherwise, the agency theory of the undisclosed principal controls.
a. Agency Undisclosed Principal Where the principal is partially disclosed (the
existence of a principal is known but not his identity, it is inferred that the agent is a
party the contract and is liable for damages and can be sued on the K.
3. Water, Waste, & Land, Inc. v. Lanham (1998, p.300)—D is a manager and member of
P.I.I., LLC; however, his business card only says “P.I.I.” He negotiates a K with Ps and
only gives them his business card. When P.I.I. doesn’t pay on the K, they sue D
individually.
a. RULE: The statutory notice provision applies only where a third party seeks to
impose liability on an LLC’s members or managers simply due to their status as
members of the LLC. When a third party sues a manager or member of an LLC
under an agency theory, the principles of agency law apply notwithstanding the
LLC Act’s statutory notice rules.
b. HELD: LLC’s notice provision was not intended to alter the partially disclosed
principal doctrine. If D had told P’s rep that they were acting on behalf of P.I.I.,
LLC, the failure to disclose the fact that the entity was a limited liability company
would be irrelevant by virtue of the statute. The county court, however, found that
P did not identify themselves as agents of P.I.I., LLC, but as P.II. The missing link
between the limited disclosure made by D and the protection of the notice statute
was the failure to state that P.I.I., the company, stood for P.I.I., LLC.
i. The court implies legislative intent from the rule that the LLC must have LLC
in its name.
c. NOTE: If the general assembly has altered the common law rules applicable to this
case by adopting the LLC Act, then these agency rules must yield in favor of the
statute.
d. “Plain Meaning”—One the face of the statute—strongest statutory argument you
can make.
i. This is always the first step in an argument because if the court beliefs it
you win.
ii. In this case, the plain meaning could be that in order to have “notice that the
limited liability company is a limited liability company,” then you have to
know that it is a limited liability company.
e. Cannons of Statutory Construction
i. “Statutes in derogation of the common law are to be strictly construed.”
o Well, all statutes are in derogation of the common law; therefore,
unless a law is codifying common law, it is in derogation of the law
and should be narrowly construed.
ii. The OPPOSITE of ABOVE: “Remedial statutes are to be broadly construed
so as to effectuate its purpose.”
o Remedial statute is one that fixes the problem. Therefore, since all
statutes fix a problem, they are remedial and should be broadly
construed.
f. Consider Least Cost Avoider
D. OPERATING AGREEMENT

65
 1. Regardless of whether the relevant state law requires a certificate of formation or articles
of organization, that document is not the most important document relative to the LLC.
a. State LLC statutes will establish “default rules” that govern, but only if there are no
controlling provisions in the operating agreement.
b. Essentially, the operating agreement governs the internal operation of the LLC as
well as the relationship between the members and the LLC itself.
2. More specifically, the operating agreement can establish the process for admission of new
members, set forth any requirements for contribution, define classes of members or
managers, govern voting rights, provide for the dissolution and windup of the LLC, provide
for the allocation of profits and losses as well as distribution, and set forth the remedies for
breach of the agreement.
a. Essentially, the LLC, through its operating agreement, is structures as flexibly as its
members choose
b. Freedom of Contract
i. Most LLC statutes incorporate a policy of freedom of contract.
ii. For instance, the Delaware statute clearly enunciates this policy, stating “It
is the policy of this chapter to give maximum effect to the principle of
freedom of contract and to the enforcement of limited liability company
agreements.”
iii. According to Professor, key point of LLC statutes is that they let people
come up with their own rules
3. Elf Atochem North America, Inc. v. Jaffari (1999, p.305)—Member brought purported
derivative suit against limited liability company and its manager, alleging, breach of
fiduciary duty. The Court of Chancery dismissed suit for lack of subject matter jurisdiction.
a. HELD: (1) limited liability company was bound by agreement defining its
governance and operation, even though company did not itself execute agreement,
and (2) contractual provisions directing that all disputes be resolved exclusively by
arbitration or court proceedings in California were valid under Limited Liability
Company Act.
b. RULE: Only where the agreement is inconsistent with mandatory statutory
provisions (contravene the act) will the members’ agreement be invalidated. Such
statutory provisions are likely to be those intended to protect third parties.
E. PIERCING THE VEIL OF AN LLC
1. There are few cases dealing with this topic, but these cases indicate that veil piercing will
likely be permitted with respect to LLCs.
a. Despite uncertainties surrounding the piercing doctrine as applied to corporations, it
seems highly likely that similar concepts will be applied to LLCs.
b. While some of the concepts applied to corporations are not readily transferable to
LLCs, indications are that courts will “pierce” the veil of an LLC under doctrines
analogous to those currently applied in corporate piercing cases.
2. Kaycee Land and Livestock v. Flahive (2002, p. 312)—Wyoming’s LLC statute does not
mention piercing the veil. ISSUE: Does Legislative Silence provide for piercing the veil?
a. Rule: In the absence of fraud, a claim to pierce the veil of a limited liability
company (LLC) is treated in the same manner as a court would pierce a
corporate veil.
b. The argument is that the MT statute says that neither the members nor the
managers are liable for the debt or obligations of the LLC.
i. The statute doesn’t say anything about piercing the veil.
ii. Does the statute thus mean that the LLC’s veil can not be pierced? The
court says, “No.”
iii. Other states have adopted piercing provisions, and Wyoming has done
nothing---What do you argue from inaction or silence? Professor wants us

66
 to think about the different arguments… can go both ways.
o Ex. Minnesota has such a statute.
iv. This is based on a “no barking dog” analysis; if the legislature meant to
get rid of an important doctrine like veil piercing, they would have
discussed it. Because they did not, they did not mean to get rid of the
doctrine.
3. § 303(b) of Uniform LLC Act (a big departure from Corporations law)—“The failure of a
limited liability company to observe the usual company formalities or requirements relating
to the exercise of its company powers or management of its business is to a ground for
imposing personal liability on the members or managers for liabilities of the company.”
F. FIDUCIARY DUTIES IN LLCs
1. The scope of fiduciary duties owed by members and mangers of LLCs is, at best, in an
embryonic stage.
a. It should be noted that over half of state LLC statutes contain provisions which
allow the operating agreement to modify or define the fiduciary duties of members
or managers without restriction.
b. If read literally, these statutes allow LLCs to operate free of any fiduciary duties.
c. Simply stated, these statutes allow the LLC to set what will be its own fiduciary
responsibilities for members and the operating agreement will control
2. McConnell v. Hunt Sports Enterprises—Members of an LLC formed to explore the
possibility of applying for a new NHL franchise sought a declaration for breach of contract
against each other based on the exclusion of certain members’ ownership interests in the
franchise. ISSUE: Whether the member breached his fiduciary duty to the LLC?
a. Rule: A member of an LLC does not breach a fiduciary duty to the LLC by directly
competing against it where the operating agreement expressly permits competition.
i. This case is important because the court found that the members could
allow for competition with the LLC by placing a clause in the operating
agreement giving members such right.
ii. The court’s upholding of this clause indicates the strong desire of the court
to permit the parties to freely contract.
G. DISSOLUTION OF LLC
1. New Horizons Supply Cooperative v. Haack (1999, p.323)

V. The Duties of Officers, Directors, and Other Insiders

A. Board of directors can only claim the Business Judgment Rule is they have satisfied the
duty of care and duty of loyalty.
1. Conflict of interest—duty of loyalty
2. Consider the interests they protect—duty of care
B. Focus on PROCEDURE, not on substance of the decision making—did the board make a
reasoned business judgment?
1. If the Board follows the proper procedure, then there is a presumption of a proper decision
based upon the business judgment rule. In this case there must be gross negligence to
overcome the presumption.
C. THE OBLIGATIONS OF CONTROL: DUTY OF CARE
1. RULE: The question of whether a dividend is to be declared or distributed is a
matter of business judgment for the board of directors and courts will not interfere
in such a decision unless a plaintiff can show bad faith (fraud, illegality, self-
dealing), malfeasance, or misfeasance. More than imprudent or mistaken judgment
must be shown.
a. Kamin v. American Express Company (1976, p.328)— AmEx made an
investment in a brokerage firm called DLJ for $30 million. At the present time, the
value of the stock was $4 million and the directors of AmEx faced the choice of

67
 liquidating the bad stock investment (and taking a corporate tax deduction for the
loss) or distributing the stock to shareholders as a special dividend (a taxable event
for shareholders). The board opted for the stock dividend and some shareholders
brought a derivative action. The directors stated that they were concerned with
liquidating the stock and the adverse impact it could have on the company’s net
income figures.
i. HELD: P failed to allege any fraud, self-dealing, or bad faith. This is merely
a claim regarding the business judgment of the board. The court explains
that the board of directors are “experts” and its expertise/decision-making is
protected by the business judgment rule. “Directors are entitled to exercise
their honest business judgment on the information before them, and to act
within their corporate powers. That they may be mistaken, that other
courses of action might have differing consequences, or that their action
might benefit some shareholders more than others presents no
superimposition of judicial judgment, so long as it appears that the directors
have been acting in good faith.”
ii. Book the Loss Recognizes the loss on the books in order to get tax
savings—In this case the board thinks it is better to take the loss in taxes
than to report the loss. The board is afraid that if they display a loss then
the stock price will decrease.
iii. Efficient Capital Market Hypothesis All publicly available information of
a company is almost instantaneously reflected in stock price. “Publicly
Available Information” there is no secret information—you can find
everything.
o Therefore, it doesn’t matter what the accounting standard is because
the value is already reflected in the price.
o Therefore, the stock price already reflects this loss and the board’s
idea is wrong.
o Because of this rule, Professor thinks that the Court acts too quickly
in taking the board’s word for the fact that this not booking the loss
was correct.
iv. Despite the Board’s decision, Professor thinks this decision is correct
because it is not gross negligence.
2. Whether a business judgment is an informed one turns on whether the directors
have informed themselves prior to making a business decision or all material
information reasonably available to them; where an unadvised judgment has been
made, there is no business judgment protection for the board of directors.
i. The determination of whether a business judgment is an informed one turns
on whether the directors have informed themselves prior to making a
business decision, of all material information reasonably available to them.
ii. Information + Debate = Informed business Judgment
iii. How much information has to be available.
b. Smith v. Van Gorkom (`985, p.332)—Trans Union was not making enough money
to take advantage of all of its tax benefits (those available during the 1980s) and so
Van Gorkom began to think about the options for changing the nature of the
company. He spoke to the CFO (Romans) and Romans did some research on a
leveraged buyout. Romans came up with a value of the company shares (and he
determined that a loan of $60 a share would be too difficult to pay back and $50
would be easy, so he determines $55 would be best). Van Gorkom goes to see
Pritzker without consulting the board and offers him the company at $55 a share.
Van Gorkom says that he wants to make sure that $55 is the best offer so the if
other offers come through, he wants to be able to accept them—Pritzker says that

68
he doesn’t want to be the “stalking horse” bid. He wants a lock-up option (to
purchase a vault of shares at the current price--$38--so that if the company stock
price goes up, he can sell those shares for a profit). Pritzker wants to go through
with the deal and a special meeting of Trans Union takes place on Saturday to
discuss the deal—the board of directors is handed merger documents and accepts
the merger. ISSUE: Did the BOD reach an informed decision regarding the
merger
i. 12.5 million shares of stock outstanding in trans—$690,000,000 outstanding
ii. Pritzker was offering a “premium”—a premium price is the price offered
that is higher than the current value of the corporation’s stock.
iii. With premiums, if you own stock in the target company, you will take
money and re-invest it elsewhere. IF you own stock in the company
purchasing the target company, you are the one paying the premium.
o This goes with the phrase, “The Winner’s Curse” it is the idea
that when you win an auction, you have just paid the highest price
for the thing that you bought. The ball is in your court to make it
worth as much as you thought it would be.
o If you own stock in a company that is buying up other companies,
you need to be worried about “the winner’s curse.”
iv. This is a Friendly Takeover They want to be taken over.
o A premium is always paid in a takeover.
v. .HELD: The court in this case takes issue with PROCEDURE, rather than
substance. The substance of the board’s decision is protected by the BJR,
but the procedure, which was followed can be reviewed by the court. The
court finds that the directors breached their fiduciary duty of care because:
(1) they failed to inform themselves of all information readily available to
them and relevant to their decision to recommend the Pritzker merger, and
(2) They failed to disclose to the stockholders all of the information as to
how the price of the shares was arrived at.
o The court applied a theory of gross negligence to the decision
making procedures of the board
o Big Questions: Are the stock holders so uninformed that their vote
doesn’t count for anything??
o Board must make a recommendation to the stockholders, and based
on their fiduciary duty they Board must gather “all information
reasonably available,” and the Court finds the Board did not do this.
According to Professor, this is impossible based upon the
Economics of Information (discussed below).
vi. This case sets a very aggressive bar for duty of care cases in favor of
the shareholder and as such, the case raised a great outcry.
o This was the FIRST time in Delaware that a plaintiff had prevailed on
a duty of care case. Prior to this case, people really didn’t think that
plaintiffs could win a duty of care case.
vii. DISSENT: The dissent stated that a court shouldn’t second-guess a director
—plus, these men were smart, business-savvy individuals. (A.W. Wallis was
an outside director who was an economist and statistician at Yale and
Chicago and under-secretary of state for Reagan).
o Concerns of the dissent included:
 The fear that director liability would be a deterrent to an
outside person agreeing to serve as a director.
 The increased price of D&O (Director & Officer) Liability
Insurance.
69
  The fear that the decision would lead to super-cautious
decision making by directors, reliance on experts, etc.
 The fear that boards would start to second guess all
recommendations from CEOs for fear of being accused of
self-dealing.
viii. Professor is VERY skeptical about the outcome of this case.
c. Leveraged Buyout—a buyout of a company that involves a lot of debt—basically,
a group of people go to a bank and borrow money to buy up all the stock of a
company (typically a company with a small amount of equity and a large amount of
debt). The group borrows money from the bank and then pays the bank a monthly
note. At the end of the payment of the debt, the group owns the company. (It can
be compared to buying a house with a mortgage.)
i. This is only successful if the group running the company will run it well
enough to pay back the debt.
ii. Typically, LBOs involve a buyout by the management of the company. (This
is what is called taking a “public company private.”)
d. “Economics of Information”—George Stigler—a person doesn’t know whether
the decision to get more information is a good one until after more information is
gotten. At some point, a person has to say enough is enough. Stigler tried to figure
out at what point people reached this conclusion and why.
i. The board in Van Gorkom is faced with the same sort of decision.
ii. They need to get all material information but how do they know that the
information they have gotten is enough.
iii. And, who should decide whether the information is enough—the board or
the court?
e. Lock Up Option If you are going to have an auction of the selling company, then
the company who began the efforts to buy wants the selling company to sell them
treasury stock at market price (not at a premium). The company may then sell
those treasury stock to whoever wins at the auction.
f. Economics of informationPeople economize on “search costs.”
i. There is always the possibility that if you kept searching, that you could find
a better deal. People search until they think they have searched enough to
quit searching.
ii. Can’t optimize because you don’t know the parameters of what you
searching.
iii. How much information do you gather before you decide you have gathered
enough to make a decision. This is what boards are faced with when
making a business decision—at some point you must decide that enough
information has been gathered to make a decision. Therefore, the
reasonably available standard from VanGorkum decision is illusory.
g. Delaware General Corporation Law § 102(b)(7)—Opt-In Default Rule—
MEMORIZE!
i. A corporation can in its articles of incorporation have a clause that states:
ii. “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 provisions shall not eliminate or limit
the liability of a director:
o (i) For any breach of the director’s duty of loyalty to the corporation
or its stockholders,
o (ii) for acts or omissions not in good faith or which involve intentional
misconduct or a knowing violation of law,
o under § 174 of this title relating to payment of dividends, or

70
 o For any transaction from which the director derived an improper
personal benefit.
iii. Meaning Directors are not personally liable for breaching the duty of care.
iv. This amendment essentially voids Smith v. Van Gorkum, if the corporation
opts to include this provision.
v. There has been widespread adoption by states and adoption by the
shareholders. Vast majority of Fortune 500 are incorporated in DE and
have adopted §102(b)(7).
vi. A legislative reaction to a judicial decision—Who is in the better position to
change the law—judiciary or legislature?
3. Fiduciary duties of care and loyalty gives rise to the requirement that a “director
disclose to shareholders all material facts bearing upon a merger vote.
a. Cinerama v. Technicolor, Inc. (Delaware SC—p.342)—Perelman acquired
Technicolor, Inc. at a price of $23 per share (the pre-offer price was $11 per share).
Cinerama was a shareholder of Technicolor and opposed the merger with
Perelman’s company.
b. HELD: Technicolor and its board had met its burden of proving “the entire fairness”
of the transaction—and such factors to be considered in determining fairness were:
the timing, initiation, negotiation, and structure of the transaction, the disclosure to
and approval by the directors and the disclosure to and approval by the
shareholders.
4. In order to prevent the courts from becoming “super-directors,” mere disagreement
cannot serve as the grounds for imposing liability on a board of directors for
alleged breach of fiduciary duty of care and waste.
a. Brehm v. Eisner (2000, p.345)—DISNEY CASE—Eisner hires Ovitz to replace
Katzenberg as president of Disney. Ovitz receives a very nice employment contract
with a very favorable term regarding no-fault termination (if there is no cause for
firing, they can agree for him to leave and he gets a huge salary package). Eisner
and Ovitz disagree and decide that Ovitz can leave the company on no-fault
grounds (getting all the money in the employment contract). P alleges waste.
i. HELD: Based upon the facts presented, they were not particularized
enough ot show a breach of fiduciary duty by the board. The board went
through the proper procedures required by § 141(e) and considered the
information reasonably available. Additionally, the Court would NOT
second-guess the consideration given for the employment contract because
it was not an issue for the court to determine. Only when there is complete
lunacy or irrationality will the court look to the substantive aspects of the
decision.
ii. Duty of Care:
o PROCESS (reasonably informed business judgment)
 Delaware Corporate Code § 141(e)—reliance on an expert in
good faith by the board provides “full protection” by the
business judgment rule.
• Bd. relied on a compensation expert, although it was
later found to be bad advice.
o SUBSTANTIVE (waste test)—“Courts do not measure, weigh o
qualify director’s judgments. We do not even decide if they are
reasonable in this context. Due care in the decisionmaking context
is process due care only.”
 Waste—an exchange so one-sided that no person of sound
judgment could conclude that the corporation received
adequate consideration.

71
  Court says it is completely a matter of business judgment,
but there are outer limits . . . The court basically says that the
only substantive test is complete irrationality so there is
really no substantive test.
5. Two Conceptions of Business Judgment Rule (BIG Policy Consideration)
a. Treats the rule as having Substantive Content. The BJR comes into play as a
standard of liability only after one has first determined that the directors satisfied
some standard of conduct.
i. In effect, the rule simply raises the liability bar from mere negligence to
gross negligence or recklessness.
b. BJR as an Absetntion Doctrine. The rule’s presumption of good faith is also a
presumption against judicial review of duty of care claims. The court will abstain
from reviewing the substantive merits of the directors’ conduct unless the P can
rebut the business judgment rule’s presumption of good faith.
6. Professor’s Delimma: Tighten up on the rules or allow for more risk taking under the guise
of the business judgment? How does the role of reputation play into this debate?
a. Risk v. Expected Value
i. To Professor, these facts are pretty egregious.
7. The most successful claims against directors have come where the director simply fails
to do the basic thins that directors generally do. Thus, a director might be found
grossly negligent and, therefore, liable if he does some or all of the following:
i. Fails to attend meetings,
ii. Fails to learn anything of substance about the company’s business,
iii. Fails to read reports, financial statements, etc. given to him by the
corporation,
iv. Fails to obtain help when he sees or ought to see signals that things are
going to seriously wrong with the business, or
v. Otherwise neglects to go through the standard motions of diligent behavior.
b. Francis v. United Jersey Bank (1981, p.356)—Mrs. Pritchard is a director of
Pritchard & Baird, a reinsurance broker. P&B goes bankrupt, and its trustees in
bankruptcy sue Mrs.. Pritchard for violating her duty of care as a director. They
show that two officers of P&B, Charles and William Pritchard (directors, sole
stockholders, and sons of Mrs. Pritchard) have misappropriated $12 million from
trust accounts held by the company on behalf of others. During the years the
misappropriation took place, Mrs. Pritchard was elderly, alcoholic, and depressed
over the death of her husband. She hardly ever attended board meetings, knew
nothing of the corporation’s affairs, never read or obtained any financial statements,
and in general did not pay any attention to her duties as a director or to the affairs
of the corp.
i. HELD: Mrs. Pritchard breached her duty of care to the corp, and is
therefore liable for the losses caused by the misappropriation. Directors are
not required to conduct a detailed inspection of day-to-day activities. But
they must at least become familiar with the fundamentals of the business,
and must keep informed in a general way about the corp’s activities. Here,
had Mrs. Pritchard done even so little as to read the corp’s financial
statements at any time, she would have noticed an item called loans to
shareholders which dwarfed the company’s assets, and which would have
immediately put her on notice that her sons were effectively stealing trust
funds. Had she noticed this, and asked her sons to stop, they probably
would have done so.
ii. Court notes that if he comes across illegal activity then he is under a duty to
say something, and if it is not corrected, he must resign.

72
 iii. RULE: If you can’t handle the job, don’t take the job.
8. Passive Negligence—Circumstances exist that the Board arguably ought to notice and do
something about, but instead the board members do nothing—Failure to detect
wrongdoing.
a. While a board’s duty may not require it to install a system of espionage to
ferret out wrongdoing, that does of care does require that reasonable control
systems be pu in place to detect wrongdoing, even where the board has no
prior reason to suspect that wrongdoing is occurring.
b. In re Caremark Int’l, Inc. Derivative litigation (Delaware Case—1996, p.362)—
Caremark is a medical services firm, which provides various forms of therapy to
outpatients. The co. participates in various Medicare and Medicaid programs. A
federal law, the Anti-Referral Payments law (ARLP), forbids firms such as caremark
from paying doctors to refer Medicare and Medicaid patients to it. Caremark pays
physicians fees for monitoring certain patients, including Medicare and Medicaid
patients, that are under the firm’s care. They are getting a kickback. Federal
Prosecutors indict the co. on various felonies arising out of these monitoring fees,
on the theory that the fees violate ARPL. The co. settles these charges by pleading
guilty so a single felony count, and then spends $250 million to settle various
related civil claims against it. No senior officers or directors of the firm are charged
with wrongdoing. Stockholders then bring a derivative suit on behalf of the co.
against all members of the BOD, claiming that the Board members failed to
exercise their duty of care, which required them to put control mechanisms that
would have prevented such violations. The parties propose to settle the suit,
without the Ds paying any money, but with the co. taking various steps to avoid the
future violations. Court asked to approve settlement—It is a structural settlement.
i. HELD: The settlement is approved. In deciding whether a settlement
involving no financial recovery is reasonable, the court must take into
account the likelihood that the plaintiffs would have prevailed at trial. A
directors obligation includes a duty to attempt in good faith to assure that a
corporate information and reporting system, which the board concludes is
adequate, exists, and failure to do so under some circumstances may
render a director liable for losses caused by non-compliance with applicable
legal standards.
ii. However, the burden on a P who wants to establish a breach of this
obligation is high—only a sustained or systematic failure of the board to
exercise oversight—such as as an utter failure to attempt to assure a
reasonable info. and reporting system exists—will establish the lack of
good faith that is a necessary condition to liability.
o Here, not evidence exists that the director Ds were guilty of such a
sustained failure of oversight. The mere fact that the corp
committed a criminal violation does not by itself establish such a
failure of oversight by the board. Since the Ps would be unlikely
to prevail on the merits, settlement is reasonable.
iii. “No Duty . . . no responsibility . . . and level of detail”
iv. “Optimal Amount of Fraud” The company has to make a choice of how
much money you put into the security system. At some point, the
monitoring costs outweigh the benefits of what you find out.
v. A lot flows from the criminalization of white color crimes and corporate
illegal activity –high deterrent; therefore, Allis-Chalmers, “one free bite” rule
is not as relevant.
vi. Graham v. Allis-Chalmers—GE and Westinghouse sold about 90% of
electrical generating equipment and what happened was that top

73
 managements decided that the two companies should just split the business
and raise prices—pricing conspiracy (A price fixing conspiracy in violation of
Sherman Anti-Trust Act). The AG filed criminal proceedings and many
people went to jail.
o Rule: The Supreme Court of Delaware held that “absent cause for
suspicion, there is no duty upon directors to install and operate a
corporate system of espionage to ferret out wrongdoing which they
have no reason to suspect exists.”
 It is the “one bite rule”—once someone does engage in
activities causing suspicion, the board is on alert.
o In Caremark, the court says not to read the Graham decision
too broadly, but then gives no indication of how it should be read.
 It says that boards have to do something with regards to
compliance but the level of compliance is a BJR issue.
9. Problem on p. 372-373
a. Consider expected value
b. Expected Punishment = Probability of being Punishment (caught and prosecuted) x
cost of being caught (size/length of fine/imprisonment)
i. Expected punishment = probability x fine/imprisonment
c. In order to guarantee compliance, the expected punishment cannot be less than
cost of compliance must
D. DUTY OF LOYALTY
1. DIRECTORS AND MANAGERS
a. Self-Dealing Transactions One in which 3 conditions are met:
i. A key player (director or manager) and the corporation are on opposites
sides of a transaction
ii. The Key player has helped influence the corp’s decision to enter the
transaction, and
iii. The key player’s personal financial interests are at least potentially in
conflict with the financial interests of the corporation.
b. Courts approach fair dealing as follows:
i. If the Transaction is Fair, the court will uphold it.
ii. If the transaction is so unfair that it amounts to waste or fraud against the
Corp., the court will usually void it at the request of stockholders.
o Standard for Wastean exchange that is so one sided that no
business person of ordinary, sound judgment could conclude that
the corp has received adequate consideration.
c. Direct Self-Interest Self-dealing occurs when the corporation and the director
himself are the parties to the transaction.
i. Ex. Sales and purchase of property, including corp. stock; loans to and from
the company; furnishing of services by a non-management director.
d. Indirect Self-Interest Self-dealing when the corporate transaction is with antoher
person or entity in which the director has a strong personal or financial interest.
i. Courts generally look through the substance of the transaction to the
substance of the director’s interest.
ii. Ex. Corporate transactions with director’s relatives; Corp. trans with an
entity in which the director has a significant financial interest; corporate
transactions with interlocking directors.
e. Substantive and Procedural Fairness Test
i. Replaced the rule of voidability
ii. The Substantive Test focuses on the Transaction’s terms and whether the
interested director advanced his interests at the expense of the corporation.

74
 o The Court accepts the fairness of self-dealing, if the judge
concludes the transaction was in the corporation’s best
interest.
o Widespread Acceptance.
o OBJECTIVE TEST: The self-dealing transaction must replicate an
arm’s length market transaction by falling into the range of
reasonableness.
 Court will scrutinize the terms of the transaction, especially
the price.
o CORPORATE VALUE: The transaction must also be of value to the
corporation with regards to its needs and scope of business.
o Problem: Requires judicial meddling in business matters.
iii. The Procedural Test focuses on the board’s decision making process and
measures the independence of the disinterested directors.
o Process of Board Approval—Did the Board act independently?
o If there was disclosure on the part of the directors or if the other
directors knew about the issue, then the directors could vote to
approve the transaction/contract/agreement without counting the
interested directors in the vote.
o Disclosure is the key.
o DISCLOSURE ABOUT THE TRANSACTION Whether full
disclosure would have given the board a meaningful opportunity to
review the proposed transaction and negotiate more favorable
terms.
o APPROVAL OF DISINTERESTED BOARD—Some courts will
uphold the transaction and others will merely shift the burden of of
proving fairness to the plaintiff.
 A director is “disinterested” if he is not directly or indirectly
interested in the transaction and he is not dominated by the
interested director
 A director is “dominated” when he acts as requested without
independent judgment.
o ROLE OF INTERESTED DIRECTOR IN APPROVAL PROCESS—
most modern states permit the interested director to negotiate,
participate and vote upon the transaction without invalidating the
transaction; however, such participation might be evidence of
domination
o ***The bottom line is that there must be 1) disclosure and 2)
knowing acceptance.
f. Burden of Proof
i. Under the MBCA, once a challenger shows the existence of a director’s
conflicting interest in a corporate transaction, the burden generally shifts to
the party seeking to uphold it to provide the transactions validity.
ii. However, under the more process-oriented approaches, the challenger has
the burden to prove the transaction’s validity when disinterested directors or
shareholders have approved the transaction.
g. Bayer v. Beran (1944, p.374)—Directors of Celanese Corporation of America were
charged with negligence and self-interest in commencing a radio advertising
program because of the wife of the Celanese president was chosen to perform the
radio ad.
i. Rule: Policies of business management are left solely to the discretion of

75
 the board of directors and may not be questioned absent a showing of
fraud, improper motive, or self-interest.
ii. Rule of Voidability “Such personal transactions of directors with their
corps, such as transactions as may tend to produce a conflict of interest and
fiduciary obligation, are, when challenged, examined with the most
scrupulous care, and if there is any evidence of improvidence or
oppression, any indication of unfairness or undue advantage, the
transactions will be voided.”
o “The burden is on the director not only to prove the good faith of the
transaction but also to show its inherent fairness from the viewpoint
of the corporation and those interested therein.”
iii. Board Meetings Rule: Generally, directors acting separately and not
collectively as a board cannot bind the corporation. Liability may not,
however, be imposed on directors because they failed to approve the radio
program by resolution at a board meeting.
o Professor, better to have a meeting to be safe.
iv. HELD: Here, there was no evidence that the ad program was inefficient,
disproportionate in price, or conducted for personal gain so there was no
breach of loyalty. Also, disclosure was key here—the directors KNEW
about the wife’s involvement and such disclosure prevented wrongdoing.
v. Note: A court must first make a preliminary determination that the duty of
care and duty of loyalty have not been violated. Then, it can invoke the BJR
h. RULE: When directors have personal interest in a transaction and there is no
disclosure, those directors lose the protection of the business judgment rule
and must demonstrate that the transaction was fair and reasonable to the
corporation at the time it was entered into.
i. KEY ELEMENTS: Must prove EITHER:
o Disclosure and Acceptance (without vote of interested director), or
 The point is to disclose the conflict of interest and let the
disinterested directors or shareholders decide what to do.
 If there is no disclosure, the corp may void the contract,
unless the other party can show it was fair and reasonable.
o If no disclosure, Fair and Reasonable Price
ii. Lewise v. S.L. & E., Inc. (1980, p.379)—Professor Likes this Case—A
group of siblings serve as directors/shareholders of two corps, and some
serve on both corps. The shareholders of one corp claimed that the
directors had committed waste by undercharging a tenant. That tenant was
another corp in which three of the directors were heavily involved. The
claim was that those directors were using the corp. to prop up the other
corp. Basically a situation of being both a landlord and a tenant.
o HELD: This case shows a typical state statute, which takes away
the duty of loyalty issue where there is disclosure. D did not make
full disclosure and did not prove that the price paid was fair and
reasonable.
o NOTE: The burden of proof is on the defendant, who is claiming
fairness.
o Look at statute provided on p.381.
o This is an easy and best example of a duty of loyalty case!
2. CORPORATE OPPORTUNITIES
a. Corporate Opportunity is a sub-set of the duty of loyalty.
b. A director or senior executive may not compete with the corporation where the
competition is likely to harm the corp.

76
c. Conduct that would otherwise be prohibited as disloyal competition may be
validated by being approved by disinterested directors, or by being ratified by
shareholders, but the key play must make full disclosure about the conflict and
competition.
i. Preparation to compete is also a violation of the duty of loyalty.
d. USE OF CORPORATE ASSETS The key player may not use corporate assets if
this use either (1) harms the corporation or (2) gives the key player a financial
benefit.
i. Use will not be a violation if it is (1) approved by disinterested directors after
full disclosure, (2) it is ratified by shareholders after full disclosure, or (3) the
Key Player pays the fair value for any benefit he has received.
e. CORPORATE OPPORTUNITY DOCTRINE A director or senior executive may
not usurp himself a business opportunity that is found to “belong” to the
corporation.
i. EFFECT—If the key player is found to have taken a corporate opportunity,
he taking is per se wrongful to the corp, and the corp may recover damages
equal to the loss it has suffered or even the profits it would have made had
it been given the chance to pursue the opportunity.
f. Tests:
i. Interest or expectancy(Existing Corporate Interest)—used to measure
corporation’s expansion potential.
o If the corporation has an existing expectancy in a business
opportunity, the manager must seek corporate consent before taking
the opportunity.
ii. Line of Business Test (Corporation’s Existing Business)
o To measure the reach of a corporation’s expansion potential, with
the purpose of forcing disclosure.
o Courts compare the new business with the corporation’s existing
operations. The corp need not have an existing interest or special
need for the opportunity and the manager need not have learned of
the opportunity in his corp capacity.
o If the new project is functionally related to the corps existing or
anticipated business, the manager must obtain corporate consent
before exploring it.
o PROBLEMS: Today, most corporations’ line of business is to do
anything to make money.
o Guth v. Loft (note in Broz)—most famous corporate opportunity
doctrine statement in Delaware, setting forth the Line of Business
test—“If there is presented to a corporate officer or director a
business opportunity which the corporation is financially able to
undertake, is from its nature, in the line of the corporation’s business
and is of practical advantage to it, is one in which the corporation
has an interest or reasonable expectancy, and by embracing the
opportunity, the self-interest of the officer or director will be brought
into conflict with that of the corporation, the law will not permit him to
seize the opportunity for himself.”
iii. .Fairness Test—Substantive v. Procedural (see above).
g. Corporate Expansion Corporation expects managers to devote themselves to
expanding the corporation’s business in order to maximize profitability.
h. Manager Entrepreneurialism Managers expect to have freedom to pursue their
outside business interests in order to promote their entrepreneurial initiative.
i. CONSENT and INCAPACITY

77
 i. Voluntary Consent A corp can voluntarily relinquish its interest in a corp.
opportunity by voluntarily relinquishing it.
ii. Corporate Incapacity Many courts allow managers charged with usurping
a corp opportunity to assert that the corp could not have taken the
opportunity because it was financially incapable or otherwise unable to do
so.
j. Presentation to Board of Directors Presenting the opportunity to the board
creates a kind of “safe harbor” for the director, which removes he specter of a post
hoc judicial determination that the director or officer has improperly usurped a
corporate opportunity. It is not the law of Delaware that presentation to the board is
a necessary prerequisite to a finding that a corporate opportunity has not been
usurped.
k. Rule: The corporate opportunity doctrine us implicated only in cases where
the fiduciary’s seizure of an opportunity results in a conflict between the
fiduciary’s duties to the corporation and the self-interest of the director as
actualized by the exploitation of the opportunity.
i. Broz v. Cellular Info. Sys., Inc. (1996, p.384)—P is a member of board of
CIS and utilized a business opportunity for his solely owned corporation,
instead of for CIS. The opportunity involved cellular telephone service
contracts in rural Michigan. P talks to a couple of the CIS board members
about the offer, but does not make a formal presentation. The company
offering the K did not offer it to CIS because CIS had just emerged from
insolvency reorganization. PriCellular begins discussions of a tender with
CIS and PriCellular feels P owed it to disclose.
o Tender Offer—A mechanism for someone one the outside of a
corporation to come in and take over the corp. by buying the share
away from the shareholder at a premium price. Offer typically
contingent on the offeror getting a specified number of shares
sufficient to get control of the company.
 It is a takeover method that does not involve the BOD.
o HELD: P wins because the Court determines that the opportunity
came to him in his individual capacity and not his corporate capacity.
The opportunity was related more closely to the business conducted
by P than by CIS, and CIS did not have the financial capacity to
exploit the opportunity. CIS was aware that P potentially had
conflicting duties with his wholly owned subsidiary.
l. RULE: Where the opportunity engaged in by a manager is a line of business
of the corporation, arose by virtue of the manager’s association with the
corporation, and when the corporation is given no chance to reject the
opportunity, the manager has violated a duty of loyalty inherent in the
corporate opportunity doctrine.
i. In Re eBay, Inc. Shareholders Litigation (Did not go over in class—2004,
p.389)—eBay hired Goldman Sachs as its lead underwriter and Goldman, in
consultation with eBay, determined what they could sell the IPO for and
raise the amount of money that eBay wanted. Goldman allowed two of the
eBay directors to buy other companies’ IPOs at favorable prices, in order to
keep eBay bringing them business. The shareholders bringing this suit
argue that this is a corporate opportunity because eBay invests excess cash
in marketable securities—it was eBay’s line of business, it was expected,
and they were able to engage in this business.
o IPO—Initial public offering.
o Underwriter—a corporation doesn’t know how to price securities or

78
 market securities and so they will hire an underwriter (an investment
bank) to price the security and market the security.
o HELD: Directors should have gone to the board, disclosed the
opportunity, had the board approve the actions, and then met the
statutory safe harbor standards.
3. DOMINANT SHAREHOLDERS
a. Dominant shareholders owe a fiduciary duty to a minority shareholders.
b. Where a corporation is publicly held, the courts have been less quick to impose on
the controlling shareholder a fiduciary obligation with any real bite. The fact that
the controlling shareholder is generally allowed to sell his controlling interest at a
premium is one illustration of this lack of any generally recognized fiduciary
obligation.
c. The (sad) Plight of Minority ShareholdersMinority shareholders are at the
mercy of the majority shareholder’s decisions.
i. Is this a windfall for the minority shareholders who buy in knowing they are
in the minority, or do they need protection because maybe they inherited
this share?
ii. POLICY QUESTIONS: Should the law ride to the rescue of the minority
shareholder?
o The Law does come to the rescue.
d. Intrinsic Fairness Test When there is a fiduciary duty AND it is
accompanied by self dealing, there is BOTH a higher degree of fairness required
and a shift in the burden of proof under which the parent must prove, subject to
careful judicial scrutiny, that its transactions with the subsidiary were objectively
fair.
i. A parent company owes a fiduciary duty to its subsidiary.
ii. Exclusion of Minority
o Many courts hold controlling shareholders to a higher standard when
they use control in stock transactions to benefit themselves to the
exclusion of minority shareholders.
o Some courts have used this intrinsic fairness analysis to invalidate
stock redemptions and conversions that prefer controlling
shareholders.
iii. Sinclair Oil v. Levien (1971, p.394)—P owns 97% of the subsidiary
Sinven. P is a holding company of crude oil and Sinven produces
petroleum in Venezuela. P treats Sinven as an independent entity—
entering into contracts with Sinven, etc. P breaches its K with Sinven and
Sinven chooses not to remedy breach. The minority shareholders in sinven
take issue with the decision and accuse the directors of not being
intrinsically fair.
o HELD: While P attempted to argue that its business transaction with
Sinven should be governed by the business judgment rule, and not
by the intrinsic fairness test, the court disagreed. A parent does
indeed owe a fiduciary duty to its subsidiary when there are
parent subsidiary dealings. However, this alone will not invoke
the intrinsic fairness test. The intrinsic fairness standard will be
applied only when the fiduciary duty is accompanied by self-
dealing—when the parent is on both sides of a transaction with
its subsidiary.
 Self-dealing occurs when the parent, by virtue of its
domination of its subsidiary, causes the subsidiary to act in
such a way that the parent receives something from the

79
 subsidiary to the exclusion of and detriment to the minority
shareholders of the corp.
 When the parent controls the transaction and fixes the terms,
the test of intrinsic fairness applies and the burden of proof
shifts.
e. NOTE: 2 Things you could do to prevent suits and problems with minority
shareholders:
i. Buy out the minority shareholders—it could be cheaper than walking on egg
shells because there are minority owners.
ii. Ask for a vote of only the minority shareholders to ratify the decision.
f. EXCEPTION: Some cases hold the controlling shareholder does have some kind
of fiduciary obligation to avoid injuring the interests of the non-controlling
shareholders. When a controlling shareholder or group deals with the non-
controlling shareholders, it owes the latter a duty of complete disclosure with
respect to the transaction. (an entirely common law duty)
i. Zahn v. Transamerica Corp. (1947, p.399)—Axton-Fisher Tobacco Co.
had two kinds of “common stock”—Class A, mostly public shareholders who
got most of liquidation assets and right of co. to redeem stock, and Class B,
voting shareholders with no right to, mostly owned by Transamerica.
Therefore, Class B shareholders were “insider,” and became aware that the
company’s tobacco inventory had become dramatically more valuable than
shwn on the company’s books. It therefore decided to have the company
sell its assets to a third party and liquidate. In bringing this about, the board
had three main choices of how to deal with class A stock: (1) give full notice,
then liquidate, (2) simply liquidate without notice, or (3) call A’s shares
without disclosure, then liquidate. They chose option 3.
o HELD for P: A dominating or controlling stockholder is a fiduciary,
whose dealings with the corp must be subjected to rigorous scrutiny,
and the burden is on the stockholder not only to prove the food faith
of the transaction but also to show its inherent fairness from the
viewpoint of the corp and those interested therein. Because the
Class B shareholders did not act in good faith when the caused the
board to redeem the Class A shares and concealed the information
about the value of the inventory, the Class B holders breached their
fiduciary obligation to class A holders.
o “There is a radical difference when a stockholder is voting strictly as
a stockholder and when voting as a director; that when voting as a
stockholder he may have the legal right to vote with a view of his
own benefits and to represent himself only but when he votes as a
director he represents all the stockholders in the capacity of a
trustee for them and cannot use his office as a director for his
personal benefit at the expense of the stockholders.
ii. AFTERMATH: The Court found that a disinterested board of Directors
would undoubtedly have exercised its power to call the Class A stock before
liquidation, disclosing the intention to liquidate together with full information
as to the appreciated value of the tobacco inventory, and that the Class A
stockholders would thereupon have exercised their privileges to convert
their stock, share for share, into Class B stock and would thus have
participated equally with the Class B stockholders in the proceeds of
liquidation.
o Therefore, the amount is the amount each class B was awarded,
minus the money he was paid in buying out his Class A stock.
4. RATIFICATION

80
a. Where a majority of shares are cast by shareholders who neither have an
interest in the transaction nor are dominated by those who do, most courts
do NOT require defendant to show fairness. Instead, must show:
i. The transaction constituted waste
ii. The shareholders were uninformed
iii. The transaction was illegal, or
iv. The transaction was ultra vires (unauthorized) because of a limitation in the
articles of incorporation.
b. Interested Majority
i. Courts remain suspicious of self-dealing transactions if shareholder
ratification is by a majority of shareholders interested in the transaction.
ii. Some statutes do not count the shares of interested shareholders for the
purpose of ratification.
iii. Ratification of an “interested transaction” by a majority of
independent, fully informed shareholders shifts the burden of proof to
the objecting shareholder to demonstrate that the terms of the
transaction are so unequal as to amount to a gift or a waste of
corporate assets.
o Fliegler v. Lawrence (1976, p.405)—Shareholders of Agau brought
suit against its officers and directors claiming that the officers and
directors wrongfully usurped a corporate opportunity belonging to
Agau and profited accordingly.
 RULE: Shareholder ratification of an interested transaction,
although less than unanimous, shifts the burden of proof to
an objecting shareholder to demonstrate that the terms are
so unequal as to amount to a gift or waste of corporate
assets.
 § 144 of Delaware Statute—A properly ratified contract
between a corporation and one of its directors is not void or
voidable solely because of the conflict of interest.
• The statute removes an “interested director” cloud
when its terms are met and provides against
invalidation of an agreement solely because such a
director or officer is involved. Nothing in it removes
sanctions for unfairness or from judicial scrutiny.
• Professor thinks this is a poor reading to the statute
because the statute refers to “disinterested directors,”
but only to “shareholders” without modifying it with
disinterested.
 HELD: The purported ratification by the Agau shareholders
would not affect the BOP in this case because the majority of
shares voted in favor of exercising the option were cast by
the defendants in their capacity as shareholders. Only 1/3rd
of the disinterested shareholders voted. Therefore, there is
not factual basis for applying the above rule. However, even
though the actions are still subject to judicial scrutiny, they
pass the intrinsic fairness test.
c. DUTY OF CARE and RATIFICATION shareholder vote approving a challenged
merger agreement has the legal effect of curing any failure of the board to reach an
informed business judgment in its approval of the merger.
i. Van Gorkom and Wheelabrator Tech.
d. DUTY OF LOYALTY and RATIFICATION
81
 i.
2 Kinds:
o (1) “Interested” Transaction cases between corporation and its
directors (or between the corp. and an entity in which the corp.’s
directors are also directors or have a financial interest, and
 Not voidable if it is approved, in good faith, by a majority of
disinterested shareholders
 Invokes the business judgment rule and limits judicial review
to issues of gift or waste with the burden of proof upon the
party attacking the transaction.
o (2) Cases involving a transaction between the corp. and its
controlling shareholder.
 Primarily parent-subsidiary mergers that were conditioned
upon receiving majority of the minority stockholder approval.
 Standard of review is normally entire fairness, with BOP on
directors.
 BUT where the merger is conditioned upon approval by the
majority of the minority stockholder vote, and such approval
is granted, the standard of review remains entire fairness, but
the BOP for demonstrating unfairness shifts to the plaintiff.
ii. In Re Wheelabrator Tech., inc. Shareholders litigation (1995, p.408)--
Waste and WTI negotiated a merger in which Waste would own 55% of
Waste stock. WTI held a meeting to discuss the merger and after positive
results from lawyers and investment bankers, the 7 WTI members approved
the transaction. The majority of the WTI shareholders voted to approve the
transaction as well. A group of shareholders filed suit alleging that the board
of directors didn’t use due care, that they were not fully informed, and that
the proxy’s were misleading.
o This case is different because there is no majority owner.
o HELD: There was no breach of duty of loyalty or of care. Also no
breach of the duty of loyalty. The rationale is that even an informed
shareholder vote may not afford the minority shareholders sufficient
judicial protection in a duty of loyalty claim, while the duty of care
claim is more procedurally based.
 If the board is fully informed, then the claim of failure of duty
of care is extinguished.
 But, the duty of loyalty claim is not necessarily extinguished
because the court says it isn’t a business judgment issue, it
is a breach of trust issue.
 Nonetheless, if the vote truly is fully informed, it would seem
that the shareholders would already be protected.
o Rule stated above
E. SECURITIES LAW: DISCLOSURE AND FAIRNESS
1. 2 Types of Markets:
a. The primary market, in which the issuer of Securities sells them to investors
i. An initial public offering (IPO) by a corporation takes place in the primary
market.
b. The Secondary Market, in which investors trade securities among themselves
without any significant participation by the original issuer.
i. Exchange between stockholders.
2. “Blue Sky Law” in Kansas—First regulation of the primary market.
3. Securities Act of 1933
a. Principally concerned with primary market

82
 b. 2 Goals:
i. Mandating disclosure of material information to investors and prevention of
fraud.
ii. To create a Transactional Disclosure Model—mandating disclosures by
issuers in connection with primary market transactions.
4. Securities Exchange Act of 1934 (p.263 of statutory book)
a. Principally concerned with the secondary market.
b. Deals with insider trading and other forms of securities fraud, short-swing profits by
corporate insiders, regulation of shareholder voting via proxy solicitations, and
regulation of tender offers.
c. § 10b—Creates a vague, broad fraud statute—“necessary or appropriate . . .”
Congress asks the SEC to define fraud.
i. Broad, Vague Statute + Administrative Agency + Congressional Delegation
of “Legislative Authority = American Government since 1933.
ii. How Far can Congress Legislate? Pretty Far!
iii. Congress is delegating their Rule Making Power to the Commissioners
d. Requirement of periodic disclosures by publicly held corporations.
e. Created the Securities and Exchange Commission (SEC) as the primary federal
agency charged with administering the various securities laws.
i. 5 Commissioners, confirmed by senate, no more than three of whom can be
from one political party.
o Commissioners have rule making power.
ii. Staff has 3 primary functions:
o It provides interpretative guidance to private parties raising
questions about the application of the securities laws to a particular
transaction;
o It advises the Commission as to new rules or revisions of existing
rules; and
o It investigates and prosecutes violations of the securities laws.
5. Complying with the Securities law is VERY Expensive!
6. Definition of a Security
a. Knowing whether a particular type of instrument or investment will be deemed to be
a security is important for 2 reasons:
i. Tells you whether registration is needed for your transaction.
ii. To know whether you need to comply with its anti-fraud provisions, which
are less demanding and easier to prove than normal fraud (with certain
procedural advantages).
b. Statutory Definition--§ 2—The terms in § 2 shall be defined in accordance with the
various provisions of § 2, unless the context otherwise requires. Two broad categories:
i. A list of rather specific instruments—“any note, stock, treasury stock,
security future, bond, debenture.”
ii. A list of general catchall phrases, such as “evidence of indebtedness,”
“investment contract,” or in general, “any interest or instrument known as a
security.”
c. The Howey Test (most important SC case on this): “An investment contract is a
contract, transaction, or scheme whereby a person invests his money in a
common enterprise and is led to expect profits solely from the efforts of a
promoter or third party.”
i. Questions to Ask:
o Is it a profit-making venture?
o Is the investor passive?
ii. Thus, an investment contract is a security.

83
 iii. In this case, there was a partial interest in an orange orchard that was being
sold and the farm had not registered the investment contract as a security.
iv. This standard has been relaxed, to eliminate the word “solely.” You don’t
have to be solely dependent on another.
v. Robinson v. Glynn (2003, p.415)—There was an agreement (contract)
between two parties for the sale and purchase of GeoPhone. Robinson filed
suit claiming a violation of the federal securities laws. Issue: Whether that
being sold fell within the definition of a security?
o Rule: The interests of an LLC do not constitute a “security” for
purposes of the Securities Exchange Act.
 Business venture often find their genesis in the different
contributions of diverse individuals.
 Yet the securities laws do not extend to every person who
lacks the specialized knowledge of his partners or colleagues,
without showing that this lack of knowledge prevents him from
meaningful controlling his investment.
o HELD: This case deals with the definition of a security—and
reiterates the fact that the definition of a security is so broad that in fact,
a client might be selling a security and not even know it
 The key element is whether an investor, as a result of the
investment agreement or factual circumstances around it, is left
unable to exercise meaningful control over his investment.
 Since Robinson was NOT a passive investor, therefore, this
was not a security.
o Why doesn’t everyone just register as a security to be safe?
 Very expensive—many fees associated with registration.
 Why is the plaintiff trying to sue under the securities laws?
 It is much better to be a securities plaintiff rather than a
common law fraud plaintiff.
 So, the plaintiff is trying to prove that the thing being sold is a
security.
o RULE: Economic Reality—The question is whether an investor as a
result of the investment agreement itself or the factual circumstances
that surround it, is left unable to exercise meaningful control over his
investment.
o Stock: Must be called “stock” and must have the
characteristics of Stock.
 5 Characteristics of Common Stock
• The right to receive dividends contingent upon an
apportionment of profits,
• Negotiability,
• The ability to be pledged or hypothecated,
• The conferring of voting rights in proportion to the
number of shares owned,
• The capacity to appreciate in value.
7. The Registration Process
a. § 5—Imposes 3 Basic Rules prohibiting the sales of securities unless the company
issuing the securities has “registered them with the SEC:
i. A security may not be offered for sale through the mails or by use of other
means of interstate commerce unless a registration statement has been filed
with the SEC

84
 ii. Securities may not be sold until the registration statement has become
effective
iii. The prospectus (a disclosure statement) must be delivered to the purchaser
before a sale.
b. Market Failure
i. It would be great if the market worked perfectly and perfectly allocated
resources. BUT the market never works perfectly.
o Therefore, can’t have perfect competition because you can’t have
perfect information, etc. There is Imperfect Competition.
ii. Information Failure—
o REMEDY: The SEC requires public disclosure of information to help
prevent market failure.
iii. ChartismGraph of stock movement over time. People who sell chart
information and advice on stock prices. Doesn’t work!
o Random Walk By watching a drunk walk down a street, could you
predict what his next step would be? NO! This is like stock prices.
o Disproving Chartism was the first step toward the market failure
doctrine.
iv. Can’t out perform the market by advice. Must buy the market.
o “Buy the Market”—buy into a fund (a mutual fund like Vanguard) that
has a bunch of stock from a bunch of different companies. This is the
safest bet.
c. Investment banking firm is the middle man identifying who will buy the stock. The
underwriting firm will buy the entire issue at a discount off what they think they can sell
it for. Risk of loss shifted to investment bank.
d. IMPORTANT: When the SEC reviews the registration statement, it does not ask
whether the security would be a good investment. Instead, it asks whether the
registration statement contains the disclosures required by the statute and the SEC
rules thereunder and whether that information appears to be accurate.
i. The core of the registration statement is the “prospectus,” the principal
disclosure documents issuers are required by the Securities Act to give
prospective buyers.
ii. Until he SEC has approved the disclosures made in the prospectus,
companies cannot sell the new securities.
e. NO DEFAULT RULES—all mandatory registration requirements.
f. 2 Types of Exemptions:
i. Exempt Securities—need never be registered, either when initially sold by
the issuer or in any subsequent transaction.
ii. Exempt Transactions—one time exemptions.
g. Prima Facie Case for Securities Violations:
i. No registration statement filed in connection with the defendants’ offering of
securities.
ii. Defendants sold or offered to sell these securities
iii. Defendants used interstate transportation or communication in connection
with the sale or offer of sale.
h. § 4—Exemptions to Registration:
i. “(1) Transactions by any person other than an issuer, underwriter, or dealer
ii. (2) Transaction by an issuer not involving any public offering.”
o 4 Factors for Determining Exemptions:
 Number of offerees and their relationship to each other and
the issuer,
 Number of units offered

85
  The size of the offering
 The manner of the offering
o Purpose/Scope of “Private Offering” (not defined in statute)
 Purpose of act is to protect investors by promoting full
disclosure of information thought necessary to informed
investment decisions.
 The exemption turns on the knowledge of offerees.
 It is most nearly reflected in the first of the four factors (listed
above)—The number of offerees and their relationship to each
other and to the issuer.
iii. Doran v. Petroleum Management Corp. (1977, p.422)-- Doran is
approached about investing in a petroleum company in Wyoming and looks at
drilling logs and technical maps and then decides to invest. He is a “savvy
investor” and knows enough to look at this sort of information. He co-signs a
note and then the company defaults on it because the company is shut down by
Wypoming state law (state law limiting the production of oil by oil producers).
Doran is sued to follow through with his payment of the note.
o Rule: A private offering is an exempt transaction—meaning that it
falls outside the registration requirement of the Securities Act; however,
the defendant has the burden of proving that the transaction was indeed
a private offering.
o HELD: Doran states a prima facie case of a violation of the federal
securities law and then the defendant raises an affirmative defense (a
private offering exemption) and has the burden of proving it. Based on
the four factors listed above, this is a FACT based analysis
o NOTE: Sophistication of the investor is not a substitute for
access to the information that registration would disclose.
 Therefore, in a private offering the company should give the
investor the same information that would be in a registration
statement, no matter how sophisticated the investor is.
i. §5
i. (a) Unless a registration statement is in effect as to a security, it shall be
unlawful for any person, directly or indirectly:
o (1) To make use of any means or instruments of transportation or
communication in interstate commerce or through the mails to such
security through the use or medium of any prospectus or otherwise .
ii. (b) It shall be unlawful for any person, directly or indirectly?
o (1) to make use of any means or instruments of transportation or
communication in interstate commerce or of the mails to carry or
transmit any prospectus relating to any security with respect to which a
registration statement has been filed under this title, unless such
prospectus meets the requirements of § 10, specifying the required
contents of a prospectus.
iii. (c) It shall be unlawful for any person . . . [interstate commerce stuff] . . . to
offer to sell or offer to buy through the use or medium of any prospectus or
otherwise any security, unless a registration statement has been filed as to
such security.
j. Other Exemptions
i. Regulation D Basically codifies the four factors listed above, and provides
safe harbors for issuers.
o Generally exempt only the initial sale.

86
 o Safe harbors:
 If an issuer raises < $1 million through securities, it may
generally sell them to an unlimited number of buyers without
registering the securities. Rule 504.
 If it raises < $5 million through securities, it may sell to 35
buyers but no more. Rule 505.
 If it raises more >$5 million, it may sell to no more than 35
buyers, and each buyer must pass various tests of financial
sophistication. Rule 506.
o Cannot widely advertise.
o Must file with the SEC a notice of sale shortly after it issues the
securities.
o Limits on the numbers of buyers does not include accredited
investors-banks, brokers, etc.
o Issuer must still give buyer some information.
k. Civil Liabilities—Securities Fraud
i. Common Law fraud does not work with the way securities are set up—must
show reasonable reliance, causation, scienter, and injury.
ii. Congress wanted to impose civil liability as an important deterrent and
therefore enacted various express private rights of action for private parties
injured by securities laws violations.
iii. Even where the Acts don’t explicitly state a private right of action, the Court
has implied a private right of action (they have re-written the statutes).
o “implied private right of action”—statute is silent about a private right
of action, so the Courts make one up. Courts no longer do this because
it was illegitimate, but they didn’t overrule the old cases. Today, if
Congress wants there to be private rights of action, Congress must
expressly say so.
iv. Securities Act § 12(a)(1)
o Strict liability on sellers of securities for offers or sales made in
violation of § 5.
o Failure to register is an example.
o The remedy here is rescission.
v. Securities Act § 11
o If there is a material misrepresentation or error on the registration
statement, then the issuer of the security is held strictly liable.
o The plaintiff does not have to prove scienter (intent).
o Others (not the issuer) are held to a negligence standard and must
prove that they were NOT negligent through due diligence.
o Due diligence is a defense to misrepresentation and is the only
viable defense to a § 11 claim.
 Due diligence is “reasonable investigation” which gives
reasonable belief that the statements were true at the time given.
o Text of § 11.
 (a) In case any part of the registration statement . . .
contained an untrue statement of material fact or omitted to state
a material fact required . . . or necessary . . ., any person
acquiring a such a security . . . may sue?
• Every person who signed the registration statement
• Every person who was a director of . . . the issuer
• Every accountant, engineer, or appraiser, or any

87
 person whose profession give authority to the statement
made by him, who has with his consent been named as
having prepared or certified any part of the registration
statement . . .
• Every underwriter with respect to such security
 (b) Due Diligence Defense—No person, other than the
issuer, shall be liable as provided therein who shall sustain the
burden of proof: . . . (3) that registration statements:
• (A) Not purporting to be made on the authority of an
expert, . . . he had, after reasonable investigation,
reasonable ground to believe and did believe, at the
time such part of the registration statement became
effective, that the statements therein were true and that
there was no omission . . .
• (B) Purporting to be made upon his authority as an
expert, (i) he had after reasonable investigation,
reasonable ground to believe and did believe, at the time
such part of the registration statement therein were true
and that there were no omissions . . . or (ii) such part of
the registration statement did not fairly represent his
statement as an expert or was not a fair copy of his exact
report . . .
• (C) Purporting to be made on the authority of an
expert (other than himself) . . . he had reasonable
grounds to believe, at the tiem such part of registration
statement became effective, that the statements therein
were untrue or that there was an omission.
vi. Rule: Due diligence is a defense to a claim under § 11; however, the
defendant must prove reasonable investigation and reasonable belief that
the statements made were correct at the time.
o Under § 11 of the Securities Act, the fact that is falsely stated
must be “material”
o What is a Material Fact?
 Not defined by § 11
 “Those matters as to which an average prudent investor
ought reasonably to be informed before purchasing the security
registered.”
• “Average Prudent Investor” is the Standard by
which the due diligence standard is judged.
 Material facts are those that an investor needs to know
before purchasing so that he can make an intelligent, informed
decision about whether or not to buy the security.
 This is NOT a binary (yes/no) question—it is more of a
sliding scale based on the facts of the situation.
o Escott v. BarChris Construction Corp. (432, p.432)—Escott and
other purchasers of debentures (secured bonds) sued BarChris for
material false statements and material omissions on the registration
statement of the debentures. This case came out of the bowling craze in
the 1950s and the fallout when this craze tanked. Secured bonds on the
bowling alleys were being sold.
 HELD: Here, the Court finds one year to be material and

88
 another year not to be material. The issuer of the security is
strictly liable for a misrepresentation or false statement of
material information. The other individuals involved must prove
due diligence to avoid liability. Due diligence is “reasonable
investigation”
 To say that the entire registration statement is expertised
because some lawyer prepared it would be an unreasonable
construction of the statute. Neither the lawyer for the company
nor the lawyer for the underwriters is an expert within the
meaning of § 11.
 Ignorance is no excuse if you sign the document.
 The lawyer made no investigation and relied on the others to
get it right. As a lawyer, he should have known his obligations
under the statute. He should have known that he required to
make a reasonable investigation into the truth of all statements in
the unexpertised portion of the document he signed. Having
failed to make such an investigation, he did not have reasonable
ground to believe that all these statements were true.
 § 11 imposed liability in the first instance upon a director, no
matter how new he is. He is presumed to know his responsibility
when he becomes a director. He can escape liability only by
using that reasonable care to investigate the facts, which a
prudent man would employ in the management of his own
property.
 More is required of the director writing the registration
statement. He is not required to conduct an independent audit,
but he is required to check matters readily verifiable.
 Professor really doesn’t think that these sorts of laws are
such a good idea.
l. Integrated Disclosure System
i. There were originally two separate disclosure systems under the Securities
Act and the Exchange Act. However, the SEC adopted a new modern,
integrated disclosure system.
o The Securities Act registers offerings.
o The Exchange Act registers companies.
ii. The SEC developed this system based on the efficient capital market
hypothesis—the idea that all publicly available information is more or less
instantaneously incorporated into the market price of its securities.
iii. Integrated disclosure starts with the reports that must be filed under the
Exchange Act.
8. Rule 10b-5—Securities Fraud
a. Purchasers and Sellers: 10b-5 standing Only actual purchasers or sellers may
recover damages in private 10b-5 action. The standing requirement, often called the
Birnbaum Rule, avoids speculation about whether and how much a plaintiff might
have traded.
b. In these cases, the company itself is not buying and selling its own shares—
company is NOT a market participant in 10b-5 Rules.
i. Absent this federal law, there is no state cause of action for breach of the
duty of loyalty.
c. Section 10(b)—Delegation of Congressional Power
i. It shall be unlawful for any person, directly or indirectly, by use of any
means or instrumentality of interstate commerce or of the mails, or of any

89
 facility of any national security exchange . . .
(b) To use or employ, in connection with the purchase or sale of any
security registered on a national securities exchange or any security not
registered . . . , any manipulative or deceptive device or contrivance in
contravention of such rules and regulations as the Commission may prescribe
as necessary or appropriate in the public interest or for the protection of
investors.
d. 10b-5—Adopted Pursuant to General Rule-Making Authority—“It shall be unlawful
for any person directly or indirectly, by use of any means or instrumentality of interstate
commerce, or of the mails or of any facility of any national securities exchange,
(a) To employ any device, scheme, or artifice to defraud
(b) To make any untrue statement of a material fact or to omit to state a
material fact necessary in order to make the statements made, in light of
the circumstances under which they were made, not misleading, or
(c) To engage in any act, practice, or course of business which operates or
would operate as a fraud or deceit upon any person,
in connection with he purchase or sale of any security.
e. Rule 10b-5 case law is a series of species of federal common law only loosely tied
to the statutory text.
f. Fraud Elements of Private 10b-5 ActionThe plaintiff has the burden of showing
the following elements, each of which tests whether the supplier of misinformation
should bear another’s investment losses:
i. Material misinformation. The defendant affirmatively misrepresented a
material fact, or omitted a material fact that made his statement misleading or
remained silent in the face of a fiduciary duty to disclose a material fact.
ii. Scienter. The defendant knew or was reckless in not knowing the
misrepresentation and intended the plaintiff rely on the misinformation.
o “Manipulative or Deceptive Device of Contrivance”—
iii. Reliance. The plaintiff relied on the misrepresentation. IN 10b-5 cases of a
duty to speak, courts will dispense with reliance if the undisclosed information
was material. In 10b-5 cases involving transactions on impersonal trading
markets, courts will infer reliance from the dissemination of misinformation in
the trading market.
iv. Causation. The plaintiff suffered actual losses as a result of his reliance.
v. Damages. The plaintiff suffered damages. Courts use various theories to
measure damages under Rule 10b-5. Punitive damages are not available.
g. Material Deception 10b-5 prohibits false or misleading statements of material
fact. This means a true, but incomplete, statement can be actionable if it omits
material information that renders the statement misleading.
i. Materiality—The SC has held that a fact is material for purposes of 10b-5 if
there is a substantial likelihood that a reasonable investor would (NOT
might) consider it important in deciding how to for or consider it as
altering the “total mix” of information in deciding whether to buy or sell
(Basic Inc. v. Levinson).
o Cascade Effect
 Justification for securities laws is forcing disclosure of
(material) information to investors. This creates a fear that
companies will dump everything on the public record to the point
where there is so much that no once could ever sift through the
information.
 Thus, the Court does not want to require disclosure of an
overabundance of information, leading management to “simply

90
 bury the shareholders in an avalanche of trivial information—a
result that is hardly conducive to informed decision-making.”
Basic
o In general, if Disclosure of the information would affect the price of
the company’s stock, the information is material.
o West v. Prudential securities Inc. (2002, p.463)—Hoffman, a
securities broker at Prudential, gave material false information to his
client about an upcoming merger. A class action was certified on behalf
of everyone who bought the touted stock during the period that the
misinformation was being given.
 RULE: A class action may not be brought on behalf of
everyone who purchased stock during a period when a
broker violated securities laws by not providing material
non-public information.
 ISSUE: Whether the action may proceed not on behalf of
those who received Hoffman’s news in person but on behalf of
everyone who bought Jefferson stock during the months when
Hoffman was misbehaving.
 HELD: No causation in this class certification. Because the
record here does not demonstrate that non-public information
affected the price of Jefferson Savings’ stock, a remand is
unnecessary. This case deals with private information that a
stock broker distributed to private clients. There is no proof that
non-public information affects the market (accepting a weak
version of the Efficient Capital Market Hypothesis). Additionally,
the misinformation never made it to institutional traders—the
small investors to whom it was given do not have any tangible
effect on the market price.
 “No one these days accepts the strongest version of the
efficient capital market hypothesis, under which non-public
information automatically affects prices. That version is
empirically false: The public announcement of news (good and
bad) has big effects on stock prices, which could not happen if
prices already incorporated the effect of non-public information.”
• Three levels of Efficient Capital Market
Hypothesis
o Strongest form: Even non-public information
affects price
o Intermediate: Publicly available information is
impounded into the market price.
o Weakest Form: Can’t use past price
movement to predict future prices
 Horizontal Demand Curve: “One fundamental attribute of
efficient markets is that information, not demand in the abstract
determines stock prices. There are so many substitutes for any
one firm’s stock that the effective demand curve is horizontal. It
may shift up or down with new information but it is not sloped like
the demand curve for physical products. That is why institutional
purchases do not elevate prices, while relatively small trades by
insiders can heave substantial effects, the latter trades convey
information and the former do not.”
• However, this theory has almost completely been

91
 rejected by economists.
• Professor thinks it is crazy to delegate to the court the
power to make this kind of decision.
ii. Duty to Speak—Normally, silence is not actionable under Rule 10b-5.
Nonetheless, courts have imposed a duty to speak when defendants have a
relationship of trust and confidence with the plaintiff.
o Basic suggests saying “no comment”
iii. Corporate Mismanagement—Mismanagement by corporate officials can
violate Rule 10b-5 if the mismanagement involves fraudulent securities
transactions that can be said to injure the corporation.
o Santa Fe Industries v. Green ( p)—A parent company merged with
its majority owned subsidiary after giving minority shareholders notice of
the merger and an information statement that explained their rights to a
state appraisal remedy. The parent stated that a valuation of the
subsidiary’s assets indicated a $640 per share value, even though the
parent was offering only $125 per share, an amount slightly higher than
the valuation of the subsidiary by the parent’s investment banker.
 RULE: Not every corporate fiduciary breach involving a
securities transaction gives rise to a 10b-5 action. A claim of
fraud and breach of fiduciary breach states a cause of action
under 10b-5 only if the conduct alleged can be fairly viewed as
“manipulative or deceptive” within the meaning of the statute.
• Manipulation Virtually a term of art when used in
connection with securities markets, referring generally
to practices, such as wash sales, matched orders, or
rigged prices, that are intended to mislead investors
by artificially affecting market activity.
 HELD: Unless the disclosure had been misleading (which Ps
did not claim was the case) no liability could result. An unfairly
low price does not amount to fraud.
 Factors in determining Congressional intent to create a
federal cause of action:
• Fundamental purpose of act is full disclosure.
• Whether the cause of action is one traditionally
relegated to state law.
• Clear statement requirement—“Absent a clear
indication of congressional intent, we are reluctant to
federalize the substantial portion of the law of
corporations that deals with transactions in securities,
particularly where established state policies of
corporate regulation would be overridden. . . .
Corporations are creatures of state law, and investors
commit their funds to corporate directors on the
understanding that, except where federal law
expressly requires certain responsibilities of directors
with respect to stockholders, state law will govern the
internal affairs of the corporation.”
 NOTE: The problem was if this action succeeded, it would
lead Federal securities law towards taking over state
corporations laws.
h. Reliance  The reliance requirement tests the link between the alleged

92
misinformation and the plaintiff’s buy/sell decision—I weeds out claims where the
misinformation had little to no impact on the plaintiff’s decision to enter the transaction.
Courts treat reliance as an element in all private 10b-5 cases, but relax the
requirements of proof in a number of circumstances:
i. Non-Disclosure—when the defendant fails in a duty to speak—whether in a
face-to-face transaction or anonymous trading market—courts dispense of
proof of reliance if the undisclosed facts were material.
ii. Fraud on the Market (The Same Principle as the Efficient Capital
Market Hypothesis Theory)—In cases of false or misleading representations
on public trading market—so called fraud on the market—courts have created a
rebuttable presumption of reliance (Basic Inc. v. Levinson).
o THEORY: Those who trade on public trading markets rely on the
integrity of the stock’s market price. In an open and developed stock
market, the efficient capital market hypothesis posits that market prices
reflect all publicly available information about the company’s stock. This
“fraud on the market” theory assumes that if the truth had been
disclosed, investors would not have trading at the prevailing
nondisclosure price.
o “In face-to-face transactions, the inquiry into an investor’s reliance
upon information is into the subjective pricing of that information by that
investor. With the presence of a market, the market is interposed
between seller and buyer and, ideally, transmits information to the
investor in the processed form of a market price. Thus, the market
is performing a substantial part of the valuation process performed by
the investor in a face-to-face transaction. The market is acting as the
unpaid agent of the investor, informing him that given all the information
available to it, the value of the stock is worth the market price.”—Basic.
 SAY ON EXAM: “All information is impounded into the
market price.”
o People have sold based on misinformation in the market. Otherwise
you have to show that the plaintiff heard the statement and specifically
relied on it.
o Rebutting the Presumption: Any showing that severs the link
between the alleged misrepresentation and either the price received (or
paid) by the plaintiff, or his decisions to trade at a fair market price, will
be sufficient to rebut the presumption of reliance. EXAMPLES:
 Prove the market makers were privy to information on the
truth of the mergers, so market price was not affected by
misstatements.
 Prove news of the merger discussions interrupted the
marketplace and dissipated the effects of the misstatements.
 Prove certain plaintiffs did not rely on misstatements when
divesting themselves of their shares.
o Could argue this protects the market, and through it, stockholder’s in
their reliance on the market.
o BUT ask: Is this really necessary when we have state corporations
laws to deal with these situations?
i. Causation Courts have required that 10b-5 Plaintiffs show two kinds of
causation to recover:
i. Transaction Causation—Requires the plaintiff to show that “but for” the
defendant’s fraud, the plaintiff would not have entered into the transaction or
would have entered under different terms—a restated reliance requirement.

93
 ii. Loss Causation—requires the plaintiff to show that the fraud produced the
claimed loss to the plaintiff—a foreseeability or a proximate cause requirement.
j. Damages Private 10b-5 plaintiffs have a full range of equitable and legal
remedies. The Exchange Act imposes only two limitations. § 28 states that the
plaintiff’s recovery cannot exceed actual damages, imply that the goal of liability is
compensation and effectively precluding punitive damages.
k. Basic Inc. v. Levinson (1988, p.450)—Basic made public statements that it was
not in merger negotiations. However, it was in negotiations with Combustion regarding
a tender offer. When the merger was finally publicly announced, Levinson and other
shareholders alleged that the company’s repeated denials of merger negotiations were
material misrepresentations upon which they relied and sold Basic Stock. This is a
class action in which the shareholders are suing the Co.; not the people who bought
the Basic stock. This deals with the secondary market. ISSUE: Was this information
material?
i. MATERIALITY RULE: Whether a company statement is material in the
context of merger discussions requires a case-by-case analysis of the
probability that the transaction will be consummated and the significance of the
transaction to the issuer of the securities. Where the information is material,
and investor’s reliance on the material, public misrepresentations will be
inferred under a fraud-on-the-market theory.
o There is not valid justification for artificially excluding from the
definition of materiality information concerning merger discussions,
which would otherwise be considered significant to the trading decision
of a reasonable investor, merely because agreement-in-principle as to
the price and structure has not yet been reached y the parties or their
representatives.
o Court Rejects the “Agreement-in-Principle” Theory, that there were
no negotiations as to price and structure of the transaction has been
reached between the would be merger partners.
o COURT’S SOLUTION: Don’t answer questions concerning the
mergers—ALWAYS say “no comment”
ii. FRAUD-ON-THE MARKET RULE: Because most publicly available
information is reflected in market price, an investor’s reliance on any publicly
available material misrepresentations, may be presumed for purposes of a rule
10b-5 action.
iii. EFFECT: If shown to be material, reliance is no longer an issue
because of the Fraud on the Market Rule.
iv. DISSENT: “Confusion and contradiction in court rulings are inevitable when
traditional legal analysis is replaced with economic theorization by the federal
courts.”
o While Professor likes the economic analysis of the majority, he does
not necessarily disagree that the courts should not be making
legislation.
v. Remedy: Amount you could have sold stock at and the amount at which the
stock was actually sold. Difficulty is determining how much you could have sold
it for.
l. Secondary Liability: There was no implied private right of action against those who
aid and abet violations of Rule 10b-5. The scope of conduct prohibited by § 10(b)
is controlled by the text of the statute. Where the plain text does not resolve some
aspect of the Rule 10b-5 cause of action, courts must infer how the 1934 Congress
would have addressed the issue had the 10b-5 action been included as an express
provision of the act.

94
9. Application of Rule 10B-5 to Insider Trading
a. No statute or rule defines insider trading—its regulation remains largely a matter of
federal common law.
b. Goodwin v. Agassiz (1933, p.478)—This is a case brought in STATE court and
signifies the majority view of state courts until the late 1930s. Agassiz is the president
of a mining company and the company has surveys going on trying to figure out if there
is material in Michigan to mine. One of the geologists studying the area has a theory
about what is available in Michigan and Agassiz knows the information because he is
president of the company. The plaintiff in the case wanted to sell his stock and there
was a buyer—but the two never met—it was not a face to face transaction. The plaintiff
sells his stock to the buyers who are directors of the company but later sues stating
that he would NOT have sold his stock if he had known about the geologist’s
information.
i. Early State Majority No Duty Rule—corporate insiders, having inside
information do not have a duty not to trade with regards to the corporation of
which they are a part based on that inside information.
ii. RULE: Where a director personally seeks a stockholder for the purpose of
buying his shares without making disclosure of material facts within his
peculiar knowledge and not within reach of the stockholder, the transaction
will be closely scrutinized. But Fraud cannot be presumed; it must be
proved.
iii. HELD: Every element of actual fraud or misdoing by the defendant is
negated by the findings, as the facts afford no ground for inferring fraud or
conspiracy and no facts placed upon them a duty to disclose the theory.
The theory was at most a hope and a possibility.
o “Fiduciary obligations of directors ought not to be made so onerous
that men of experience and ability will be deterred from accepting
such office.”
iv. Big Question: What kind of rule do you want, given that any insider is
always going to be in a better position with more information, yet not
preventing directors from buying and selling their own stock.
c. Federal Duty to “Disclose or Abstain” from Trading Overtime, federal courts
have developed rules against insider trading based on implied fiduciary duties of
confidentiality.
i. Early federal courts held that just as every securities trader is duty-bound
not to lie about material facts, anyone in possession of material insider
information must either abstain from trading or disclose to the investing
public. However, to impose an abstain-or-disclose duty on everyone with non-
public, material information, however, obtained, would significantly dampen the
enthusiasm for trading in the stock market.
o SEC v. Texas Gulf Sulphur Co. (1969, p.482)—TSG began
exploratory drilling in Canada and it looked like there was an
extraordinary high mineral content in the area from the drilling. The
company employees were ordered to keep the drilling results a secret.
Several TSG employees and their tipees then bought TSG stock and
call options on the stock. Rumors began to circulate about the drilling
results and TSG issued press releases stating the rumors were
exaggerated and unfounded.
 RULE: Insiders are those who are officers, directors, or
employees within the corporation. Those insiders who obtain
material information prior to its release have a duty to abstain
from trading or to disclose the information and wait until the

95
 information is reasonably disseminated to the investing public
before trading. RULE applies to ANYONE, not just directors.
• Matter of Cady, Roberts & Co—Anyone who is
trading for his own account in the securities of a
corporation has access, directly or indirectly, to
information intended to be available only for a corporate
pupose and not for personal benefit of anyone, may not
take advantage of such information knowing it is
unavailable to those with whom he is dealing.
o Applied insider trading prohibition of § 16(b) to
ALL transactions.
 HELD: Officers, directors, and employees of an issuer
who know of favorable information as a result of their
position within the company, as well as tippees who obtain
material information before its release, violate rule 10b-5 if
they purchase shares or options before the information is
released.
• Furthermore, an insider is not always prevented from
investing in his own company just because he is familiar
with the company’s operations—“essentially
extraordinary circumstances require disclosure.”
• The court states that “it was the Congressional
purpose [of 10b-5] that all investors should have equal
access to the rewards of participation in securities
transactions.”—Professor disagrees—there is nothing in
the Congressional statute of 10(b) to indicate equal
access.
ii. The existence of this legal prohibition, which conveys a public impression of
an unrigged game, is misleading.
d. Fiduciary Duty of Confidentiality—In the early 1980s SC provided a framework
for the abstain or disclose duty. Chiarella and Dirks. A decade later the court
brought “outsider trading” within its framework. O’Hagan. Thus, the SC anchors
federal regulation of classic insider trading on a presumed fiduciary duty of
corporate insiders to the corporations shareholders, even though state corporate
law has largely refused to infer such a duty in impersonal trading markets.
i. Congress should fix this, but Congress never does anything—The
Agency keeps trying to broaden their own rule. An example of backdoor
legislation.
ii. Traditional Insider Trading Theory: § 10(b) and Rule 10b-5 are violated
when a corporate insider trades in the securities of his corporation on the
basis of material non-public information. This information qualifies as a
“deceptive device” under § 10(b) because a relationship of trust and
confidence exists between the shareholders of a corporation and those
insiders who have obtained confidential information by reason of their
position within the corp.
o That relationship gives rise to a duty to disclose or abstain from
trading because of the necessity of preventing a corporate insider
from taking unfair advantage of uninformed stockholders.
o This duty also applies to attorneys, accountants, consultants, and
other temporary fidicuaries.
iii. Chiarella v. United States: Chiarella was employed in the composing room
of a financial printer. Using his access to confidential takeover documents

96
 that his firm printed for corporate raiders, he figured out the identity of
certain takeover targets. Chiarella then bought stock in the targets, contrary
to explicit advisories by his employer. He later sold at a profit when the
raiders announced their bids.
o HELD: Reversed Chiarella’s criminal conviction under Rule 10b-5
and held that Rule 10b-5 did not impose a “parity of information”
requirement. Merely trading on the basis of nonpublic material
information, the Court held, could not trigger a duty to disclose or
abstain. Chiarella had not duty to the shareholders with whom he
traded because he had no fiduciary relationship to the target
companies or their shareholders.
o Misappropriation of Information is the plug in this loophole.
iv. Dirks v. SEC (1983, p.494)—Dirks was a securities analyst whose job was
to follow the insurance industry. When he learned of an insurance
company’s massive fraud and imminent financial collapse from Secrist, a
former company insider, Dirks passed on the information to his firm’s
clients. They dumped their holdings before the scandal became public.
o RULE: For an insider to have tipped improperly, there has to be
a fiduciary breach. A breach occurs when the insider gains
some direct or direct personal gain or a reputational benefit
that can be cashed in later.
 The Tippee’s duty to disclose or abstain is derivative from
that of the insider’s duty.
 Some tippees must assume an insider’s duty to the
shareholders not because they receive inside information,
but rather because it has been made available to them
improperly. And for Rule 10b-5 purposes, the insider’s
disclosure is improper only where it would violate the
Cady, Roberts duty. Thus, a tippee assumes a fiduciary
duty to the shareholders of a corporation not to trade on
material nonpublic information only went the insider has
breached his fiduciary duty to the shareholders by
disclosing the information to the tippee and the tippee
knows or should know that there has been a breach.
• This not the case with insider’s disclosing information
to analysts.
 TEST for determining whether a disclosure is a breach of
duty: Will the insider personally benefit, directly or indirectly,
from his disclosure? Absent some personal gain, there has
been no breach of duty to stockholders. And absent a
breach by the insider, there is not derivative breach.
o HELD: On appeal from the SEC disciplinary sanctions for Dirk’s
tipping of confidential information, the SC held that Dirks did not
violate Rule 10b-5 because Scrist’s reason for revealing the Scandal
to Dirks were not to obtain an advantage for him. Secrist had
exposed the fraud with no expectation of personal benefits, and
Dirks could not be liable for passing on the information to his firm’s
clients.
 If the SEC rule were correct, then there would be no
incentive for anyone to go out and determine whether there
is fraud occurring. “Imposing a duty to disclose or abstain
solely because a person knowingly receives material

97
 nonpublic information from an insider and trades on it could
have an inhibiting influence on the role of market analysts.”
v. Misappropriation theory of Insider-Trading: A person commits fraud in
connection with a securities transaction, and thereby violates § 10b and
Rule 10b-5, when he misappropriates confidential information for securities
trading purposes, in breach of a duty owed to the source of the
information (not to the shareholders).
o A fiduciary’s undisclosed, self-serving use of the principal’s
information to purchase or sell securities, in breach of a duty of
loyalty and confidentiality, defrauds the principal of the exclusive use
of that information.
o DISTINCTION: In lieu of premising liability on a fiduciary
relationship between the company insider and purchaser or seller of
the company’s stock, the misappropriation theory premises liability
on a fiduciary-turned-trader’s (“Outsider’s”) deception of those who
entrust him with access to (source of) confidential information.
o Full disclosure forecloses liability under the misappropriation
theory. Because the deception essential to the misappropriation
theory involves feigning fidelity to the source of the information, if the
fiduciary discloses to the source that he plans to trade on the
nonpublic information, there is no deceptive device and thus, no §
10(b) violation—although the fiduciary-turned-trader (outsider) may
remain liable under state law for breach of a duty of loyalty.
vi. U.S. v. O’Hagan (1997, p.501)—O’Hagan was a partner in a law firm
retained by a company planning to make a tender offer for a target
company. He purchased common stock and call options on the target’s
stock before the bid. Both the bidder and the law firm had taken
precautions to protect the bid’s secrecy. When the bid was announced,
O’Hagan sold for profit of more than $4.3 million. After an SEC
investigation, the Justice Department brought an indictment against
O’Hagan, alleging securities fraud, mail fraud, and money laundering. He
was convicted on all counts and sentenced to prison. The 8th Circuit
reversed the conviction on the grounds that misappropriation did not violate
Rule 10b-5. NOTE: O’Hagan is not the attorney for the company in which
he held stock, but for the other firm.
o RULE: The unauthorized use of confidential information is (1) the
use of a “deceptive device” under 10(b) and (2) “in connection with”
securities trading.
o HELD: Reversed and validated the misappropriation theory. First,
the misappropriator devices the source that entrusted to him
the material, nonpublic information by not disclosing his evil
intentions, a violation of fiduciary duty. Second the “fiduciary’s
fraud is but when . . . he uses the information to purchase or
sell securities.” Citing to the legislative history of the exchange act
and to SEC releases, the court concluded that misappropriation
liability would “insure the maintenance of fair and honest markets
and thereby promote investor confidence.” O’Hagan’s trading
operated as fraud on the source in connection with securities
trading, a violation of Rule 10b-5.
o § 14(e) Expressly gives rulemaking authority to regulate tender
offers.
o Rule 14e-3(a)--“If any person has taken a substantial step or steps

98
 to commence, or has commenced, a tender offer, it shall constitute
a fraudulent, deceptive or manipulative act or practice within the
meaning of section 14(e) of the Exchange Act for any other person
who is in possession of material information relating to such tender
offer which information he knows or has reason to know is nonpublic
and which he knows or has reason to know has been acquired
directly or indirectly from:
 (1) the offering party,
 (2) The issuer of the securities sought or to be sought by
such tender offer, or
 (3) Any officer, director, partner, or employee or any other
person acting on behalf of the offering person or such issuer.
o Agree Rule 14e-3(a) applies in this case. The Court defers to the
agencies interpretation.
10. Disgorging Short-Swing Profits
a. This is Congress’s stab at trying to prevent insider trading.
b. Section 16(b) imposes automatic strict liability on qualifying officers,
directors, and 10% shareholders who make a profit in short-swing
transactions within a six month period.
c. Recovery is to the corporation, and suit may be brought either by the corporation or
by a shareholder in a derivative suit.
d. The mechanical short-swing profit rules are both overly broad and overly narrow.
They broadly cover innocent short-swing trading that occurs without the use of
inside information or any wrongful intent, yet they fail to cover abusive insider
trading that occurs outside the six month window or by those who are not insiders
specified under 16.
e. Short-Swing Algorithm: A two-part algorithm determines whether disgorgement is
available:
f. Shareholder status (10%) “immediately before” BOTH transactions: For 10%
shareholders, it is necessary that the person have held more than 10% immediately
before both the purchase and sale to be matched. The rationale is that 10%
shareholders are less likely to have access to inside information or to corporate
control mechanisms than officers or directors. Thus, their insider status must exist
at both ends of the matching transactions.
i. Reliance Electric Co. v. Emerson Electric Co. (1972, p. 511)—Did not go over in class—
Emerson owned 13.2% of Reliance stock and disposed of its entire holdings in two sales,
both of them within six months of purchase. The first sale reduced Emerson’s holdings to
9.96%, and the second disposed of the remainder. ISSUE: Whether the profits derived from
the second sale are recoverable by the corporation?
o HELD: The statute clearly contemplates the requirement that a 10% owner be such
both a the time the purchase and the sale of security involved, meaning an insider
might sell enough shares to bring his holdings below the 10% and later, but still
within the 6 months, sell additional shares free of liability under the statute.
o NOTE: A purchase of stock falls within 16(b) where the purchaser becomes a 10%
owner by virtue of the purchase.
F. INDEMNIFICATION AND INSURANCE
1. Most states have detailed statutory provisions covering the authority or obligation of a
corporation to indemnify officers or directors for any damages they might incur in
connection with their corporate activities and for the expenses of defending themselves.
a. Numerous situations giving rise to liability—claim by third person or for injury to
corporation or shareholders, or claims by employees, customers, competitors, or
government agencies.
b. Risk of liability may be remote, but the amount of damages can be large in relation
to the wealth of the director. This includes costs of defense

99
 c. Corporation may be able to purchase insurance.
d. Concern about the possibility of a hostile take-over.
2. This is so important because the biggest threat to directors and officers and securities
violations. Therefore, it is necessary to allow corporations to indemnify because otherwise,
salaries would have to increase in order to by insurance for themselves.
3. Delaware Law is typical - § 145 (For suits by third parties, not for derivative suits)
a. (a) Provision relating to suits by third parties allowing indemnification in
certain circumstances for expenses, judgments, fines, and amounts paid in
settlement.
i. A discretionary indemnification power, not mandatory
ii. “A corporation shall have power to indemnify any person who was or is a
party . . . to any threatened, pending or completed action . . . whether civil,
criminal, administrative or investigative (other than an action by or in the
right of the corporation) by reason of the fact that he is or was a director,
officer, employee or agent of the corporation . . . against expenses
(including attorneys’ fees), judgments, fines, and amounts paid in settlement
actually and reasonably incurred by him in connection with such action, . . .
if he acted in good faith and in a manner he reasonably believed to be in or
not opposed to the best interests of the corporation, and, with respect to any
criminal action or proceeding, had no reasonable cause to believe his
conduct was unlawful.”
iii. Trying to expand what corporations can indemnify.
b. (b) Covers indemnification for suits by or in the right of the corporation—that
is, in derivative suits it allows indemnification only for expenses.
i. Permissive
ii. Exception: If the person seeking indemnification has been found liable to
the corporation, only with judicial approval.
iii. Indemnify expenses and attorneys’ fees if acting in good faith.
c. (c) Expenses must be reimbursed if the officers and directors successfully
defended claims.
i. Affirmative/Mandatory requirement.
ii. “To the extent that a director, officer, employee, or agent of a corporation
has been successful on the merits or otherwise in a defense of any action . .
. he shall be indemnified against expenses (including attorneys’ fees)
actually and reasonably incurred by him in connection therein.
d. (e) Advancement of expenses, which may be of the utmost importance.
i. BUT may have to give the money back if D loses.
e. (f) A corporation may provide indemnification rights that go beyond the
rights provided by § 145(a) and the other substantive subsections of § 145.
i. HOWEVER, any such indemnification rights provided by a corporation
contract must be consistent with the substantive provisions of § 145,
including subsection (a). Contract may not exceed the scope of corps.
Indemnification powers—“private arties may not circumvent the legislative
will simply by agreeing to do so.” Waltuch, p. 521
ii. Thus, indemnification rights may be broader than those set out in the
statute, but they cannot be inconsistent with the scope of the corp’s power
to indemnify, as delineated in the statute’s substantive provisions.
iii. “If § 145(f) gave corporation unlimited power to indemnify directors and
officers, the final clause of subsection (g) would be unnecessary: that is its
grant of power to purchase and maintain insurance is meaningful only
because in some insurable situations, he corporation simply lacks the power
to indemnify its directors and officers directly.”—Waltuch

100
 o Surplusage—If you have two reading of a statute and any part is
made useless by a certain reading, then that reading is un-favored
and wrong. Based on the idea that everything the legislature does is
carefully considered and is there for a reason.
iv. NOTE: The indemnification agreement can be in the employment contract.
f. (g) Insurance is authorized
i. Explicitly allows a corporation to circumvent the “good faith” clause of
subsection (a) by purchasing directors and officers liability insurance policy.
ii. Corp. can buy insurance that covers directors’ actions not otherwise entitled
to indemnification.
iii. These policies are not easy to come buy—the problem is often evaluating
the risk—if you can estimate risk, then you can sell insurance.
o Often have high deductible and have maximum amounts that they
will pay.
o Important Exclusions—including Environmental Risks are not
covered, and criminal behavior (anti-trust and certain securities
laws).
4. INDEMNIFICATION The corporation’s promise to reimburse the director for litigation
expenses and personal liability if the director is sued because she is or was a director.
a. To encourage qualified individuals to accept corporate positions and take good-
faith risks for the corporation, corporate statutes permit the corporation to indemnify
directors and officers against liability arising from their corporate position.
b. General Rule: Mandatory Indemnification for Successful Defense If a
director is sued because of her corporate position and she defends successfully,
the corporation is obligated under all state statutes to indemnify the director for
litigation expenses, including attorney’s fees.
i. Indemnification rights continue even after one has left the corporation.
c. 2 Issues with this defense: (1) When is a defense successful? and (2)Can their be
mandatory indemnification for a partially successful defense.
d. Some statutes require indemnification “to the extent” the director is
successful, compelling the corporation to reimburse a partially successful
director’s litigation expenses related to those claims or charges she defends
successfully.
i. Waltuch v. ContiCommodity Services, Inc. (1996, p.521)—Applying a
Delaware law to require indemnification of litigation expenses incurred by
director charged with conspiring to corner silver market, after company (but
not director) paid to settle private lawsuits brought by silver traders.
o Drafting Issue: Employment Contract concerning indemnification
should have addressed how settlements would be treated.
o HELD:
 (1) The contract would require indemnification of Watuch
even if he acted in bad faith, which is inconsistent with §
145(a) and thus exceeds the scope of a Delaware
corporation’s power to indemnify.
• Whole Act Rule: Reading the statute in its entirety.
 (2) Once Wltuch achieved his settlement gratis, he achieved
success on the merits or otherwise. Success is sufficient to
constitute vindication. Thus, his settlement vindicated him.
5. INSURANCE Corporate statute permit the corporation to buy insurance for itself to fund
its own indemnification obligations and for directors to fill the gaps in corporate
indemnification, principally when a director is liable to the corporation in a derivative suit.
a. Indemnification is a form of insurance provided by the corporation to its directors,

101
 officers, and employees, and other agents. The corporation can meet its
indemnification obligations, statutory or extra-statutory, either by acting as a self
insurer or by purchasing insurance from outside insurance companies.
6. Citadel Holding Corp. v. Roven (1992, p.529)—There were limitations on his ability to
exercise his options, so this doesn’t fall under a 16(b). D’s claim for indemnification and
reimbursement was prompted by a suit brought by P against him. P alleged that D violated
section 16(b) of the SE Act by purchasing certain options to buy stock while he was a
director. P claims they don’t have to pay you the things you are not obligated to indemnify
(because you are never entitled to indemnification in a 16(b) action); therefore, they do not
have to pay an advance.
a. HELD: The Agreement requires P to advance to D all reasonable costs incurred in
defending the federal action. This determines the rights to advance, not to
indemnification. The provisions speak to Roven’s right to indemnification and not to
advance. Therefore, nothing in the agreement compels the conclusion that D is not
entitled to advance for the costs of defending federal action.
b. Absurd Result Test If you were to read the statute in this manner, then there
would be an absurd result.

VI. Problems of Control

A. PROXY FIGHTS
1. You can attend a yearly meeting, or give away your proxie, which will be used to vote the
way the corporation’s Board of Directors thinks is best.
2. Shareholders are Rationally Ignorant and they Remain Passive As a shareholder,
you are uninformed because it is not worth your time or energy to find out what the right
answer should be (to get involved).
3. Strategic use of Proxies Incumbent directors (present management) may use the
corporate funds and resources in a proxy contest if the sums are not excessive and the
shareholders are fully informed.
a. Levin v. Metro-Goldwyn-Mayer, Inc. (1967, p.535)—The plaintiffs own 11% of the
company and seek to take over the company by putting up their slate of candidates
for board positions and getting the shareholders to vote by proxy for their
candidates. The O’Brien Group is the current management and the Levin Group is
the insurgency. Each group is soliciting proxies for a vote at the annual meeting.
The plaintiff seeks an injunction to stop the incumbents from using corporate
money in the solicitation and in addition seeks money damages.
i. HELD: P lose because of state law and business judgment rule. As long as
the incumbents can characterize what they are doing as reasonable and not
excessive in order to “communicate with the shareholders” then the court is
going to uphold the behavior. The court finds nothing excessive or
unreasonable about the incumbent uses of corporate funds and resources
and emphasized the right of the shareholders to be fully informed.
4. Reimbursement of Costs In a contest over policy, as compared to a purely power
contest, corporate directors have the right to make reasonable and proper
expenditures, subject to the scrutiny of the courts when duly challenged, from the
corporate treasury for the purpose of soliciting shareholder proxy votes for policies
that the directors believe in good faith are the best interests of the corporations.
The stockholders have the right to reimburse successful insurgents for the
reasonable and bona fide expenses incurred in any such policy contest, subject to
court scrutiny.
a. Rosenfeld v. Fairchild Engine & Airplane Corp. (1955, p. 537)—P brings a
shareholders derivative suit to have the $261,522 that was paid out of corporate
treasury to reimburse both sides of a proxy fight returned to the corporation. The

102
 insurgent group actually won the proxy fight, and the original management paid for
their side of the proxy fight and the new management voted to reimburse the
insurgent group, which won, for their expenses.
i. HELD: Right to reimbursement. It should be a policy contest and not a
personality contest.
ii. Professor says not hard to prove policy and courts will rarely second guess
reimbursement to a successful insurgent, absent some egregious waste.
5. Regulation of Proxy Fights--§ 14(a) of the Exchange Act
a. Prohibits people from soliciting proxies in violation of the SEC rules.
b. These rules require a proxy statement—a communication between the insurgency
group to stockholders that must look a certain way and have certain information in
it.
c. 14(a)-7 states that management can either: (1) mail the insurgent group’s material
to the shareholders directly and charge the group for the costs, or (2) give the
group a copy of the shareholder’s list and let it distribute its own materials.
6. Shareholder Proposals under 14a-8 The SEC shareholder proposal rule seeks to
promote shareholder democracy by allowing shareholders to propose their own resolutions
using the company financed Proxy machinery.
a. Rule 14a-8 Procedures—Any shareholder who has owned 1% or $2,000 worth of
a public company’s shares for at least one year may submit a proposal—14a-8(b)
(1). The proposal must be in the form of a resolution (only one) that the
shareholder intends to introduce at the shareholder’s meeting.
b. Proper Proposals: Rule 14a-8 contains a dizzying list of 13 reasons for
management to exclude a shareholder’s proposal:
i. Proposals inconsistent with centralized management—Four of the
exclusions aim at proposals that interfere with the traditional structure of
corporate governance.
ii. Proposals that interfere with management’s proxy solicitation---The
rule has four exclusions for proposals that threaten to interfere with orderly
proxy voting
iii. Proposals that are illegal, deceptive, or confused—Five of the
exclusions are meant to prevent spurious or scandalous proposals.
c. Professor, therefore, thinks that these rules are a total waste of time.
i. Most famous of these proposals was in the late 1960s and involves Ralph
Nader who bought up GM stock and started something called “Project
GM” which wanted to make GM socially responsible. It of course, got voted
down
d. EXCEPTION: If a shareholder proposal relates to less than 5% of the total assets
of the corporation and is not significantly related to the business, then the
management is not required to include the proposal on the proxy statement.
i. Lovenheim v. Iroquois Brands, Ltd. (1985, p.559)—Lovenheim sought an
injunction barring Iroquois from excluding on its proxy statement a proposed
resolution that he intended to offer at the upcoming shareholders meeting,
which related to force feeding geese for pate.
o HELD: Did not have to include it.
o Professor find this Exception Totally Ambiguous, and since it is
ambiguous, the courts must determine what “significantly related” is
supposed to mean. Look to the federal register to determine what
the SEC might have meant.
e. RULE: Corporations may omit shareholder proposals from proxy materials
only if the proposal falls within an exception in rule 14a-8.
i. New York City’s Employees’ Retirement Sys. v. Dole Food Co. (1992,
103
 p.563)—A retirement fund, which manages billions of dollars, wants to
include a proposal on the Dole proxy statement. Dole’s argument to
excluding the statement is that it has no power to effectuate he proposal—it
is beyond its power to do anything about it and thus it is a waste of time and
money.
o HELD: Because Dole failed to prove the proposal fell within one of
the exceptions, the court ordered Dole to include the proposal in the
proxy statement.
o Professor thinks this case is WRONG.
f. RULE: In attempting to omit a shareholder proposal, the burden rests on the
corporation to demonstrate that the proposal does not relate to the ordinary
business operations of the company.
i. Austin v. Consolidated Edison Co. of NY, Inc. (1992, p.568)—
Shareholder sued to compel D to include a proposal in its proxy materials
endorsing a change in the company’s pension policies.
o HELD: The proposal relates to the redress of a personal claim or
grievance against the company, not one that relates to the conduct
of ordinary business. Thus, D fulfills its burden in proving this.
o Professor thinks decided correctly.
7. Information Rights To facilitate shareholder’s voting powers, corporate law gives
shareholder the right to receive information from the corporation.
a. Inspection of Corporate Books and Records—Corporate statutes codify
shareholder’s common law rights to inspect corporate books and records. MBCA
16.02. Some statutes limit this right to record shareholders, not beneficial owners.
i. Some records, such as the Articles of incorporation, bylaws, and minutes of
shareholder’s meetings, are available as of right. MBCA 16.01(e).
ii. Other records, such as board minutes, accounting records, and shareholder
lists, are available for inspection only upon a showing of a “proper
purpose.”
o Courts have found such a purpose if the shareholder’s request for
these records relates to the shareholder’s interest in his
investment.
b. Thus, management must provide a shareholder’s list to a shareholder planning to
solicit proxies from fellow shareholders or internal financial records to a shareholder
seeking to value her investment or uncover mismanagement. But management
need not provide records to a shareholder planning to give them to
competitors or seeking to advance a political agenda unrelated to his
investment.
i. RULE: A shareholder wishing to inform others regarding a pending
tender offer should be permitted to access the company’s shareholder
list, unless it is sought for an objective adverse to the company or its
stockholders.
o Crane Co. v. Anaconda Co. (1976, p.572)—Crane, a shareholder,
demanded access to D’s shareholder list for the purpose of
informing other shareholders of a pending tender offer.
 HELD: P not barred from access by liberally construing the
statute in favor of shareholder.
 Narrowly Construed—A cannon of statutory interpretation
that says that statutes in derogation of the common law
should be narrowly construed. Professor thinks this should
have been narrowly construed.

104
 • Liberally construed is the opposite interpretation
adopted here.
ii. State ex rel. Pillsbury v. Honeywell, Inc.—P is the great grandson of
Pillsbury baker and was Doon in college, which eventually became
Doonsbury. P was upset with Honeywell’s contributions to the Vietnam
ware effort and buys 100 shares of Honeywell stock and then seeks access
to the shareholder list and corporate documents/records.
o RULE: In order for a shareholder to inspect shareholder lists and
corporate documents, the shareholder must demonstrate a proper
purpose relating to an economic interest.
o HELD: Denied inspection of shareholders’ list by shareholder
seeking to communicate anti-war beliefs with other shareholders.
B. CONTROL IN CLOSELY HELD CORPORATIONS
1. Closely Held Corporation One in which the stock is held in a few hands, or in a few
families, and wherein it is not at all, or only rarely, dealt in buying or selling. (partners in all
but name). Gallar
a. F. Hodge O’Neal Developed/Conceptualized the category of closely held
corporations.
b. Shareholder agreements similar to that in question here are often, as a practical
consideration, quite necessary for the protection of those financially interested in
the close corporation.
c. While the shareholder of a public-issue corporation may readily sell his shares on
the open market should management fail to use, in his opinion, sound business
judgment, his counterpart of the close corporation often has large total of his
entire capital invested in the business and has no ready market for his
shares should he desire to sell.
i. Concern about minority shareholders—cannot dissolve a corporation like
you can in a partnership.
ii. Without a shareholder agreement, specifically enforceable by the courts,
insuring him a modicum of control, a large minority shareholder might find
himself at the mercy of an oppressive or unknowledgeable majority.
iii. Often the only sound basis for protection is afforded by a lengthy, detailed
shareholder agreement securing the rights and obligations of all concerned.
iv. Plight of the Minority Shareholder Subject to the will of the majority
decision—“at mercy of an oppressive majority.” BUT, most minority
shareholders buy into the situation. Professor thinks that according to
O’Neal, the minority shareholder is the victim. Professor tends to think that
most people voluntarily enter into the situation
o O’Neal is kind of a windfall to minority shareholders, but legislature
has bought into it.
2. Old Rule: Restrictions on directorial Discretion are invalid as a matter of public policy. The
board must be free from outside contractual decisions. Minority stockholders have a right
for the board to not be subject to contractual restraints on their discretion.
a. McQuade v. Stoneham (1934, p.606)—Three shareholders of the corp. that
owned the NY Giants baseball team agreed as shareholders to elect themselves as
directors and as directors appoint themselves as officers at specified salaries.
Stoneham owns a majority of shares and McQuade and McGraw are minority
shareholders. Eventually, McQuade is dropped as director and his claim is that the
contract made between the three was not kept—he seeks specific performance.
The Ds argue that the K was void because contracts compelling someone to keep
certain persons in office are illegal.
i. HELD: BY neutralizing the role of the board so much so that it did not have

105
 effective control over the corporation contradicted the statute stating that the
board controlled the company.
ii. However, in small corporations these types of agreements are very
common, and the rule in this case is not the standard anymore.
iii. NOTE: In this case there are minority shareholders.
3. Evolution of Old Rule: Where the directors are also the sole shareholders of a
corporation, a contract between them to vote for specified persons to serve as
directors is legal and not in contravention of public policy, provided there is
unanimous agreement amongst investors and notice to potential investors.
a. “No harm, no foul” Rule of Construction If the enforcement of a particular
contract does not damage anyone, then there is no reason for holding it to be
illegal.
b. Clark v. Dodge (1936, p.611)—Clark and Dodge are the sole shareholders in two
pharmaceutical cos. And enter into a shareholders’ agreement regarding Clark’s
continuation as manager and director. Clark owned 25% and Dodge owned 75% of
the corps. Clark acted as manager, but Dodge held the medicinal formulas. After
making the agreement that he would be kept as manager, Clark gave the formula
to Dodge’s son. Clark was fired and sued for breach of Contract.
i. NOTE: This is a close corporation without a “ready market” for stock.
There are NO minority stockholders.
ii. ISSUE: Whether the agreement for continuing manager position was valid?
iii. HELD: If a Corporation can get unanimous agreement among investors for
the contract and there is notice to potential investors, an agreement for a
continuing managing position is valid. The requirement of unanimity
followed by notice is an attempt to soften the McQuade Rule.
4. TODAY—Legislative willingness to view small corporations from large corporations
a. The NY legislature changed the corporations law in the state to conform to this
decision--§ 620
i. (a) An agreement between two or more shareholders, if in writing and
signed by the parties thereto, may provide that in exercising any voting
rights, the shares held by them shall be voted as therei provided, or as they
may agree, or as determined in accordance with a procedure agreed upon
by them.
ii. (b) Shall nevertheless be valid: (1) if all the incorporators or holders of
record of all outstanding shares, whether or not having voting power, have
authorized such provision in the certificate of incorporation or an
thereof; and (2) If, subsequent to the adoption of such provision, shares are
transferred or issued only to persons who had knowledge or notice thereof
or consented in writing to such provision.
b. The Delaware statute permits a corporation to contract around the idea that the
board of directors shall manage the business and affairs of every corporation and
provides for more flexibility—141, 142
i. 141—if any such provision is made in the certificate of incorporation, the
powers and duties conferred or imposed upon the board of directors by this
chapter shall be exercised or performed to such extent and by such
persons or persons as shall be provided in the certificate of incorporation.
ii. 142—Officers shall be chosen in such manner and shall hold their officers
for such terms as are prescribed by the by-laws or determined by the BODs
or other governing body.
5. Corporate Planning by use of Employment Contracts
a. EXAM! 2 Additional things Clark could have done to protect himself—this is how
you get money out of a closely held corporation when you leave—Need BOTH:

106
 i. Negotiate an employment contract, which defines a term of employment,
what would happen at the end of the term, and “good cause” stated for
firing.
o This is the way to contract around the “plight of the minority
shareholder”
ii. Negotiate a buy-sell agreement
o 182-183 Buyout Agreements—Cross Reference—Even though
dealing with partnerships same problem, same solution.
o Not really necessary for large corporation, but is necessary for
closely held corporations because there is generally no one to sellt
he stock to and no good way to value the shares.
iii. Would also like to have a Dividend Payout Contract if you can get it—Like
you have in Gallar.
b. Issues to Address in an Employment Contract:
i. DURATION
o Number of years, and then what?
o Termination for Cause—By whom? What is cause?
 Helpful to give some performance standard.
o Effect of illness, incapacity, etc.
ii. COMPENSATION
o Salary
o Adjustments (ex. for inflation)
o Bonuses, stock options, etc.
o Benefits
o Travel and other expenses
o Perquisites
iii. DUTIES AND STATUS
o Job Description and other duties
o Amount of time, vacation, etc.
o Outside activities
iv. COMPETITION AND TRADE SECRETS
v. CONSEQUENCES OF TERMINATION
o Liquidation Damages – Important
o Duty to mitigate
vi. PARTIES
o Mergers, etc.
o Guarantee by majority shareholder
6. Shareholder Agreements, Voting Truss, Statutory Close Corporations, and
Involuntary Dissolution:
a. Agreements by which the shareholders simply commit to elect themselves, or their
representative, as directors, are generally considered unobjectionable, and are now
expressly validated in many jurisdictions. They do not interfere with the obligations
of the directors to exercise their sound judgment in managing the affairs of the
corporation.
b. Courts have more difficulty with shareholder agreements requiring the appointment
of particular individuals as officers or employees of the corporation, since such
agreements do deprive the directors of one of their most important functions.
i. Modern View Reflected in Gallar—Such agreements are enforceable, at
least for closely held corporations, as long as they are signed by all
shareholders.
c. VOTING TRUST Shareholders who wish to act in concert turn their shares over

107
 to a trustee. The trustee then votes all the shares, in accordance with instructions
in the document establishing trust.
i. Voting Trusts are often used to maintain control of a corporation owned by a
family or group.
ii. Can create voting trusts and instruct the trustee to vote all the shares for
directors, and on other matters submitted to shareholder vote, in
accordance with decisions reached by the five members by majority vote.
iii. Voting trusts generally must be made public.
d. LIMITED LIABILITY COMPANIES Issues of control are generally left largely to
individual choice, reflected in a document, drafted by or for the investors and called
regulations or operating agreement. This may be member managed (like a
partnership) or manager managed (like a corporation).
7. Modern Test: A shareholder agreement that substantially curtails the discretion of
the Board of Directors will nonetheless be upheld if (1) it doesn’t injure any minority
shareholder, (2) it doesn’t injure creditors or the public, and (3) it doesn’t violate any
express statutory provision.
a. Galler v. Galler (1964, p.618)—The two principal owners of a corporation, Ben and
Izzy, each owned 47.5% of the stock. They signed an agreement in which they
agreed to pay certain dividends each year and to pay, in the event either should
die, a pension to the remaining spouse. This includes a salary continuation
provision for 5 years. Ben dies and Izzy refused to carry out the agreement (Emma
is ben’s widow). Under McQuade, this would violate public policy. ISSUE: Is the
shareholder agreement valid?
i. HELD: The court orders specific performance of the agreement. The Court
relies on F. Hodge O’Neal (who basically developed/categorized the
category for closely held corporations) and determines that a court should
not analyze these agreements with an eye towards voiding them because
often the only sound basis for protection afforded by a lengthy detailed
shareholder agreement securing rights of obligations of all concerned.
o “There is no reason why mature men should not be able to adapt to
the statutory form to the structure they want, so long as they do not
endanger other stockholders, creditors, or the public, or violate a
clearly mandatory provisions of the corporation laws.”
o Specific Performance creates a poisonous atmosphere, therefore,
the COASE Theorem may determine what happens post settlement.
o Shows the problems that state legislatures have attempted to
remedy with special statutes.
b. Where there is no injury to a minority shareholder, no fraud, no injury to the
public or to creditors, and no statute is violated, then an agreement between
shareholders will be upheld.
i. Ramos v. Estrada (1992, p.623)—Estrada violated a shareholder
agreement by voting her shares in opposition to the majority, which was
required in the agreement. In addition, the agreement placed a restriction
on transfer and treated the shareholder’s noncompliance with the voting
agreement as an election to sell the shares at market price minus a
premium. Ramos sued because Estrada violated the voting agreement.
o HELD: The Estrada’s breached the agreement by their written
repudiation of it, requiring them to repudiate.
o STATUTE: “An agreement between two or more shareholders of a
close corporation, if in writing and signed by the parties thereto, may
provide that in exercising any voting rights the shares held by them
shall be voted as provided by the agreement, or as the parties may

108
 agree or as determined in accordance with a procedure agreed upon
by them.”
 Even though this corporation is not a close corporation, the
“section shall not invalidate any voting or other agreement
among shareholders which agreement is not otherwise
illegal.” This is intended to “preserve any agreements which
would be upheld under court decisions even though they do
not comply with one or more of the requirements of this
section, including voting agreements of corporations other
than close corporations.
c. Zion v. Kurtz (1980, p. 628)—Using choice of law rules, the Court decided
shareholder agreement under Delaware law, but stated that the result would be the
same under NY law. There were essentially two shareholders with Kurtz holding
the majority interest and Zion the minority. An agreement between them narrowly
defined the intended activities of the corp. and provided that no other activities
could be engaged in without the minority shareholder’s consent.
i. HELD: In supporting its view that the agreement did not violate the public
policy of Delaware, the court cited Delaware provisions relating toe statutory
close corporations, although the corporation involved in the case was not a
statutory close corporation and the restriction in the agreement was not
made part of the articles of incorporation, as might be required in the case
of a statutory close corporation.
C. ABUSE OF CONTROL
1. Fiduciary Obligation of Majority to Minority Some states have recently formulated a
theory of fiduciary obligation to resolve close corporation duties. This is the direction close
corporation law is headed.
a. These courts, especially the Massachusetts courts, have held that a majority
stockholder in a close corporation has a fiduciary obligation to minority
shareholders and must behave towards him with good faith.
b. Violation of this obligation can be compensated by an award of damages.
c. This fiduciary obligation doctrine is important as a method of resolving disputes
because it gives courts that apply it a method of rectifying the minority
shareholder’s grievance without ordering dissolution.
d. NOTE: Trying to protect the reasonable expectations of the minority shareholders.
2. “Squeeze Outs” or “Freeze Outs”—The majority freezes out a minority shareholder
a. If a majority attempts a classic squeeze-out or freeze-out of a minority holder, the
majority of holder may be found to have violated his fiduciary obligation.
b. For instance, if the majority refuses to pay dividends and refuses to employ the
minority shareholder so that the minority has no way to participate in the fruits of
ownership, this may be a violation of the majority fiduciary duty.
c. Donohue rule is similar to that of Mienhardt—Treat you close corporation
shareholders with the utmost good faith an loyalty.
i. “Stockholders in the close corporation owe one another substantially the
same fiduciary duty in the operation of the enterprise that partners owe to
one another.”
ii. Strict good faith standard. “They may not act out of avarice, expediency, or
self-interest.”
o Professor—it is hard to tell people not to act out of self-interest
because that is what people do.
d. Two Step Wilkes Test Cutting back on the Donohue standard, not every action
by the majority that is disadvantageous to the minority will be a breach of the
fiduciary obligation. Where a freeze out has occurred, the test is:

109
 i. (1) The Majority shareholders must demonstrate a legitimate business
purpose for the action, and
o Who decides what is a legitimate business purpose? This is a
problem, but this is better than Donohue with no limit on the duty of
good faith.
ii. (2) The minority shareholder must then show that there was another
course of action that would have been less harmful to the minority
shareholder and would have achieved the same business purposes.
e. Wilkes v. Springside (1976, p.630)—P and three other shareholders each owned
25% of the corporation. Each shareholder participated in management and
received an equal salary. Relations between P and another shareholder
deteriorated and the other shareholders caused the corporation to terminate P’s
salary and drop him from the Board. P filed suit.
i. HELD: The court attempts to redefine the Donohue Rule, holding that there
will be some cases where actions might be disadvantageous to a minority
shareholder, but where there is no breach of a fiduciary duty. There is a
right to selfish-ownership. Here the shareholders had violated their
fiduciary duty by squeezing P out—stripping him of his ability to obtain his
expected return on investment. The Defendants had no legitimate business
purpose.
ii. NOTE: The court is trying to apply partnership law to close corporations, but
the court does not say how small the company must be.
iii. Should have had an employment K and a buy/sell provision.
o You can define the terms of your own employment if you sign an
employment contract and a buy/sell agreement.
f. RULE: No duty of loyalty and good faith akin to that between partners arises
among those operating a business in the corporate form who have only the
rights, duties, and obligations of shareholders an not those of partners.
i. Ingle v. Glamore Motor Sales, Inc. (p.637)—P was employed as a
manager and wanted to buy into the company and his first request was
denied. Later, he was permitted to buy in and after some time, P signs a
written agreement, which allows D to buy back P’s stock if he ceases to be
employed for any reason. But there is no explicit employment agreement. P
was eventually voted out and fired and D exercises its option and buys back
the stock. P files suit stating that the fiduciary duty was owed to him so he
cannot be fired.
o HELD: A minority shareholder in a close corporation, who
contractually agrees to repurchase his shares upon termination of
his employment for any reason, acquires no right from the corp. or
majority shareholders against at will discharge. Basically, the court
is attempting to re-write and create reasonably expectations from the
sloppy expectations that these people have.
 Court is determining what the reasonable expectations of the
minority shareholder. This is why you should write your
expectations in contracts.
o DISSENT: Should have talked about Wilkes.
g. Additional evidence of a freeze-out is offering a low-ball offer to buyout the minority
shareholder’s stock. Therefore, should advise your client that if he is going to offer
to buy out the minority’s stocks then it must be an adequate, likely market price,
offer.
i. Sugarman v. Sugarman (1986, p.642)—Leonard is the majority and others
are minority shareholders. Allegations arises that Leonard abused his

110
 fiduciary duties by engaging in self-dealing and paying himself an exorbitant
salary (derivative) and then paying no dividends. Leonard offers to buy out
the minority offering far less than what the stock is worth. You can’t even
tell if this is a direct or derivative suit.
o RULE: Shows the point of contractual agreements between parties.
o HELD: The court looks to the totality of circumstances and although
in reality nothing really amounts to much, the court add up and find
that the plaintiff wins. This is a claim for waste and for personal
recovery on the theory of a freeze-out.
3. Obligation of Minority Stockholders
a. One lower court in Mass. went so far as to hold that a minority shareholder has a
fiduciary obligation to his co-shareholders, if the minority shareholder has been
given veto power over corporate actions.
b. Smith v. Atlantic Properties (p.646)—Wolfson was one of four shareholders in a
corporation that owns real estate and the corporate charter gives each shareholder
an effective veto power over any corporate decision. Wolfson refused to all the
corp to pay a dividend out of his surplus and the corp was assessed large penalties
by the IRS for excessive accumulation of earnings. The other three would not
agree to what Wolfson wanted to do and Wolfson would not agree to what they
wanted. Three other shareholders sued against Wolfson. ISSUE: Whether
Wolfson is liable for the loss of the IRS assessment?
i. HELD: Finds fault with Wolfson, but all parties are guilty and fault lies in the
veto agreement.
ii. Shows that the courts are not always good at applying the Wilkes/Donohue
standard and therefore there should be contractual agreements so not
relying on the courts.
4. Delaware Court has not adopted such a fiduciary duty.
a. Nixon v. Blackwell (p. 650)—A stockholder who bargains for stock in a closely
held corporation can make a business judgment whether to buy into such a minority
position and if so on what terms.
i. HELD: Shareholders are not always treated equally for all purposes and
the only issue is whether the corporation’s actions meet the standard of
entire fairness. The tools of a good corporate practice are designed to give
a purchasing minority stockholder the opportunity to bargain for protection
before parting with consideration. Permitting ad hoc court rulings would do
violence to normal corporate practice and corporation law.
5. QUESTION: Who is better to make this decisions? Court or Legislature?

VII. Mergers, Acquisitions, and Takeovers

A. Merger A transaction by which one corporation (acquiring firm) purchases the assets and
liabilities of another corporation (acquired firm) in return for either its own securities or cash, or a
combination of both.
1. 3 Types: (1) Horizontal—between competitors, (2) Vertical—between corporations that
stand in supplier/customer relationship, and (3) Conglomerate—catchall merger with no
real connection.
B. Statutory Merger—a merger accomplished pursuant to the procedures prescribed by state law.
1. Terms spelled out in a merger agreement, drafted by the parties, which prescribes among
other things, the treatment of the shareholders of each corporation. Considerably flexibility
is available.
2. Upon the filing of the merger agreement with the appropriate state official, the acquired
company would have disappeared and all the property interests, rights, and obligations of
the acquired company would have passed by law to the acquiring company.

111
 3. Approval by votes of the board of directors and the shareholders of each of the two
corporations is required.
4. Appraisal Right In addition, shareholders of each corporation who voted against the
merger are entitled to demand from the courts that they be paid in cash the fair value of
their shares, determined by agreement.
a. Delaware Corporations Law, § 251—“Statutory Merger” Provisions, including
appraisal rights.
b. Delaware Corporations Law § 262—Appraisal Right of Dissenting Shareholders.
i. (b)(1)—only applies to companies that are not publicly traded. This makes
sense because if it were publicly traded you could just trade your shares if
you no longer wanted ownership. Therefore, you either take the market
price or the price offered in the merger.
c. If a shareholder does not think the offer is sufficient, he can ask the Court to
appraise the value and award him what they think is sufficient.
d. Not Used Very Often because there are delays and there is no guarantee that you
will get any greater amount.
5. Delaware Statute, § 262(h) Shareholders who dissent from a merger and seek appraisal
fights are entitled to seek cash payment equal to the fair value of the shares “exclusive of
any element of value arising from the accomplishment of expectation of the merger.”
a. If you dissent from the merger, you can attempt to perfect your appraisal rights, but
you must take what the shares were worth pre-acquisition.
b. The point is to benefit the minority shareholder and to encourage merger.
c. If this statute did permit dissenting shareholders to get the merger value of the
shares, then mergers wouldn’t happen—and we want mergers to happen because
it increase the value of the firm.
d. Anything traced to the merger or the prospect of the merger is not shared in by
dissenters, because they dissented.
e. Majority State Rule—controlling shareholders may receive a premium for their
shares without sharing that premium with the majority.
f. HOWEVER, the Federal Williams Act does require the highest price paid to any
shareholder must be paid to all shareholders. This decreases the number of
acquisitions and it discourages tender offers.
C. Practical Mergers
1. An acquisition where the acquiring corporation acquires the assets of the acquired
corporation for cash or for its securities, or some of each.
2. One advantage is that the acquiring corporation may be able to avoid succeeding to the
liabilities of the acquired corporation.
3. Formally, there is no transaction between the two corporation’s shareholders.
4. SHORT-FORM MERGER—Acquiring firm offers its shares to the shareholders of the
acquired company in return for shares of the acquired firm.
5. ASSET ACQUISITION: Buy all the assets of another company for cash. Would deal with
the company rather than with the shareholders. Acquiring corporation does not succeed to
unforeseen liabilities of the acquired corporation as it would under a statutory merger.
Known liabilities will be satisfied by the seller or assumed by the buyer and taken into
account in the purchase price.
D. The De Facto Merger Doctrine is the theory that a transaction that is not literally a merger, but
which is found to be the functional equivalent of a merger should be treated as if it were a merger
for the purpose of appraisal rights and required shareholder votes.
1. Shows you the nature of mergers and different ways to achieve this effect.
2. Consequences when the doctrine is accepted:
a. The selling shareholders who are disputing the merger get appraisal rights
the most common result

112
 b. The selling (disputing) shareholders get the right to vote on the transaction, which
they might not otherwise have, and
c. Creditors of the seller might have a claim against the buyer, which they might not
have had otherwise.
3. Only occasionally accepted—Minority view is acceptance of the de facto merger, and they
have done so in special circumstances.
4. No hard and fast rules, but here are important factors that have arisen:
a. Whether the target corporation has transferred all its assets and then is dissolved.
b. Whether the pooling method of accounting is used rather than the purchase
method.
c. Whether the target shareholders receive most of their consideration as shares in
the acquiring company rater than as cash or bonds.
5. De Facto Merger (Minority Rule): The Court must look to the realities of the
transaction (substance rather than form) and where a transaction, which is not
literally a merger, but which is found to be the functional equivalent of a merger,
then it should be treated as if it were a merger for the purposes of appraisal rights
and required shareholder votes.
a. Farris v. Glen Alden Corp. (1958, p.715)—List, a holding company, purchased
38.5% of the outstanding stock of Glen, a corporation engaged in mining and
manufacturing and placed three of its directors on the Glen board. The two
corporations entered into a reorganization agreement, which entitled Glen to
purchase the assets of List and take over lists liabilities, giving List shareholders
stock in Glen, and dissolving List. Glen shareholders received notice and agreed to
the reorganization. Farris, a shareholder of Glen filed suit to enjoin the proceedings
because it did not conform to the statutory requirements for mergers. Glen
defended on grounds that this was a sale of assets, rather than a merger.
i. HELD: It was substance over procedure, therefore, should be treated as a
merger.
o NOTE: the court says the book value goes down, but according to
Professor, book value means nothing. It is the market value that is
important.
ii. But the Pennsylvania legislature saw it a different way and they amended
the statute to abolish the theory of de facto mergers in Pennsylvania.
6. Equal Dignities Rule (Delaware Law and Majority Rule): The sale of assets statute and
the merger statute are independent of each other, that is, they are of equal dignity
and the framers of a reorganization plan may resort to either type of corporate
mechanics to achieve the desired end. In other words, if there are two ways to skin a
cat, the parties may choose either way.
a. Hariton v. Arco Electronics, Inc. (p.722)—Loral Electronics and D agreed to a
sale of assets which had the economic result as being exactly the same had D
merged into Loral. D’s dissenting shareholders did not get appraisal rights and
Hariton argues that this is a de facto merger, entitling him to appraisal rights.
i. HELD: Delaware Court rejects the de facto merger doctrine. The fact that a
sale of assets procedure, followed by a merger might happen to produce
the same results as the merger statute alone would have produced is
irrelevant to the issue of the shareholder’s appraisal rights. The corporation
chose the sale of assets, and not the merger, statute.
E. Freeze-Our Mergers
1. Occurs when a majority uses its control, through the merger process, to try and get the
minority shareholders to sell their shares at an unfavorable price.
2. Nearly any freeze-out transaction requires the insiders to be on both sides of the
transaction and therefore, courts will give strict scrutiny to the fairness of the

113
 transaction.
3. Intrinsic Fairness Test Virtually all courts carefully scrutinize the transaction to make
sure that it is intrinsically fair to the outsider/minority shareholders.
a. Two Aspects of Shareholders and if either is lacking, the court will likely find the
transaction unfair and either enjoin it or award damages.
i. Fair procedures under which the corporation’s board decided to approve
the transaction, thus creating a fair price, and
ii. Adequate disclosure to the outside minority shareholder concerning the
transaction.
4. Where directors of a Delaware corporation are on both sides of the transaction, they
are required to demonstrate their utmost good faith and the most scrupulous
inherent fairness of the bargain.
a. Weinberger v. UOP, Inc. (1983, p.724)—Singnal is a big company that buys lots of
other companies through conglomerate mergers—it buys, sells, and uses money to
buy again. Signal buys a controlling interest in D, which is going to sell new stock to
Signal at $21 a share. The sale is contingent upon D stockholders responding to a
tender offer of 4.3 million shares bought by Signal. The premium offer of $21 a
share was so high that the tender offer was “over-subscribed.” As the 51% majority
shareholder, Signal elects its own-directors and makes a Signal man the CEO of D.
Signal then decides to purchase the minority shares of D. Problem: There was not
full disclosure from Signal-UOP directors as to conflicts—their own evaluation
found they could have paid $21-$24, but this was no disclosed to shareholders.
i. Over-Subscribed So many shareholders responded to sell their shares in
the tender offer that the same percentage of shares had to be purchased
from everyone, no one owner of shares could sell all their stock so every D
shareholder had accepted the tender offer had a purchase of their shares
purchased.
ii. HELD: there was a breach of fiduciary duty because no full disclosure. The
transaction did not meet the requirement of entire fairness because it lacked
procedural fairness, fairness of price, and fair disclosure. The court looks
mostly to a two part fairness test: Substance—fair price, and Procedural—
fair dealing.
o Also, found the court may use whatever valuation method it wishes,
do not have to use the Delaware Block Method: Elements of value
were assigned a particular weight and the resulting amounts were
added to determine the value per share. Opens up the ability of
Courts to look at any other accepted methods or techniques for
accounting.
o No requirement to articulate a “business purpose” for this type of
transaction.
o Independent Committee to Negotiate: The court makes it clear
that one of the best steps insiders can take to insulate the
transaction from the subsequent attack is by making sure that
a special committee of independent, outside directors is
appointed to negotiate the transaction. This is the road map
noted in the footnote.
iii. RULE: Plaintiff, in a suit challenging a cash-out merger must allege specific
acts of fraud, misrepresentation, or other items of misconduct to
demonstrate the unfairness of the merger terms to the minority.
iv. RULE: Where corporate action has been approved by an informed vote of a
majority of the minority shareholders, we conclude that the burden entirely
shifts to the plaintiff to show that the transaction was unfair to the minority.

114
 But the burden remains on those relying on the vote to show that they
completely disclosed all material facts relevant to the transaction.
v. FAIRNESS TEST (IMPORTANT):
o (1) Fair Dealing (Procedural)—questions of when transaction was
timed, how it was initiated, structured, disclosed to the directors, and
how the approvals of the directors and the stockholders were
obtained.
o (2) Fair Price (Procedural)—relates to the economic and financial
considerations of the proposed merger, including all relevant factors:
assets, market value, earnings, future prospects, and any other
elements that affect the intrinsic or inherent value of the company’s
stock.
o IMPORTANT to Professor! We want the court to evaluate the
procedure to keep them out of deciding substance. The Court can
come to a professional expert judgment over procedure.
Assumption is that fair procedures lead to fair substance.
5. Best Price rule
a. Court goes against DE precedent and against increasing the value of the
corporation by discouraging the use of two-step acquisitions.

VIII. Hostile Takeovers

A. Hostile only from the point of public relations.
B. More than any other corporation regulating device, a hostile takeover exposes management to
shareholder control. It draws into high relief the tension between the shareholder liquidity rights
(attached to voting power) and management discretion.
C. Thus, the primary question is: What should be the role of the board of directors when
shareholders seek to exercise control.
D. Dilemma of Takeover Defense management of the corp and control of the corp’s governance
machinery reside with the board of directors. When the shareholders are presented with a tender
offer that the management opposes, should the board be passive and not interfere or should it be
activist and resist? A hostile bidder premises its bid on ousting incumbent management. There is
an omnipresent conflict of interest—shareholders seeking a premium price while incumbent
management has a self-interest in opposing any hostile bid
1. Passivity Thesis
a. The Entrenchment Motive—To perpetuate the power and prestige of control—
suggests that the target board should not be allowed to use corporate
resources to interpose obstacles.
b. Studies show that defensive tactics against takeovers do not result in better bids or
more valuable corporations; therefore, the board should be passive.
2. Activist Thesis
a. Despite the potential conflict of interest, the board is uniquely able to use
corporate resources to further shareholder (and non-shareholder) interests.
b. That is, the board can negotiate on behalf of the dispersed public shareholders.
c. Measured, defensive tactics can drive away weak or destructive bids, induce better
bids, buy time to find other bidders, and otherwise assure fair treatment.
d. Professor—Bad because the corporation is the shareholder and the goal is to
increase the value of the corp, not to protect management’s jobs.
E. Judicial Review the court has responded to the takeover dilemma in an ambivalent and
inconsistent way.
1. Actual Purpose Review Courts initially dealt with the takeover dilemma by a judicial
slight of hand and to determine whether an entrenchment motive lurked behind a take-over

115
defense, courts adopted a process-oriented standard.
a. Good Faith and Reasonable Investigation the courts accepted defensive
actions if the incumbent board could point to good faith and a reasonable
investigation (preferably by outside directors) into a plausible business purpose for
the defense, thus showing the absence of an entrenchment motive.
b. Once this was done, the challenger bore the difficult burden of providing the
board’s dominant motive was entrenchment.
c. RESULT: Courts readily accepted almost any business justification for defensive
tactics. Thus, it virtually absolved takeover defenses from fiduciary review and
insulated management incumbents from discipline of the market in corporate
control.
d. Cheff v. Mathes (1964, p.758)—Maremont is attempting to takeover Holland
furnace Co. Maremont begins to buy up stock of Holland and then meets with Cheff
regarding the feasibility of a merger. The discussions between the two breakdown,
but Maremont keeps buying stock of Holland. The board of Holland is going to pay
“greenmail” to Maremont to go away. Maremont wanted to change the way Holland
marketed its product, wanted to cut the retail division, and sell the furnaces
wholesale. But is this really a danger. The managers are worried about losing their
jobs, so they are willing for the co. to take on a bunch of debt to purchase the stock
from maremont. The shareholders bring a derivative suit stating that the board
should not have used greenmail to buy the stock—they breached their fiduciary
duty which is to increase the value of the corporation make the shareholder’s more
money.
i. RULE: “Actual Purpose View”—If the board has acted solely or primarily
because of the desire to perpetuate themselves in office, then the use of
corporate funds or defensive mechanisms against takeovers is improper.
ii. TEST: “The question then presented is whether or not the defendant
satisfied the burden of proof showing reasonable grounds to believe a
danger to corporate policy and effectiveness existence by the presence of
Maremont’s stock ownership. The directors satisfy their burden by showing
good faith and reasonable investigation; the directors will not be penalized
for an honest mistake of judgment if the judgment appeared reasonable at
the time the decision was made.
o This is a problem because it should deal with shareholder interests.
iii. HELD:the court explains that the Ds have proves reasonable grounds that
danger to corporate policy and effectiveness existed by the presence of the
Maremont stock owners. Furthermore, it appears to be the business
judgment rule and the duty of care—in the end the court ends up saying
that “if there is danger to the status quo as a result of the takeover, then the
directors can defend themselves by saying that they are trying to maintain
the status quo.”
iv. “Greenmail” the target company board agrees to buy the stock
from the raider at a price above the market price to make the raider go
away.
o When a corporation pays greenmail, it entices others to try and do
the same. However, the premium paid to the first person depletes
the resources of the company and makes it less attractive to other
investors and entrenches the current board.
v. Professor Notes:
o Professor doesn’t really think this is take over is bad—Maremont is
going into the market, buying up stock and offering to sell it.
o Sometimes liquidation is a good thing because the whole is not

116
 greater than the sum of the parts—it may be better and more
valuable to liquidate.
o How do you determine true/primary motives? Most people have
several motives in making a decision?
2. Proportionality Review Delaware developed in Unocal Corp. v. Mesa Petroleum Co.—
Preponderance of Evidence Standard.
a. Two Prong Unicol Test:
i. (1) The board must reasonably perceive the bidder’s action as a threat
to corporate policy—a threshold dominant purpose inquiry into the
board’s investigation, and
o “When a board addresses a pending takeover bid it has an
obligation to determine whether the offer is in the best interests of
the corporation and its shareholders. . . its decision should be no
less entitled to the respect they otherwise would be accorded in the
realm of business judgment. There are however, certain caveats to
a proper exercise of this function. Because of the omnipresent
pecter that a board may be acting primarily in its own interests rather
than those of the corporation and the shareholders, there is an
enhanced duty which calls for judicial examination at the threshold
before the protections of the BJR may be conferred.”
o “In the face of inherent conflict directors must show that they had
reasonable grounds for believing that a danger to corporate policy
and effectiveness existed because of another’s ownership in stock.”
ii. (2) Any defensive measure must be reasonable in relation to the threat
posed—a proportionality test.
o To Professor, the goal/threat should deal with the value/price of the
stock and should not concern yourself with constituencies, as the
case notes.
b. If the defensive tactic fails either prong of the test, the court invalidates the
defensive tactic as a violation of the board’s fiduciary duties.
c. Unocal Corp. v. Mesa Petroleum Co. (1985, p.770)—T. Boone Pickens is a man
who went around buying up companies from their current managers in the oil
industry. He makes a two-tired front loaded cash tender offer for a certain
percentage of Unocal stock—those participating at the front end would receive $54
in cash; those on the back end got $54 worth of junk bonds. Unocol developed a
plan to thwart the takeover in which the company would give money to the
shareholders to decrease their shares, excluding Mesa and in order to do it would
have to borrow $6.5 billion (a poison pill). Thus, if Pickens actually succeeds in
taking over the company, he would get it with an additional $6.5 billion in debt,
deterring him from the takeover. The inside directors on the board are also officers.
i. T. Boone Pickens’ idea was to buy up companies making bad investments
and get them back on track.
ii. ISSUE: Did the unocal board have the power and duty to oppose a
takeover threat it reasonably believed harmful to the corporate enterprise,
meaning entitled to the business judgment rule?
iii. HELD: The problem here is that there is no idea what the court means by
corporate enterprise, but they state it is the best interests of the corporation
and its shareholders. The court goes on to say that the board must take
into account the shareholders and the constituencies other than
shareholders, but this is not the case. If the board starts taking things into
account besides the welfare of the stock holders, then there is no standard
because it opens the door for any justification of a defensive mechanism

117
 against a takeover.
iv. Del. Code § 141(a)—The power of the board is to manage the corporation’s
business and affairs.
F. Development: Two-Tiered “Front-Loaded” Cash Tender Offer
1. The second step of a two-step transaction is less desireable.
2. This offer coerces each shareholder into tendering and forecloses a more advantageous
auction for the stock. It is called “coercing” a two-tier tender offer.
3. Example: Pickens offers to buy 51% of the stock at $65 (the front end) and announces
that he will then merge the company into his own firm in a transaction that pays $55 cash
per share for the remaining 49% of the stock (the back end). Suppose that you, the
shareholder, think that if Pickens’ bid fails, then there will be rival raiders which could bid
the price of your stock up to $70.
a. You have three options:
i. Option #1: You tender your stock to Pickens and the deal goes through—
you receive $65 dollars for 51% of your stock and $55 for the rest, with a
blended price of $60.
o The securities laws require a “pro-rata” purchase so that each
shareholder has the opportunity to sell a portion of their shares at
the premium price.
ii. Option #2: You don’t accept the first offer but the tender goes through and
at the second step of the transaction, your entire stock is purchased for $55
a share—this is less than option 1. So, 1 is better than 2.
o The truth is, if the corporation is a large corporation, then your small
percentage of stock isn’t going to be able to affect the outcome.
o The small shareholders choice is between 1 and 2—3 will not really
come into play.
iii. Option #3: If the transaction doesn’t go through and Pickens goes away
and another bidder comes along and offers $70 for the stock, then you
could possibly get more (but see discussion above).
o Everyone will act in their own self-interest hoping to get more
money.
o But, if you can’t change the outcome, then you should go with
Option #1.
o This is called “coercing a two-tier tender offer”—it forces the
shareholders to sell.
G. SEC Reaction to Poison Pills After Unocal, the SEC demonstrated its disapproval of
discriminatory self-tenders by amending its rules to prohibit issuer tender offers other than
those made to all shareholders. Thus, self-tender offers are basically prohibited.
1. Poison Pills—The rule did not prohibit poison pills. This is a plan by which shareholders
receive the right to be bought out by the corporation at a substantial premium on the
occurrence of a stated triggering event. They are highly complex plans, known as
Shareholders Rights Plans—it is adopted by the board without shareholder action in
which a warrant grants the holder the option to purchase new shares of stock of the issuing
corp. The rights become exercisable upon appearance of bidder or takeover. Flip-in
element typically triggered by acquisition of 20% of issuers stock.

118