Professional Documents
Culture Documents
B USINESS A SSOCIATIONS
Fall 2010/Prof. Fendler/Joshua R. Collums
Business Associations (7th Ed.) by Klein, Ramseyer & Bainbridge
C H A PTER O N E : A G EN CY
I. W ho is an Agent?
A. Restatement (Third) of Agency § 1.01 Agency Defined
Agency is the fiduciary relationship that arises when one person (a “principal”) manifest’s assent to another
person (an “agent”) that the agent shall act on the principal’s behalf and subject to the principal’s control, and
the agent manifests assent or otherwise consents so to act.
B. Restatement (Third) of Agency § 1.02 Parties’ Labeling and Popular Usage Not
Controlling
An agency relationship arises only when the elements stated in § 1.01 are present. W hether a relationship is
characterized as agency in an agreement between parties or in the context or industry or popular usage is not
controlling.
C. Restatement (Third) of Agency § 1.03 Manifestation
A person manifests assent or intention through written or spoken words or other conduct.
D. Gorton v. Doty (Idaho 1937)
1. Issue. W as the coach, Garst, the agent of appellant while and in driving her car from Soda
Springs to Paris, and in returning to the point where the accident occurred?
2. Broadly speaking, “agency” indicates the relation which exists where one person acts for
another. It has these three principal forms:
a. The relation of the principal and agent.
b. The relation of master and servant; and
c. The relation of employer or proprietor and independent contract.
3. Agency. The relationship 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.
a. Manifestation of consent by P that A will act:
(1) On P’s behalf
(2) Subject to P’s Control
b. A’s consent so to act.
4. This court has not held that the relationship of principal and agent must necessarily involve
some matter of business, but only that where one undertakes to transact some business or
manage some affair for another by authority and on account of the latter, the relationship
of principal and agent arises.
5. Appellant could have driven car herself. Instead, she designated the driver (Garst) and, in
doing so, made it a condition precedent that the person she designated should drive her
car.
a. Appellant consented that Garst should act for her and in her behalf, in driving her
car to and from the game from her act in volunteering the use of her car upon the
express condition that he should drive it.
b. Garst consented to so act for the appellant by driving the car.
6. It is not essential to the existence of authority that there be a contract between principal
and agent or that the agent promise to act as such, nor is it essential to the relationship or
principal and agent that they, or either, receive compensation.
a. There must be an agreement but it does not necessarily have to rise to the level of
a legal contract.
7. The fact of ownership alone, regardless of the presence or absence of the owner in the car
at the time of the accident, establishes a prima facie case against the owner for the reason
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that the presumption arises that the driver is the agent of the owner. 1
8. Dissenting Opinion.
a. An agent is one who acts for another by authority from him, one who undertakes
to transact business or manage some affair for another by authority and on
account of the latter. Agency means more than mere passive permission. It
involves a request, instruction or command.
E. A. Gay Jenson Farms Co. v. Cargill, Inc. (Minn. 1981) (Lender Liability)
1. Plaintiffs Argument. Plaintiffs alleged that Cargill was jointly liable for W arren’s indebtedness
as it had acted as principal for the grain elevator.
2. Issue. W hether Cargill, by its course of dealing with W arren, became liable as principal on
contracts made by W arren with plaintiffs.
3. Rule. Agency is the fiduciary relationship that 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.
a. In order to create an agency, there must be an agreement, but not necessarily a
contract between the parties.
(1) An agreement may result in the creation of an agency relationship
although the parties did not call it an agency and did not intend the legal
consequences of the relation to follow.
b. The existence of the agency may be proved by circumstantial evidence which
shows a course of dealing between the two parties.
(1) W hen an agency relationship is to be proven by circumstantial evidence,
the principal must be shown to have consented to the agency since one
cannot be the agent of another except by consent of the latter.
4. Creditor/Debtor. A creditor who assumes control of his debtor’s business may become
liable as principal for the acts of the debtor in connection with the business. 2
a. Security holder’s mere veto power v. Becoming a principal. 3
5. Buyer/Supplier v. Principal/Agent
a. One who contracts to acquire property from a third person and convey it to
another is the agent of the other only if it is agreed that he is to act primarily for
the benefit of the other and not for himself.
(1) Factors indicating that one is a supplier, rather than an agent, are 4:
(a) That he is to receive a fixed price for the property irrespective
of price paid to him. This is the most important.
(b) That he acts in his own name and receives title to the property
which he thereafter is to transfer.
1
W illi v. Schaefer Hitchcock Co. (Idaho 1933).
2
A creditor who assumed control of his debtor’s business for the mutual benefit of himself and his debtor
may become a principal, with liability for the acts and transactions of the debtor in connection with the business.
Restatement (Second) of Agency § 14 O.
3
“A security holder who merely exercises a veto power over the business acts of his debtor by
preventing purchases or sales above specified amounts does not thereby become a principal. However, if he takes
over the 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 obligations 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. Id., cmt. a.
4
Id., § 14 K, cmt. a.
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The power to bind is equal. The principal is equally bound whether based on actual or apparent authority.
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Actual authority is created by direct manifestations from the principal to the agent, and the extent of
the agent’s actual authority is interpreted in light of all circumstances attending those manifestations, including the
customs of business, the subject matter, any formal agreement between the parties, and the facts of which both parties
are aware.
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relationship.
7. Restatement (Second) of Agency § 8A. Inherent Agency Power.
Inherent agency power is a term used in the restatement of this subject to indicate the power of an
agent which is not derived from authority, apparent authority or estoppel, but solely from the agency
relation and exists for the protection of persons harmed by or dealing with a servant or other agent.
8. Restatement (Second) of Agency § 194 states that an undisclosed principal is liable for acts
of an agent “done on his account, if usual or necessary in such transactions, although
forbidden by the principal.”
9. Under the Restatement (Second) of Agency § 195, “An undisclosed principal who entrusts
an agent with the management of his business is subject to liability to third persons with
whom the agent enters into transactions usual in such business and on the principal’s
account, although contrary to the directions of the principal.”
10. The Restatement (Third) of Agency rejected the concept of inherent agency power in
favor of a rule directly targeted at cases like W atteau:
a. Restatement (Third) of Agency § 2.06. Liability of Undisclosed
Principal.
(1) An undisclosed principal is subject to liability to a third party who is justifiably induced
to make a detrimental change in position by an agent acting on the principal’s behalf and
without actual authority if the principal, having notice of the agent’s conduct and that it
might induce others to change their positions, did not take reasonable steps to notify them of
the facts.
(2) An undisclosed principal may not rely on instructions given an agent that qualify or
reduce the agent’s authority to less than the authority a third party would reasonably believe
the agent to have under the same circumstances if the principal had been disclosed.
B. Ratification
1. Ratification. Occurs when a principal affirms a previously unauthorized act. Ratification
validates the original unauthorized act and produces the same legal consequences as if the
original act had been authorized.
a. Ratification can take place in the following ways:
(1) Expressly
(2) Implied > Accept benefits
(3) Implied > Silence/Inaction
(4) Lawsuit to enforce the contract
b. Ratification is an “all or nothing” principle.
2. Restatement (Third) of Agency § 4.01. Ratification Defined.
(1) Ratification is the affirmance of a prior act done by another, whereby the act is given effect as if
done by an agent acting with actual authority.
(2) A person ratifies an act by
(a) manifesting assent that the act shall affect the person's legal relations, or
(b) conduct that justifies a reasonable assumption that the person so consents.
(3) Ratification does not occur unless
(a) the act is ratifiable as stated in § 4.03,
(b) the person ratifying has capacity as stated in § 4.04,
(c) the ratification is timely as stated in § 4.05, and
(d) the ratification encompasses the act in its entirety as stated in § 4.07.
3. Botticello v. Stefanovicz (Conn. 1979).
a. Agency is defined as “the fiduciary relationship which results from 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....” Restatement
(Second) of Agency § 1.
(1) Three elements required to show the existence of an agency
relationship:
(a) a manifestation by the principal that the agent will act for him;
(b) acceptance by the agent of the undertaking; and
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himself of the impostor’s lack of authority and thus escape liability for
the consequential loss thereby sustained by the customer.
2. Restatement (Third) of Agency § 2.05. Estoppel to Deny Existence of Agency
Relationship.
A person who has not made a manifestation that an actor has authority as an agent and who is not
otherwise liable as a party to a transaction purportedly done by the actor on that person's account is
subject to liability to a third party who justifiably is induced to make a detrimental change in position
because the transaction is believed to be on the person's account, if
(1) the person intentionally or carelessly caused such belief, or
(2) having notice of such belief and that it might induce others to change their positions, the
person did not take reasonable steps to notify them of the facts.
D. Agent’s Liability on the Contract
1. Restatement (Third) of Agency § 6.01. Agent for Disclosed Principal.
W hen an agent acting with actual or apparent authority makes a contract on behalf of a disclosed
principal,
(1) the principal and the third party are parties to the contract; and
(2) the agent is not a party to the contract unless the agent and third party agree otherwise.
2. Restatement (Third) of Agency § 6.02. Agent for Unidentified Principal.
W hen an agent acting with actual or apparent authority makes a contract on behalf of an unidentified
principal,
(1) the principal and the third party are parties to the contract; and
(2) the agent is a party to the contract unless the agent and the third party agree otherwise.
3. Restatement (Third) of Agency § 6.03. Agent for Undisclosed Principal.
W hen an agent acting with actual authority makes a contract on behalf of an undisclosed principal,
(1) unless excluded by the contract, the principal is a party to the contract;
(2) the agent and the third party are parties to the contract; and
(3) the principal, if a party to the contract, and the third party have the same rights,
liabilities, and defenses against each other as if the principal made the contract personally,
subject to §§ 6.05–6.09.
4. Restatement (Third) of Agency § 6.10. Agent’s Implied W arranty of Authority.
A person who purports to make a contract, representation, or conveyance to or with a third party on
behalf of another person, lacking power to bind that person, gives an implied warranty of authority to
the third party and is subject to liability to the third party for damages for loss caused by breach of that
warranty, including loss of the benefit expected from performance by the principal, unless
(1) the principal or purported principal ratifies the act as stated in § 4.01; or
(2) the person who purports to make the contract, representation, or conveyance gives notice
to the third party that no warranty of authority is given; or
(3) the third party knows that the person who purports to make the contract, representation,
or conveyance acts without actual authority.
5. W hen is an agent liable on a contract?7 It depends on the type of principal.
a. Disclosed – Agent is not personally liable.
(1) Exceptions. (1) If the parties intend the agent to be personally liable on
the contract he will be personally liable. However, a parole evidence
rule issue may arise, therefore, it is best to expressly set out in the
contract the agent’s liability. (2) The agent had no authority to enter
into the contract and the principal did not ratify. This would be a
breach of the agent’s implied warranty of authority.
7
The rules on contract liability are default rules. They can be overridden by express or implied agreement
between the agent and third party.
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John Doe is personally liable under #39 but is not personally liable
under #1 & #2.
8. General Agent/Special Agent.
a. General Agent. If a principal authorizes an agent “to conduct a series of
transactions involving a continuity of service,” the law calls the agent a general
8
The rationale is one of expectations. W ithout knowing the identity of the principal, the third party is
presumably relying on the trustworthiness, creditworthiness, and bona fides of the agent.
9
Arkansas courts would invoke the parole evidence rule and exclude external testimony about the parties’
intent.
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agent.
b. Special Agent. If a principal authorizes the agent only to conduct a single
transaction, or to conduct a series of transactions that do not involve “continuity
of service,” then the law calls the agent a special agent.
III. Liability of Principal to Third Parties in Tort
A. Servant Versus Independent Contractor
1. Restatement (Second) of Agency § 1. Agency; Principal; Agent.
(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.
(2) The one for whom action is to be taken is the principal.
(3) The one who is to act is the agent.
2. Restatement (Second) of Agency § 2. Master; Servant; Independent
Contractor.
(1) A master is a principal who employs an agent to perform service in his affairs and who controls or
has the right to control the physical conduct of the other in the performance of the service.
(2) A servant is an agent employed by a master to perform service in his affairs whose physical conduct
in the performance of the service is controlled or is subject to the right to control by the master.
(3) An independent contractor is a person who contracts with another to do something for him but who
is not controlled by the other nor subject to the other’s right to control with respect to his physical
conduct in the performance of the undertaking. He may or may not be an agent.
3. Restatement (Second) of Agency § 219. W hen Master is Liable for Torts of His
Servants.
(1) A master is subject to liability for the torts of his servants
committed while acting in the scope of their employment.
(2) A master is not subject to liability for the torts of his servants acting outside the scope of their
employment, unless:
(a) The master intended the conduct or the consequences, or
(b) The master was negligent or reckless, or
(c) The conduct violated a non-delegable duty of the master, or
(d) The servant purported to act or to speak on behalf of the principal and there was reliance
upon apparent authority, or he was aided in accomplishing the tort by the existence of the
agency relation.
4. Restatement (Second) of Agency § 220. Definition of Servant.
(1) A servant is a person employed to perform services in the affairs of another and who with respect to
the physical conduct in the performance of the services is subject to the other’s control or right to
control.
(2) In determining whether one acting for another is a servant or an independent contractor, the
following matters of fact, among others, are considered:
(a) the extent of control which, by the agreement, the master may exercise over the details of
the work;
(b) whether or not the one employed is engaged in a distinct occupation or business;
(c) 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;
(d) the skill required in the particular occupation;
(e) whether the employer or the workman supplies the instrumentalities, tools, and the place
of work for the person doing the work;
(f) the length of time for which the person is employed;
(g) the method of payment, whether by the time or by the job;
(h) whether or not the work is part of the regular business of the employer;
(i) whether or not the parties believe they are creating the relation of master and servant;
and
(j) whether the principal is or is not in business.
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The injured party may also assert claims of direct responsibility against the principal. In any event, the
tortfeasor agent will be directly liable. Being an agent does not immunize a person from tort liability. A tortfeasor is
personally liable, regardless of whether the tort was committed on the instruction from or to the benefit of a principal.
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That licensee construct its motel according to plans, specifications, feasibility studies, and locations
approved by licensor; That licensee employ the trade name, signs, and other symbols of the ‘system’ designated by
licensor; That licensee pay a continuing fee for use of the license and a fee for national advertising of the ‘system’;
That licensee solicit applications for credit cards for the benefit of other licensees; That licensee protect and promote
the trade name and not engage in any competitive motel business or associate itself with any trade association designed
to establish standards for motels; That licensee not raise funds by sale of corporate stock or dispose of a controlling
interest in its motel without licensor's approval; That training for licensee's manager, housekeeper, and restaurant
manager be provided by licensor at licensee's expense; That licensee not employ a person contemporaneously engaged
in a competitive motel or hotel business; and That licensee conduct its business under the ‘system’, observe the rules
of operation, make quarterly reports to licensor concerning operations, and submit to periodic inspections of facilities
and procedures conducted by licensor's representatives.
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defendant exercised control over the relevant security policies at the [franchisee’s]
restaurant through adopting the QSC Play Book.”
B. Tort Liability and Apparent Agency
1. Miller v. McDonald’s Corp. (Ore. App. 1997).
a. Actual Agency. The kind of actual agency relationship that would make defendant
vicariously liable for 3K’s negligence requires that defendant have the right to
control the method by which 3K performed its obligations under the
Agreement. 12
(1) A number of courts have applied the right to control test to a franchise
relationship.
(a) “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.”
(2) W e believe that a jury could find that defendant retained sufficient
control over 3K’s daily operations that an actual agency relationship
existed. The Agreement did not simply set standards that 3K had to
meet. Rather, it required 3K to use the precise methods that defendant
established. Defendant enforced the use of those methods by regularly
sending inspectors and by its retained power to cancel the Agreement.
b. Apparent Agency 13
(1) Restatement (Second) of Agency § 267.
(a) “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 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 her were
such.”
(2) W e have not applied § 267 to a franchisor/franchisee situation, but
courts in a number of other jurisdictions have done so in ways that we
find instructive. In most case the courts have found that there was a jury
issue of apparent agency. The crucial issues are whether the putative
principal held the third party out as an agent and whether the plaintiff
relied on that holding out.
2. Restatement (Third) of Agency § 7.08. Agent Acts W ith Apparent Authority.
A principal is subject to vicarious liability for a tort committed by an agent in dealing or
communicating with a third party on or purportedly on behalf of the principal when actions taken by
the agent with apparent authority constitute the tort or enable the agent to conceal its commission.
C. Scope of Employment
1. Restatement (Second) of Agency § 228. General Statement.
(1) Conduct of a servant is within the scope of employment if, but only if:
(a) it is of the kind he is employed to perform;
(b) it occurs substantially within the authorized time and space limits;
(c) it is actuated, at least in part, by a purpose to serve the master, and
(d) if force is intentionally used by the servant against another, the use of force is not
12
Under the right to control test it does not matter whether the putative principal actually exercises control;
what is important is that it has the right to do so.
13
Apparent agency is a distinct concept from apparent authority. Apparent agency creates an agency
relationship that does not otherwise exist, while apparent authority expands the authority of an actual agent. In this
case, the precise issue is whether 3K was defendant’s apparent agent, not whether 3K had apparent authority.
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The R.3d is less formulaic. Note that R.3d has revised the R.2d’s third condition–substituting “an
independent course of conduct not intended by the employee to serve any purpose of the employer” for “actuated, at
least in part, by a purpose to serve the master.” The R.3d also rejects the R.2d’s condition–“substantially within the
authorized time and space limits”–as antiquated.
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employment.
7. Ira S. Bushey & Sons, Inc. v. United States (2d Cir. 1968).
a. The Government relies on Restatement of Agency 2d § 228(1) which says that
“conduct of a servant is within the scope of employment if, but only if: (c) it is
actuated, at least in part, by a purpose to serve the master.”
(1) In Nelson v. American-W est African Line (2d Cir. 1936), Judge Learned
Hand concluded that a drunken boatswain who routed the plaintiff out
of his bunk with a blow, saying “Get up, you big son of a bitch, and
turn to,” and the continued to fight, might have thought he was acting
in the interest of the ship.
(2) It would be going too far to find such a purpose here; while Lane’s
return to the Tamaroa was to serve his employer, no one has suggested
how he could have though turning the wheels to be, even if–which is
by no means clear–he was unaware of the consequences.
b. Motive Test No Longer Viable. In light of the highly artificial way in which the
motive test has been applied, the district judge believed himself obliged to test the
doctrine’s continuing vitality by referring to the larger purposes respondeat
superior is supposed to serve.
(1) A policy analysis, however, is not sufficient to justify this proposed
expansion of vicarious liability.
(a) W hatever may have been the case in the past, a doctrine that
would create such drastically different consequences for the
actions of the drunken boatswain in Nelson and those the
drunken seaman here reflects a wholly unrealistic attitude
towards the risks characteristically attendant upon the operation
of a ship.
(b) Not Negligence Standard of Foreseeability. Put another way,
Lane’s conduct was not so “unforeseeable” as to make it unfair
to charge the Government with responsibility. W e agree with
a leading treatise that “what is reasonably foreseeable in this
context (of respondeat superior) is quite a different thing from
the foreseeably unreasonable risk of harm that spells negligence.
c. Test. The proper test here bears far more resemblance to that which limits
liability for workmen’s compensation than to the test for negligence. The
employer should be held to expect risks, to the public also, which arise out of and in the
course of his employment of labor.
d. Factors of Importance to J. Friendly:
(1) Foreseeability – W ell known that sailors on shore leave drink like
Irishmen.
(2) Economics – Judge Friendly says that the trial court’s economic analysis
may be valid but it is unknown what effect allocation would have.
(3) Justice – Justice requires this. The employer ought not to get a benefit
and be able to simultaneously disclaim the risk.
(4) Proximity – Geographically, seems to be a concern of Judge Friendly
(5) Risks associated with enterprise v. Risk attendant on the activities of the
community in general
(6) Because of the employment, unusual circumstances are encountered,
e.g., the job is inherently stressful.
8. Clover v. Snowbird Ski Resort (Utah 1991). (Frolic & Detour)
a. Ski resort restaurant chef/supervisor, while skiing between resort restaurant
locations, severely injured another skier after ignoring warning signs and
launching off a jump. The trial court granted summary judgment to the resort on
the theory that the employee was not acting within the scope of his employment.
b. The Supreme Court concluded that summary judgment should not have been
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agent was acting adversely to the principal, and the third party knew or
had reason to know that the agent was acting adversely to the principal.
(2) Business Organizations. The law concerning attribution of knowledge is
important when the principal is an organization, like a corporation or
other business entity, that has multiple agents. If the requirements for
imputation are otherwise met, the knowledge of all of the agents is
imputed to the corporation.
C H A PTER T W O : P AR TN ER SH IPS
I. W hat is a Partnership? And W ho Are the Partners?
A. Partners Compared W ith Employees
1. Revised Uniform Partnership Act § 202. Formation of Partnership.
(a) Except as otherwise provided in subsection (b), the association of two or more persons to carry on
as co-owners a business for profit forms a partnership, whether or not the persons intend to form a
partnership.
(b) An association formed under a statute other than this [Act], a predecessor statute, or a comparable
statute of another jurisdiction is not a partnership under this [Act].
(c) In determining whether a partnership is formed, the following rules apply:
(1) Joint tenancy, tenancy in common, tenancy by the entireties, joint property, common
property, or part ownership does not by itself establish a partnership, even if the co-owners
share profits made by the use of the property.
(2) The sharing of gross returns does not by itself establish a partnership, even if the persons
sharing them have a joint or common right or interest in property from which the returns are
derived.
(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:
(i) of a debt by installments or otherwise;
(ii) for services as an independent contractor or of wages or other compensation to
an employee;
(iii) of rent;
(iv) of an annuity or other retirement or health benefit to a beneficiary,
representative, or designee of a deceased or retired partner;
(v) of interest or other charge on a loan, even if the amount of payment varies
with the profits of the business, including a direct or indirect present or future
ownership of the collateral, or rights to income, proceeds, or increase in value
derived from the collateral; or
(vi) for the sale of the goodwill of a business or other property by installments or
otherwise.
2. Fenwick v. Unemployment Compensation Commission (N.J. 1945).
a. There are several elements that the courts have taken into consideration in
determining the existence or nonexistence of the partnership relation:
(1) Intention of the parties.
(a) The agreement between the parties is evidential although not
conclusive.
(2) Right to share in profits.
(a) Sharing of profits will raise a presumption that a partnership
exists. See RUPA § 202(c)(3).
(b) However, not every agreement that gives the right to share in
profits is, for all purposes, a partnership agreement.
(3) Obligation to share in losses.
(4) Ownership and control of the partnership property and business.
(5) Community of power in administration.
(6) Language in the agreement.
(7) Conduct of the parties toward third persons.
(8) Rights of the parties on dissolution.
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(1) Southex insists that the 1974 Agreement contains ample indicia that a
partnership was formed, including: (1) a 55-45% sharing of profits; (2)
mutual control over designated business operations, such as show dates,
admission prices, choice of exhibitors, and “partnership” bank accounts;
and (3) the respective contributions of valuable property to the
partnership by the partners.
(2) The 1974 Agreement is simply entitled “Agreement,” rather than
“Partnership Agreement.”
(3) Rather than an agreement for an indefinite duration, it prescribed a
fixed (albeit renewable) term.
(4) Rather than undertake to share operating costs with RIBA, SEM not
only agreed to advance all monies required to produce the shows, but to
indemnify RIBA for all show-related losses as well.
(a) State law normally presumes that partners share equally or at
least proportionately in partnership losses.
(5) Southex not only entered into contract but conducted business with
third parties, in its own name, rather than in the name of the putative
partnership. As a matter of fact, their mutual association was never
given a name.
(6) Similarly, the evidence as to whether either SEM or RIBA contributed
any corporate property, with the intent that it become jointly-owned
partnership property is highly speculative, particularly since their mutual
endeavor simply involved a periodic event, i.e., an annual home show,
which neither generated, nor necessitated, ownership interests in
significant tangible properties, aside from cash receipts.
c. “Partnership” is a notoriously imprecise term, whose definition is especially
elusive in practice. Since a partnership can be created absent any written
formalities whatsoever, its existence vel non normally must be assessed under a
“totality-of-the-circumstances” test.
d. Profit Sharing Does Not Have to Compel Finding of Partnership. Similarly, even
though the UPA explicitly identifies profit sharing as a particularly probative
indicium of partnership formation, and some courts have even held the absence of
profit sharing compels a finding that no partnership existed, it does not necessarily
follow that evidence of profit sharing compels a finding of partnership
information.
(1) Even though the UPA specifies five instances in which profit sharing
does not create a presumption of partnership formation, Southex cites
(and we have found) no authority for the proposition that the
evidentiary presumption created by profit sharing can be overcome only
by establishing these five exceptions, rather than by competent evidence
of other pertinent factors indicating the absence of an intent to form a
partnership (e.g., lack of mutual control over business operations, failure
to file partnership tax returns, failure to prescribe loss-sharing).
e. The term “partner” is frequently defined with a view to its context. More
importantly, the labels the parties assign, while probative of partnership
formation, are not necessarily dispositive as a matter of law, particularly in the
presence of countervailing evidence.
D. Partnership by Estoppel
1. Young v. Jones (D.S.C. 1992)
a. Plaintiffs assert that PW-Bahamas and PW-US [the Price W aterhouse partnership
in the United States] operate as a partnership, i.e., constitute an association of
persons to carry on, as owners, business for profit. In the alternative, plaintiffs
contend that if the two associations are not actually operating as partners they are
operating as partners by estoppel.
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b. As a general rule, persons who are not partners as to each other are not partners as
to third persons.
(1) Partnership by Estoppel. However, a person who represents himself, or
permits another to represent him, to anyone as a partner in an existing
partnership or with other not actual partners, is liable to any such person
to whom such a representation is made who has, on the faith of the
representation, given credit to the actual or apparent partnership.
II. The Fiduciary Obligations of Partners
A. Introduction
1. Meinhard v. Salmon (N.Y. 1928). 15
a. Duty of Loyalty. 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 forbidden to
those bound by fiduciary ties. A trustee is held to something stricter than the
morals of the market place. Not honesty alone, but the punctilio of an honor the
most sensitive, is then the standard of behavior.
b. Uncompromising rigidity has been the attitude of courts of equity when
petitioned to undermine the rule of undivided loyalty by the “disintegrating
erosion” of particular exceptions.
c. The trouble with Salmon’s conduct is that he excluded his coadventurer from any
chance to compete, from any chance to enjoy the opportunity for benefit that had
come to him alone by virtue of his agency.
(1) All these opportunities were cut away from the plaintiff through
another’s intervention.
(2) The very fact that Salmon was in control with exclusive powers of
discretion charged him the more obviously with the duty of disclosure,
since only through disclosure could opportunity be equalized.
d. A different question would be here if there were lacking any nexus of relation
between the business conducted by the manager and the opportunity brought to
him as an incident of manager.
(1) Here the subject-matter of the new lease was an extension and
enlargement of the subject-matter of the old one. A managing
coadventurer appropriating the benefit of such a lease without warning
to his partner might fairly expect to be reproached with conduct that
was underhand, or lacking, to say the least, in reasonable candor, if the
partner were to surprise him in the act of signing the new instrument.
e. Judge Andrews’ Dissent
(1) It seems to me that the venture . . . had in view a limited object and was
to end at a limited time. There was no intent to expand it into a far
greater undertaking lasting for many years. Doubtless in it Mr.
Meinhard has an equitable interest, but in it alone.
2. Revised Uniform Partnership Act § 404. General Standards of Partner’s
Conduct.
(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) A partner's duty of loyalty to the partnership and the other partners is limited to the following:
(1) to account to the partnership and 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;
15
Although Meinhard v. Salmon involved a joint venture rather than a partnership, Cardozo’s words are
equally applicable to partnerships.
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(2) 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
(3) to refrain from competing with the partnership in the conduct of the partnership business
before the dissolution of the partnership.
(c) A partner's duty of care to the partnership and the other partners in the conduct 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 law.
(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) 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) 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 partner are the same as those of a person who is not a
partner, subject to other applicable law.
(g) This section applies to a person winding up the partnership business as the personal or legal
representative of the last surviving partner as if the person were a partner.
B. Opting Out of Fiduciary Duties
1. Perretta v. Promethus Development Company, Inc. (9th Cir. 2008).
a. Under California law, the general partner of a limited partnership has the same
fiduciary duties as a partner in any other partnership. 16
b. Not all self-interested transactions violate the duty of loyalty. The question is not
whether the interested partner is benefitted, but whether the partnership or the
other partners are harmed.
(1) Partnerships is a fiduciary relationship, and partners may not take
advantages for themselves at the expense of the partnership. Thus, a partner
who seek a business advantage over another partner bears the burden of
showing complete good faith and fairness to the other.
(a) Ratification. One way a self-interested partner may meet this
burden is to have disinterested partners ratify its actions. 17
Upon a showing of proper ratification by the partners, any
claim against the partner for a violation of the duty of loyalty is
extinguished.
c. Under California law, a transaction with an interested partner would be
inconsistent with the interested partner’s duty of loyalty and would require
unanimous approval of the partners–unless the partnership agreement provides
differently.
(1) California law permits a partnership agreement to vary or permit
ratifications of the duty of loyalty only if the provision doing so is not
16
(b) A partner’s duty of loyalty to the partnership and the other partners includes all of the following:
(1) To account to the partnership and 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 or information, including the appropriation of a partnership
opportunity.
(2) 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...
17
There is no breach of fiduciary duty if there has been a full and complete disclosure, if the partner who
deals with the partnership property first discloses all of the facts surrounding the transaction to the other partners and
secures their approval and consent.
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“manifestly unreasonable.”
(a) A comment to the 2001 Uniform Limited Partnership Act,
explaining the provision allowing ratification upon a specified
vote of the limited partners, notes: “The Act does not require
that the authorization or ratification be by disinterested partners,
although the partnership agreement may so provide.
i) The court disagrees. To the extent ratification
represents an exception to California’s general policy
of “thorough and relentless” scrutiny of self-dealing,
we are confident that a California court would
construe it narrowly, with particular skepticism
toward any aspect that might hint of unfairness.
ii) California statutes in related areas of the law support
the idea that interested partners should not be allowed
to count their votes in a ratification vote.
iii) Allowing an interested partner to participate in a
ratification election subverts the very purpose of
ratification itself.
(b) W e hold that a partnership agreement provision that allows an
interested partner to count its votes in a ratification vote would
be “manifestly unreasonable” within the meaning of the statute.
2. Revised Uniform Partnership Act § 103. Effect of Partnership Agreement;
Nonwaivable Provisions.
(a) Except as otherwise provided in subsection (b), relations among the partners and
between the partners and the partnership are governed by the partnership agreement. To the
extent the partnership agreement does not otherwise provide, this [Act] governs relations
among the partners and between the partners and the partnership.
(b) The partnership agreement may not:
(1) vary the rights and duties under Section 105 except to eliminate the duty to
provide copies of statements to all of the partners;
(2) unreasonably restrict the right of access to books and records under Section
403(b);
(3) eliminate the duty of loyalty under Section 404(b) or 603(b)(3), but:
(i) the partnership agreement may identify specific types or categories of
activities that do not violate the duty of loyalty, if not manifestly
unreasonable; or
(ii) all of the partners or a number or percentage specified in the
partnership agreement may authorize or ratify, after full disclosure of all
material facts, a specific act or transaction that otherwise would violate
the duty of loyalty;
(4) unreasonably reduce the duty of care under Section 404(c) or 603(b)(3);
(5) eliminate the obligation of good faith and fair dealing under Section 404(d),
but the partnership agreement may prescribe the standards by which the
performance of the obligation is to be measured, if the standards are not
manifestly unreasonable;
(6) vary the power to dissociate as a partner under Section 602(a), except to
require the notice under Section 601(1) to be in writing;
(7) vary the right of a court to expel a partner in the events specified in Section
601(5);
(8) vary the requirement to wind up the partnership business in cases specified in
Section 801(4), (5), or (6);
(9) vary the law applicable to a limited liability partnership under Section
106(b); or
(10) restrict rights of third parties under this [Act].
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transferring title to the property of the person's capacity as a partner or of the existence of a partnership and
without use of partnership assets, is presumed to be separate property, even if used for partnership purposes.
E. Revised Uniform Partnership Act § 501. Partner Not Co-Owner of Partnership
Property.
A partner is not a co-owner of partnership property and has no interest in partnership property which can be
transferred, either voluntarily or involuntarily.
F. Revised Uniform Partnership Act § 502. Partner’s Transferable Interest in Partnership.
The only transferable interest of a partner in the partnership is the partner's share of the profits and losses of the
partnership and the partner's right to receive distributions. The interest is personal property.
G. Revised Uniform Partnership Act § 503. Transfer of Partner’s Transferable Interest.
(a) A transfer, in whole or in part, of a partner's transferable interest in the partnership:
(1) is permissible;
(2) does not by itself cause the partner's dissociation or a dissolution and winding up of the partnership
business; and
(3) does not, as against the other partners or the partnership, entitle the transferee, during the
continuance of the partnership, to participate in the management or conduct of the partnership
business, to require access to information concerning partnership transactions, or to inspect or copy the
partnership books or records.
(b) A transferee of a partner's transferable interest in the partnership has a right:
(1) to receive, in accordance with the transfer, distributions to which the transferor would otherwise be
entitled;
(2) to receive upon the dissolution and winding up of the partnership business, in accordance with the
transfer, the net amount otherwise distributable to the transferor; and
(3) to seek under Section 801(6) a judicial determination that it is equitable to wind up the
partnership business.
(c) In a dissolution and winding up, a transferee is entitled to an account of partnership transactions only from
the date of the latest account agreed to by all of the partners.
(d) Upon transfer, the transferor retains the rights and duties of a partner other than the interest in distributions
transferred.
(e) A partnership need not give effect to a transferee's rights under this section until it has notice of the transfer.
(f) A transfer of a partner's transferable interest in the partnership in violation of a restriction on transfer
contained in the partnership agreement is ineffective as to a person having notice of the restriction at the time of
transfer.
IV. Raising Additional Capital*
V. The Rights of Partners in Management
A. Revised Uniform Partnership Act § 401. Partner’s Rights and Duties.
(a) Each partner is deemed to have an account that is:
(1) credited with an amount equal to the money plus the value of any other property, net of the
amount of any liabilities, the partner contributes to the partnership and the partner's share of the
partnership profits; and
(2) charged with an amount equal to the money plus the value of any other property, net of the
amount of any liabilities, distributed by the partnership to the partner and the partner's share of the
partnership losses.
(b) Each partner is entitled to an equal share of the partnership profits and is chargeable with a share of the
partnership losses in proportion to the partner's share of the profits.
(c) A partnership shall reimburse a partner for payments made and indemnify a partner for liabilities incurred by
the partner in the ordinary course of the business of the partnership or for the preservation of its business or
property.
(d) A partnership shall reimburse a partner for an advance to the partnership beyond the amount of capital the
partner agreed to contribute.
(e) A payment or advance made by a partner which gives rise to a partnership obligation under subsection (c) or
(d) constitutes a loan to the partnership which accrues interest from the date of the payment or advance.
(f) Each partner has equal rights in the management and conduct of the partnership business.
(g) A partner may use or possess partnership property only on behalf of the partnership.
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(h) A partner is not entitled to remuneration for services performed for the partnership, except for reasonable
compensation for services rendered in winding up the business of the partnership.
(i) A person may become a partner only with the consent of all of the partners.
(j) A difference arising as to a matter in the ordinary course of business of a partnership may be decided by a
majority of the partners. An act outside the ordinary course of business of a partnership and an amendment to
the partnership agreement may be undertaken only with the consent of all of the partners.
(k) This section does not affect the obligations of a partnership to other persons under Section 301.
B. UPA § 18(e) states that “all partners have equal rights in the management and conduct of the
partnership business,” and § 18(h) provides that “any difference arising as to ordinary matters
connected with the partnership business may be decided by a majority of the partners.” 18
1. Thus, if there are three partners and they disagree as to an “ordinary” matter, the decision
of the majority controls. The majority can deprive the minority partner.
2. If however, there are only two partners, there can be no majority vote that will be
effective to deprive either partner of authority to act for the partnership.
C. National Biscuit Company v. Stroud (N.C. 1959).
1. In Johnson v. Bernheim, this Court said: A and B are general partners to do some given
business; the partnership is, by operation of law, a power to each to bind the partnership in
any manner legitimate to the business. If one partner goes to a third person to buy an
article on time for the partnership, the other partner cannot prevent it by writing to the
third person not to sell to him on time. And what is true in regard to buying is true in
regard to selling. W hat either partner does with a third person is binding on the partnership.
a. It is otherwise where the partnership is not general, but is upon special terms, as
that purchases and sales must be with and for cash. There the power to each is
special, in regard to all dealings with third persons at least who have notice of the
terms.
2. G.S. § 59.39(1). Partner Agent of Partnership as to Partnership Business
a. “Every partner is an agent of the partnership for the purpose of its business, and
the act of every partner, including the execution in the partnership name of any
instrument, for apparently carrying on in the usual way the business of the
partnership of which he is a member binds the partnership, unless the partner so
acting has in fact no authority to act for the partnership in the particular matter,
and the person with whom he is dealing has knowledge of the fact that he has no
such authority.”
3. G.S. § 59.45 provides that “all partners are jointly and severally liable for the acts and
obligations of the partnership.”
4. G.S. § 59.48. Rules Determining Rights and Duties of Partners.
a. (e) All partners have equal rights in the management and conduct of the
partnership business.”
b. (h) Any difference arising as to ordinary business matters connected with the
partnership business may be decided by a majority of the partners; but no act in
contravention of any agreement between the partners may be done rightfully
without the consent of all the partners.
5. Freeman, as a general partner with Stroud, with no restrictions on his authority to act
within the scope of the partnership business so far as the agreed statement of facts shows,
had under the Uniform Partnership Act “equal rights in the management and conduct of
the partnership business.” Stroud, his co-partner, could not restrict the power and
authority of Freeman to buy bread for the partnership as a going concern, for such a
purchase 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 Stroud was
not, and could not be, a majority of the partners.
6. In Crane on Partnership it is said: “In cases of an even division of the partners as to whether
18
To the same effect is RUPA §§ 103, 401(f) and (j).
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or not an act within the scope of the business should be done, of which disagreement a
third person has knowledge, it seems that logically no restriction can be placed upon the
power to act. The partnership being a going concern, activities within the scope of the
business should not be limited, save by the expressed will of the majority deciding a
disputed question; half of the members are not a majority.”
D. Summers v. Dooley (Idaho 1971).
1. UPA § 18(h) provides: “Any difference arising as to ordinary matters connected with the
partnership business may be decided by a majority of the partners.”
2. UPA § 18(e) provides: “The rights and duties of the partners in relation to the partnership
shall be determined, subject to any agreement between them, by the following rules . . .
All partners have equal rights in the management and conduct of the business.”
a. This section bestows equal rights in the management and conduct of the
partnership business upon all of the partners. The concept of equality between
partners with respect to management of business affairs is a central theme and
recurs throughout the Uniform Partnership law.
(1) Thus, the only reasonable interpretation of § 18(h) is that business
difference must be decided by a majority of the partners provided no
other agreement between the partners speaks to the issues.
3. In the case at bar one of the partners continually voiced objection to the hiring of the third
man. He did not sit idly by and acquiesce in the actions of his partner. Under these
circumstances it is manifestly unjust to permit recovery of an expense which was incurred
individually and not for the benefit of the partnership but rather for the benefit of one
partner.
E. Day v. Sidley & Austin (D.D.C. 1975).
1. Fraud.
a. The misrepresentation regarding plaintiff’s status cannot support a cause of action
for fraud, however, because plaintiff was not deprived of any legal right as a result
of his reliance on this statement.
b. Plaintiff’s allegations of an unwritten understanding cannot now be heard to
contravene the provisions of the Partnership Agreement which seemingly
embodied the complete intentions of the parties as to the manner in which the
firm was to be operated and managed.
c. Nor can plaintiff have reasonably believed that no changes would be made in the
W ashington office since the S & A Agreement gave complete authority to the
executive committee to decide questions of firm policy, which would clearly
include establishment of committees and the appointment of members and
chairpersons.
2. Breach of Fiduciary Duty
a. An examination of the case law on a partner’s fiduciary duties reveal that courts
have been primarily concerned with partners who make secret profits at the
expense of the partnership.
(1) Partners have a duty to make a full and fair disclosure to other partners
of all information which may be of value to the partnership.
(2) The essence of a breach of fiduciary duty is that one partner has
advantaged himself at the expense of the firm.
(3) The basic fiduciary duties are:
(a) a partner must account for any profit acquired in a manner
injurious to the interests of the partnership, such as
commissions or purchases on the sale of partnership property.
(b) a partner cannot without the consent of the other partners,
acquire for himself a partnership asset, nor may he divert to his
own use a partnership opportunity.
(c) he must not compete with the partnership within the scope of
business.
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b. W hat plaintiff is alleging in the instant case, however, concerns failure to reveal
information regarding changes in the internal structure of the firm. No court has
recognized a fiduciary duty to disclose this type of information, the concealment
of which does not produce any profit for the offending partners nor any financial
loss for the partnership as a whole.
(1) Note. Day would have been in better shape under the Revised Uniform
Partnership Act § 403(c)(1) which provides: “Each partner and the
partnership shall furnish to a partner, and to the legal representative of a deceased
partner or partner under legal disability: (1) without demand, any information
concerning the partnership's business and affairs reasonably required for the proper
exercise of the partner's rights and duties under the partnership agreement or this
[Act].”
F. Technically, under the UPA §§ 29 and 31, the old partnership is dissolved by the retirement of any
partner and when the remaining partners continue their practice a new partnership is formed.
1. “Continuation” agreement: an agreement obligating the remaining partners to continue to
associate with one another as partners under the existing agreement (or, perhaps, some
variation of it).
G. Under RUPA § 601, if a partner retires pursuant to an appropriate provision in the partnership
agreement (and in various other situations), there is a “dissociation” rather than a “dissolution.”
1. 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 an 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 the interest from the date of
dissociation. § 701(a) and (b).
VI. Partnership Dissolution
A. The Right to Dissolve
1. Uniform Partnership Act § 31. Causes of Dissolution.
Dissolution is caused:
(1) W ithout violation of the agreement between the partners,
(a) By the termination of the definite term or particular undertaking specified in the
agreement,
(b) By the express will of any partner when no definite term or particular undertaking is
specified,
(c) By the express will of all the partners who have not assigned their interests or suffered
them to be charged for their separate debts, either before or after the termination of any
specified term or particular undertaking,
(d) By the expulsion of any partner from the business bona fide in accordance with such a
power conferred by the agreement between the partners;
(2) In contravention of the agreement between the partners, where the circumstances do not permit a
dissolution under any other provision of this section, by the express will of any partner at any time;
(3) By any event which makes it unlawful for the business of the partnership to be carried on or for
the members to carry it on in partnership;
(4) By the death of any partner;
(5) By the bankruptcy of any partner or the partnership;
(6) By decree of court under section 32.
2. Uniform Partnership Act § 32. Dissolution by Decree of Court.
(1) On application by or for a partner the court shall decree a dissolution whenever:
(a) A partner has been declared a lunatic in any judicial proceeding or is shown to be of
unsound mind,
(b) A partner becomes in any other way incapable of performing his part of the partnership
contract,
(c) A partner has been guilty of such conduct as tends to affect prejudicially the carrying on
of the business,
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of the remaining partners to wind up the partnership business, for which purpose a partner's
rightful dissociation pursuant to Section 602(b)(2)(i) constitutes the expression of that
partner's will to wind up the partnership business;
(ii) the express will of all of the partners to wind up the partnership business; or
(iii) the expiration of the term or the completion of the undertaking;
(3) an event agreed to in the partnership agreement resulting in the winding up of the partnership
business;
(4) an event that makes it unlawful for all or substantially all of the business of the partnership to be
continued, but a cure of illegality within 90 days after notice to the partnership of the event is effective
retroactively to the date of the event for purposes of this section;
(5) on application by a partner, a judicial determination that:
(i) the economic purpose of the partnership is likely to be unreasonably frustrated;
(ii) another partner has engaged in conduct relating to the partnership business which makes
it not reasonably practicable to carry on the business in partnership with that partner; or
(iii) it is not otherwise reasonably practicable to carry on the partnership business in
conformity with the partnership agreement; or
(6) on application by a transferee of a partner's transferable interest, a judicial determination that it is
equitable to wind up the partnership business:
(i) after the expiration of the term or completion of the undertaking, if the partnership was
for a definite term or particular undertaking at the time of the transfer or entry of the
charging order that gave rise to the transfer; or
(ii) at any time, if the partnership was a partnership at will at the time of the transfer or
entry of the charging order that gave rise to the transfer.
8. Revised Uniform Partnership Act § 802. Partnership Continues After
Dissolution.
(a) Subject to subsection (b), a partnership continues after dissolution only for the purpose of winding
up its business. The partnership is terminated when the winding up of its business is completed.
(b) At any time after the dissolution of a partnership and before the winding up of its business is
completed, all of the partners, including any dissociating partner other than a wrongfully dissociating
partner, may waive the right to have the partnership's business wound up and the partnership
terminated.
In that event:
(1) the partnership resumes carrying on its business as if dissolution had never occurred, and
any liability incurred by the partnership or a partner after the dissolution and before the
waiver is determined as if dissolution had never occurred; and
(2) the rights of a third party accruing under Section 804(1) or arising out of conduct in
reliance on the dissolution before the third party knew or received a notification of the waiver
may not be adversely affected.
9. Collins v. Lewis (Tex. 1955).
a. Power to Dissolve But Not a Right. W e agree with the appellants that there is no
such thing 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.
10. Page v. Page (Cal. 1961).
a. The Uniform Partnership Act provides that a partnership may be dissolved “By
the express will of any partner when no definite term or particular undertaking is
specified.”
b. In Owen v. Cohen, the court held that when a partner advances a sum of money
to a partnership with the understanding that the amount contributed was to be a
loan to the partnership and was to be repaid as soon as feasible from the
prospective profits of the business, the partnership is for the term reasonably
required to pay the loan.
(1) It is true that these cases hold that partners may impliedly agree to
continue in business until a certain sum of money is earned, or one or
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more partners recoup their investments, or until certain debts are paid,
or until certain property could be disposed of on favorable terms.
(a) In each of these cases, however, the implied agreement found
support in the evidence.
(b) In the instant case, however, defendants failed to prove any
facts from which an agreement to continue the partnership for a
term may be implied.
c. Power to Dissolve Must Be Exercised in Good Faith. Even though the Uniform
Partnership Act provides that a partnership at will may be dissolved by the express
will of any partner, this power, like any other power held by a fiduciary, must be
exercised in good faith.
(1) A partner at will is not bound to remain in a partnership, regardless of
whether the business is profitable or unprofitable. A partner may not,
however, by use of adverse pressure “freeze out” a co-partner and
appropriate the business to his own use. A partner may not dissolve a
partnership to gain the benefits of the business for himself, unless he fully
compensates his co-partner for his share of the prospective business
opportunity.
B. The Consequences of Dissolution
1. Prentiss v. Sheffel (Ariz. 1973).
a. Facts. Plaintiffs owned a 42 ½ % interest each in the partnership (a shopping,
while the defendant owned a 15 % interest. The plaintiffs alleged that the
defendant derelict in his duties, in particular that he had failed to contribute his
share of the losses. The plaintiffs sought to dissolve the partnership. The trial
court held that a partnership-at-will existed and that it was terminated when the
plaintiff froze-out the defendant. The court ordered a sale and the plaintiffs were
the high bidders.
b. Issue. W hether two majority partners in a three-man partnership-at-will, who
have excluded the third partner from partnership management and affairs, should
be allowed to purchase the partnership assets at a judicially supervised dissolution
sale.
c. W rongful Purpose Necessary. W hile the trial court did find that the defendant was
excluded from the management of the partnership, there was no indication that
such exclusion was done for the wrongful purpose of obtaining the partnership assets in
bad faith rather than merely being the result of the inability of the partners to
harmoniously function in a partnership relation.
d. Not Injured by Partners’ Participation in Sale. Moreover, the defendant has failed to
demonstrate how he was injured by the participation of the plaintiffs in the
judicial sale.
(1) Because of the plaintiffs’ bidding in the judicial sale, it appears that the
defendant’s 15% interest in the partnership was considerably enhanced by
the plaintiff’s participation.
e. The defendant has cited no cases, nor has this court found any, which have
prohibited a partner from bidding at a judicial sale of the partnership assets.
(1) Not an Attack on the Order to Sell. It should be emphasized that on this
appeal the defendant does not attack the fact that the trial court ordered
a sale of the assets. The only area of attack is that plaintiffs have been
allowed to participate and bid in that sale.
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19
RUPA is essentially the same as UPA. However, a wrongfully dissociate partner is entitled to have
goodwill included in the calculation.
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***
II. The right, as against each partner who has cause dissolution
wrongfully, to damages for breach of the agreement.
(b) The partners who have not cause the dissolution wrongfully, I they
all desire to continue the business in the same name, either themselves or
jointly with others, may do so, during the agreed term for the
partnership and for that purpose may possess the partnership property,
provided they secure the payment by bond approved by the court, or
pay to any partner who has caused the dissolution wrongfully, the value
of his interest in the partnership at dissolution, less any damages
recoverable under clause (2a II) of this section, and in like manner
indemnify him against all present or future partnership liabilities.
(c) A partner who has caused the dissolution wrongfully shall have:
***
(II) If the business is continue under paragraph (2b) of this section the
right as against his co-partners and all claiming through them in respect
of their interest 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 the business shall not be
considered.
c. 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.
d. Dissent/Concurrence
(1) The partnership agreement is a contract, and event though a partner may
have the power to dissolve, he does no necessarily have the right to do
so. Therefore, if the dissolution he causes is a violation of the
agreement, he is liable for any damages sustained by the innocent
partners as a result.
(a) The innocent partner also has the option to continue the
business in the firm name provided they pay the partner cause
the dissolution the value of the interest of his partnership.
(2) W hile the rights and duties of the partners in relation to the partnership
are governed by the Uniform Partnership Act, the uniform act also
provides that such rules are subject to any agreement between the parties
(a) The partnership agreement entered into by PSC and Vasso in
pertinent part provides:
i) “the property [patents, etc.] shall be returned to PSC at the
expiration of this partnership.”
ii) The majority holds this provision is unenforceable
because its enforcement would affect defendant’s
option to continue the business. No authority is cited
for such a rule.
(3) I think it clear the parties agreed the partnership only be allowed the use
of the patents during the term of the agreement. The agreement having
been terminated, the right to use the patents is terminated.
C. The Sharing of Losses*
D. Buyout Agreements
1. A buy-out, or buy-sell, agreement is an agreement that allows a partner to end her or his
relationship with other partners and receive a cash payment, or series of payment, or some
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assets of the firm, in return for her or his interest in the firm.
2. Issues
a. Trigger Events: (1) Death; (2) Disability; (3) W ill of any partner
b. Obligation to Buy v. Option: (1) Firm; (2) Other Investors; (3) Consequences of
Refusal to Buy [If there is an obligation]/[If there is no obligation].
c. Price: (1) Book value; (2) Appraisal; (3) Formula (e.g., five times earnings); (4) Set
price each year; (5) Relation to duration (e.g., lower price in first five years)
d. Method of Payment: (1) Cash; (2) Installments (with interest?)
e. Protection Against Debts of Partnership
f. Procedure for Offering Either to Buy or Sell: (1) First mover sets price to buy or sell;
(2) First mover forces others to set price
3. G & S Investments v. Belman (Ariz. 1984).
a. Facts. Century Park was a limited partnership formed to receive ownership of an
apartment complex. Nordale had a 25.5% interest. Nordale became a cokehead
and a hermit. He had coke rage all the time and threatened the other partners.
He totally hit on jailbait and refused to pay rent on the apartment the partnership
let him use after his divorce. Nordale starting make irrational demands. The
other partners finally sought a dissolution of the partnership which would allow
them to carry on the business and buy out Nordale’s interest. Nordale died after
the filing of the complaint. The complaint was amended to invoke their right to
continue the partnership and acquire Nordale’s interest under article 19 of the
partnership’s Articles of Limited Partnership.
b. Uniform Partnership Act § 32 authorizes the court to dissolve a partnership
when:
***
(2) A partner becomes in any other way incapable of performing his part of the
partnership contract.
(3) A partner has been guilty of such conduct as tends to affect prejudicially the
carrying on of the business.
(4) A partner willfully or persistently commits a breach of the partnership
agreement, or otherwise so conducts himself in matters relating to the partnership
business that it is not reasonably practicable to carry on the business in partnership
with him.
c. Mere Filing of Complaint Does Not Dissolve. In Cooper v. Isaacs, the court was met
with the same contention made here, to-wit, that the mere filing of the complaint
acted as a dissolution. The court rejected this contention. Dissolution would
occur only when decreed by the court or when brought about by other acts.
d. Gibson and Smith testified that the parties actually intended and understood
“capital account” to mean exactly what it literally says, the account which shows
a partner’s capital contribution to the partnership plus profit minus losses.
(1) The capital amount is also reduced by the amount of any distributions.
(2) The words “capital account” are not ambiguous and clearly mean the
partner’s capital account as it appears on the books of the partnership.
e. Partnership buy-out agreements are valid and binding although the purchase price
agreed upon is less or more than the actual value of the interest at the time of
death.
(1) Modern business practice mandates that the parties be bound by the
contract they enter into, absent fraud or duress. It is not the province of
this court to act as a post-transaction guardian of either party.
E. Partnership Capital Accounts 20
1. Capital Account. As part of the settling-up process, partners are paid the amounts owed “in
20
See Partnership Capital Accounts Handout.
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respect of capital.” The bookkeeping devices that track the amount the partnership owes
each partner “in respect of capital” are called capital accounts.
2. Contribution/Distribution. Property contributed to the partnership increases the
contributing partner’s capital account by an amount equal to the fair market value of the
asset as of the time of contribution, as do profits allocated to partners from ongoing
activities. Distributions made to partners decreased their respective capital account, as do
losses allocated to partners from ongoing activities.
3. Appreciation/Depreciation. Post-contribution appreciation of depreciation of a contributed
asset does not affect the contributing partner’s capital account. The contribution severs the
contributor’s direct connection to the asset; subsequent vicissitudes in the asset’s value are
“for the partnership’s account.”
VII. Limited Partnership
A. Holzman v. De Escamilla.(Cal. App. 1948).
1. Facts. Russell and Andrews were limited partners in Hacienda Farms with Escamilla, the
general partner. Holzman, the trustee in bankruptcy, brought an action to determine that
Russell and Andrews were liable as general partners to the creditors of the partnership.
The evidence showed that Escamilla consulted Russell and Andrews as to which crops to
grow and was even overruled as to some of those decisions. In addition, Andrews and
Russell asked Escamilla to resign as manager and appointed his replacement. Furthermore,
checks drawn on Hacienda’s accounts had to be signed by two of the three partners,
therefore, Escamilla had no power to withdraw funds without the signature of at least one
of the other partners.
2. Section 2483 of the Civil Code provides as follows: “A limited partner shall not become
liable as a general partner, unless, in addition to the exercise of his rights and powers as a
limited partner, he takes part in the control of the business.”
3. The foregoing illustrations sufficiently show that Russell and Andrews both took “part in
the control of the business.”
a. The manner of withdrawing money from the bank accounts is particularly
illuminating. The two men had absolute power to withdraw all the partnership
funds in the banks without the knowledge or consent of the general partner.
b. They required him to resign as manager and selected his successor. They were
active in dictating the crops to be planted, some of them against the wish of the
general partner.
B. Revised Uniform Limited Partnership Act § 303(a) now provides that:
1. “a limited partner is not liable for the obligations of a limited partnership unless the limited
partner is also a general partner or, in addition to the exercise of his rights and powers as a
limited partner, he takes part in the control of the business. However, if the limited
partner takes part in the control of the business and is not also a general partner, the limited
partner is liable only to person who transact business with the limited partnership and who
reasonably believe, based upon the limited partner’s conduct, that the limited partner is a
general partner.
C. Revised Uniform Limited Partnership Act § 303(b) also provides that a limited partner does not
participate in control “solely by . . . (2) consulting with and advising a general partner with respect
to the business of the limited partnership.”
C H A PTER T H R EE : T H E N A TU R E O F TH E C O R PO R A TIO N
I. Promoters and the Corporate Entity
A. Promoter. A “promoter” is a 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.
1. Preincorporation. Promoters may enter into contracts on behalf of the venture being
promoted either before or after articles of incorporation have been filed.
a. Corporation Bound? A corporation is not bound by a contract made on its behalf
before it was incorporated unless the corporation agrees to be bound. The
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21
corporation must “adopt” the contract.
(1) Express or Implied. It may do so expressly, e.g., where its board of
directors passes a resolution expressly adopting the contract. Or it may
do so impliedly, by knowingly accepting the benefits of the contract.
(2) Quasi-Contract/Unjust Enrichment. The other party to the contract may
be able to assert quasi-contract or estoppel claims against the
corporation.
2. Promoter’s Liability. W hether a promoter is personally liable on the contract he makes for
the corporation that has not been formed depends on the parties’ (the third party and
promoter’s) intent.
a. Corporation Never Comes Into Existence:
(1) Presumption Promoter Liable. The presumption is that the parties intend
the promoter to be personally liable, so that if the corporation is never
formed, the third party can hold the promoter liable for breach of the
contract.
(a) Different Intent. The parties may intend that the promoter is
not liable on the contract, but instead the corporation will be
bound to the contract after it is formed and adopts the contract.
But this is unlikely, because it would mean that there really
wasn’t a contract at all.
(2) Breach of a Separate Promise. The promoter may have expressly or
impliedly promised the third party that she (the promoter) would use
her best efforts to cause the corporation to be formed and to adopt the
contract. If the corporation is never formed and the third party can
prove that this was because the promoter failed to use her best efforts,
the third party can hold the promoter liable.
b. Promoter’s Liability After the Corporation is Formed:
(1) Novation. The presumption that the parties intend the promoter to be
liable on the pre-incorporation contract continues even after the
corporation is formed and even if the corporation adopts the contract.
However, the parties may have a different intent: they may intend that
once the corporation is formed and adopts the contract, the promoter
will be released from liability. This is called a novation: the creditor
agrees to accept a new debtor in place of the old.
(a) Still Must Prove Intent. The intent to enter into a novation must
be proved. If it is not, the presumption of the promoter’s
liability will stand.
c. Defective Incorporation:
(1) If the corporation has not been properly formed, logically then, the
business must be operating as a sole proprietorship or a general
partnership–neither of which afford its owners (shareholders) limited
liability. This would give the third party–who made the contract in the
belief that he was dealing with a corporation, not an individual–an
undeserved windfall.
(2) The common law came up with two theories to deal with cases like this:
(a) De Facto Corporation. W here there has been a defect in the
incorporation process that prevents the business from being
treated as a de jure corporation, but (1) the
promoter/shareholder made a good faith effort to incorporate
the business, and (2) carried on the business as though it were a
21
Some courts describe this action as “ratification,” but technically a corporation cannot ratify acts that
occurred before its existence.
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22
In Casey v. Galli, 94 U.S. 673 (1877), the rule was stated as follows:
“W here a party has contracted with a corporation, and is sued upon the contract, neither is
permitted to deny the existence, or the legal validity of such corporation. To hold
otherwise would be contrary to the plainest principles of reason and good faith, and
involve a mockery of justice.”
23
No reported case of piercing has ever involved the shareholders of a public traded corporation.
24
Courts have articulated different tests for piercing the corporate veil, such as the “instrumentality”
doctrine of the “alter ego” test. These test focus on the use of control or ownership to “commit a fraud or perpetuate
a dishonest act” or to “defeat justice and equity.” But these tests provide little guidance, and results in particular cases
do not seem to turn on which test a court employs.
Rather, particular piercing factors seem more relevant even though no one fact emerges as determinative.
It is generally believed that courts are more likely to pierce in the following situations: (1) the business is a closely held
corporation; (2) the plaintiff is an involuntary (tort) creditor; (3) the defendant is a corporate shareholder (as opposed
to an individual); (4) insiders failed to follow corporate formalities; (5) insiders commingled business assets/affairs with
individual assets/affair; (6) insiders did not adequately capitalize the business; (7) the defendant actively participated in
the business; and (8) insiders deceived creditors.
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separate personalities of the corporation and the individual [or other corporation] no
longer exist; and second, circumstances must be such that adherence to the fiction of
separate corporate existence would sanction a fraud or promote justice.
a. As for determining whether a corporation is so controlled by another to justify
disregarding their separate identities, the Illinois cases focus on four factors:
(1) The failure to maintain adequate corporate records or to comply with
corporate formalities;
(2) The commingling of funds or assets;
(3) Undercapitalization; and
(4) One corporation treating the assets of another corporation as its own.
3. Marchese’s Playthings. These corporate defendants are, indeed, little but Marchese’s
playthings. Marchese is the sole shareholder of PS, Caribe Crown, Jamar and Salescaster.
He is one of two shareholders of Tie-Net. Except for Tie-Net, none of the corporations
ever held a single corporate meeting. During his deposition, Marchese did not remember
any of these corporations ever passing articles of incorporation, bylaws, or other
agreements. Marchese runs all of the corporations out of the same, single office, with the
same phone line, the same expense accounts, and the like. Marchese “borrows” money
from these corporations, and they borrow money from each other. Marchese used the
bank accounts of the corporations to pay multiple personal expenses.
4. First Prong. In sum, we agree with the district court that there can be no doubt that the
“shared control/unity of interest and ownership” part of the test is met in this case:
a. Corporate records and formalities have not been maintained; funds and assets
have been commingled with abandon; PS, the offending corporation, and perhaps
others have been undercapitalized; and corporate assets have been moved and
tapped and “borrowed” without regard to their source.
5. Second Prong. “Unity of interest and ownership” is not enough; Sea-Land must also show
that honoring the separate corporate existences of the defendants “would sanction a fraud
or promote injustice.”
a. Although an intent to defraud creditors would surely play a part if established, the
Illinois test does not require proof of such intent. Once the first element of the
test is established, either the sanctioning of a fraud (intentional wrongdoing) or the
promotion of injustice, will satisfy the second element.
(1) Promoting Injustice. The prospect of an unsatisfied judgment looms in
every veil-piercing action; why else would a plaintiff bring such an
action? Thus, if an unsatisfied judgment is enough for the “promote
injustice” feature of the test, then every plaintiff will pass on that score,
and the test collapses into a one-step “unity of interest and ownership”
test.
(a) In Pederson v. Paragon, the court offered the following
summary: “Some element of unfairness, something akin to
fraud or deception or the existence of a compelling public
interest must be present in order to disregard the corporate
fiction.”
(b) Generalizing from other Illinois cases, we see that courts that
have properly pierced corporate veils to avoid “promoting
injustice” have found that, unless it did so, some “wrong”
beyond a creditor’s liability to collect would result: the
common sense rules of adverse possession would be
undermined; former partners would be permitted to skirt the
legal rules concerning monetary obligation; a party would be
unjustly enriched; a parent corporation that caused a sub’s
liabilities and its inability to pay for them would escape those
liabilities; or an intentional scheme to squirrel assets into a
liability-free corporation while heaping liabilities upon an asset-
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policies and wages, executive hiring, scientific research, testing, legal counsel, public
relations, marketing (with Bristol’s name and logo), and consolidated federal tax returns.
2. Corporate Control
a. The evaluation of corporate control claims cannot, however, disregard the fact
that, no different from other stockholders, a parent corporation is
expected–indeed required–to exert some control over its subsidiary. Limited
liability is the rule, not the exception.
(1) However, when a corporation is so controlled as to be the alter ego or
mere instrumentality of its stockholder, the corporate form may be
disregarded in the interests of justice.
(2) Veil-Piercing on Summary Judgment. Ordinarily, the fact-intensive nature
of the issue will require that it be resolved only through a trial.
Summary judgment, however, can be proper if the evidence presented
could lead to but one result.
(3) The totality of the circumstances must be evaluated in determining
whether a subsidiary may be found to be the alter ego or mere
instrumentality of the parent corporation. Although the standards are
not identical in each states, all jurisdictions require a showing of
substantial domination.25
(4) Fraud or Like Misconduct (Injustice Requirement). Delaware courts do not
necessarily require a showing of fraud if a subsidiary is found to be the
mere instrumentality or alter ago of its stockholder.
(a) No Showing Required in Tort Cases. In addition, many
jurisdictions that require a showing of fraud, injustice, or
inequity in a contract case do not in a tort situation.
i) A rational distinction can be drawn between tort and
contract cases. In actions based on contract, the
creditor has willingly transacted business with the
subsidiary although it could have insisted on
assurances that would make the parent also
responsible. In a tort situation, however, the injured
party had no such choice; the limitations on corporate
liability were, from its standpoint, fortuitous and non-
consensual.
b. Direct Liability Claims
(1) Restatement (Second) of Torts § 324A: One who undertakes,
gratuitously or for consideration, to render services to another which he
should recognize as necessary for the protection of a third person or his
things, is subject to liability to the third person for physical harm
resulting from his failure to exercise reasonable care to perform his
undertakings, if
25
Among the factors to be considered are whether: (a) the parent and the subsidiary have common directors
or officers; (b) the parent and the subsidiary have common business departments; (c) the parent and the subsidiary file
consolidate financial statements and tax returns; (d) the parent finances the subsidiary; (e) the parent caused the
incorporation of the subsidiary; (f) the subsidiary operates with grossly inadequate capital*; (g) the parent pays the
salaries and other expenses of the subsidiary*; (h) the subsidiary receives no business except that given to it by the
parent; (i) the parent uses the subsidiary’s property as its own*; (j) the daily operation of the two corporations are not
kept separate; (k) the subsidiary does no observe the basic corporate formalities, such as keeping separate books and
records and holding shareholder and board meetings*.
* Indicates those factors which Fendler considers relevant. The court does not explain why the other
factors are relevant to its determination. Most of the remaining factors are present in every parent/subsidiary
relationship.
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fiduciary nature. And it cannot seriously be said that a state make such
unreasonable use of its power as to violate the Constitution when it provides
liability and security for payment of reasonable expenses if a litigation of this
character is adjudged unsustainable.
f. Equal Protection. W e do not think the state is forbidden to use the amount of
one’s financial interest, which measure his individual injury from the misconduct
to be redressed, as some measure of the good faith and responsibility of one who
seeks at his own election to act as custodian of the interests of all stockholders,
and as an indication that he volunteers for the large burdens of the litigation from
a real sense of grievance and is not putting forward a claim to capitalize personally
on it harassment value.
g. Erie Doctrine: Substantive or Procedural? Even if we were to agree that the New
Jersey statute is procedural, it would not determine that it is not applicable.
(1) This statute is not merely a regulation of procedure. W ith it or without
it the main action takes the same course. However, it creates a new
liability where none existed before, for it makes a stockholder who
institutes a derivative action liable for the expense to which he puts the
corporation and other defendants, if he does not make good his claims.
Such liability is not usual and it goes beyond payment of what we know
as “costs.” W e do not think a statute which so conditions the stockholder’s
actions can be disregarded by the federal court as a mere procedural device.
4. Eisenberg v. Flying Tiger Line, Inc. (2d Cir. 1971) 26
a. Cohen v. Beneficial Industrial Loan Corp. instructs that 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.
b. Derivative v. Individual. If the gravamen of the complaint is injury to the
corporation the suit is derivative, but “if the injury is one to the plaintiff as a
stockholder and to him individually and not to the corporation,” the suit is
individual in nature and may take the form of a representative class action.
Fletcher, Private Corporation § 5911.
c. Gordon v. Elliman Test. The test formulated by the majority in that case was
“whether the object of the lawsuit is to recover upon a chose in action belonging
directly to the stockholders, or whether it is to compel the performance of
corporate acts which good faith requires the directors to take in order to perform
a duty which they own to the corporation, and through it, to its stockholders.”
(1) Flying Tiger argues that if the directors had a duty not to merge the
corporation, that duty was owed to the corporation and only
derivatively to its stockholders.
(2) This test was condemned by commentators. It had the effect of
sweeping away the distinction between a representative and a derivative
action–in effect classifying all stockholder class actions as derivative. The
case has been limited to its facts by lower New York courts.
d. Lazare v. Knolls Cooperative Section No. 2, Inc. The court stated that security for
costs could not be required where a plaintiff “does not challenge acts of the
management on behalf of the corporation. He challenges the right of the present
management to exclude him and other stockholders from proper participation in
the affairs of the corporation. He claims that the defendants are interfering with
the plaintiff’s rights and privileges as stockholders.”
e. New York legislature, in its recodification of corporate statutes, added three
26
W hen a shareholder sues in his own capacity, as well as on behalf of other shareholders similarly situated,
the suit is not a derivative action but a class action. In effect, all of the members of the class have banded together
through a representative to bring their individual direct actions in one large direct action.
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words to the definition of derivative suits contained in § 626. Suits are now
derivative only if brought in the right of a corporation to procure a judgment “in
its favor.”
f. In routine merger circumstances the stockholders retain a voice in the operation
of the company, albeit a corporation other than their original choice.
(1) Here, however, the reorganization deprived him and other minority
stockholders of any voice in the affairs of their previously existing
operating company.
(2) Is it thus clear that Gordon is factually distinguishable from the instant
case. Moreover, a close analysis of other New York cases, the
amendment to § 626 and the other major treatises, lead us to conclude
that Gordon has lost its viability as stating a broad principle of law.
5. Special Injury Test. In Delaware, many courts long used the so-called “special injury test to
determine whether a suit was direct or derivative. A special injury was defined as a wrong
that “is separate and distinct from that suffered by other shareholders, ... or a wrong
involving a contractual right of a shareholder, such as the right to vote, or to assert
majority control, which exists independently of any right of the corporation.” Moran v.
Household Int’l, Inc. (Del. Ch. 1985).
a. Rejection of Special Injury Test. The Delaware Supreme Court rejected the special
injury test in favor of a two-pronged standard 27: (1) who suffered the alleged
harm, the corporation or the suing stockholders, individually; and (2) who would
receive the benefit of any recovery or other remedy, the corporation or the
stockholders, individually.
6. Settlement and Attorneys Fees
a. Settled Before Judgment. The corporation can pay the legal fees of the plaintiff and
of the defendants.
b. Judgment for Money Damages Imposed on Defendants. Except to the extent covered
by insurance, the defendants will be required to pay those damages and to bear
the cost of their defense as well.
(1) The corporation may pay the defendants’ expense only if the court
determines that “despite the adjudication of liability but in view of all
the circumstances of the case, [the defendant] is fairly entitled to
indemnity.”
7. Individual Recovery in a Derivative Action
a. Sometimes a court awards an individual recovery in a derivative action. In Lynch
v. Patterson (W yo. 1985), the trial court award the plaintiff damages as a individual
in the amount of 30 percent of $266,000, or $79,8000. The W yoming Supreme
Court upheld this judgment noting that “corporate recovery would simply return
the funds to the control of the wrongdoers.”
B. The Requirement of Demand on the Directors
1. Grimes v. Donald (Del. Sup. Ct. 1996).
a. Distinction Between Direct and Derivative Claims. Although the tests have been
articulated many times, it is often difficult to distinguish between a derivative and
an individual action. The distinction depends upon the nature of the wrong
alleged and the relief, if any, which could result if plaintiff were to prevail. 28
27
Tooley v. Donaldson, Lufkin & Jenrette (Del. 2004).
28
In Tooley v. Donaldson, Lufkin, & Jenrette, Inc. (Del. 2004), the Delaware Supreme Court clarified the
standard, holding that in determining whether a stockholder’s claim is derivative or direct, the issue must turn solely
on the following questions: (1) who suffered the alleged harm, the corporation or the suing stockholders, individually;
and (2) who would receive the benefit of any recovery or other remedy, the corporation of the stockholders,
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b. Abdication. Directors may not delegate duties which lie “at the heart of the
management of the corporation.” A court cannot give legal sanction to
agreements which have the effect of removing from directors in a very substantial
way their duty to use their own best judgment on management affairs.
(1) W ith certain exceptions, an informed decision to delegate a task is as
much an exercise in business judgment as any other. Likewise, business
decisions are not an abdication of directorial authority merely because
they limit a board’s freedom of future action. A board which has
decided to manufacture bricks has less freedom to decide to make
bottles. In a world of scarcity, a decision to do one thing will commit a
board to a certain course of action and make it costly and difficult
(indeed, sometimes impossible) to change course and do another. This
is an inevitable fact of life and is not an abdication of directorial duty.
(2) If an independent and informed board, acting in good faith, determines
that the services of a particular individual warrant large amounts of
money, whether in the form of current salary or severance provisions,
the board has made a business judgment decision.
(a) That judgment normally will receive the protection of the
business judgment rule unless the fact show that such amounts,
compared with the services to be received in exchange,
constitute waste or could not otherwise be the product of a
valid exercise of business judgment.
c. Demand Requirement. If a claim belongs to the corporation, it is the corporation,
acting through its board of directors, which must make the decision whether or
not to assert the claim. The derivative action impinges on the managerial
freedom of directors. The demand requirement is a recognition of the fundamental
precept that directors manage the business and affairs of the corporation.
(1) A stockholder filing a derivative suit must allege either that the board
rejected his pre-suit demand that the board assert the corporation’s claim
or allege with particularity why the stockholder was justified in not
having made the effort to obtain board action.
(a) Grounds for alleging with particularity that demand would be
futile:
i) Reasonable Doubt. “Reasonable doubt” 29 exists that
the board is capable of making an independent
decision to assert the claim if demand were made.
The basis for claiming excusal would normally be that:
a) A majority of the board has a material
financial or familial interest.;
b) A majority of the board is incapable of acting
independently for some other reason such as
domination of control; or
c) The underlying transaction is not the product
of a valid exercise of business judgment.
individually.
29
Some courts and commentators have questioned why a concept normally present in criminal prosecution
would find its way into derivative litigation. Yet the term is apt and achieves proper balance. Reasonable doubt can
be said to mean that there is reason to doubt. This concept is sufficiently flexible and workable to provide the
stockholder with “the keys to the courthouse” in an appropriate case where the claim is not based on mere suspicions
or state solely in conclusory terms.
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30
See also Handout/Chart
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contractual rights between the corporation and its stockholder and between stockholders
inter se.
a. Although later cases have not disavowed the doctrine, it is noteworthy that they
have repeatedly recognized that where justified by the advancement of the public
interest the reserved power may be invoked to sustain later charter alterations
even though they affect contractual rights between the corporation and its
stockholders and between stockholder inter se.
b. State legislation adopted in the public interest and applied to preexisting
corporations under the reserved power has repeatedly been sustained by the
United States Supreme Court above the contention that it impairs the rights of
stockholders and violates constitutional guarantees under the Federal
Constitution.
B. Business Judgment Rule. The courts have been extremely tolerant in accepting the business judgment
of the officers and directors of corporation, including their business judgment about whether a
charitable donation will be good for the corporation in the long run.
C. Internal Affairs Rule. The basic rule of corporate choice of law in all states is that the law of the state
of incorporation controls on issues relating to a corporation’s “internal affairs,” which includes
responsibilities of directors to shareholders.
D. Dodge v. Ford Motor Co. (Mich. 1919).
1. Power of Court to Interfere in Declaring Dividend. It is a well-recognized principle of law that
the directors of a corporation, and they alone, have the power 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 clearly made to appear that they are
guilty of fraud or misappropriation of the corporate funds, or refuse to declare a dividend
when the corporation has a surplus of net profits which it can, without detriment to its
business, divide among its stockholders, and when a refusal to do so would amount to such
an abuse of discretion as would constitute a fraud, or breach of that good faith which they
are bound to exercise towards the stockholders.
2. Purpose of Business Organization. A business corporation is organized and carried on
primarily for the profit of the stockholders. The powers of the directors are to be
employed for that end. The discretion of directors is to be exercised in the choice of
means to attain that end, and does not extend to a change in the end itself, to the
reduction of profits, or to the nondistribution of profits among stockholders in order to
devote them to other purposes.
3. W ithin Business Judgement. W e are not, however, persuaded that we should interfere with
the proposed expansion of the business of the Ford Motor Co. In the view of the fact that
the selling price of products may be increased at any time, the ultimate results of the larger
business cannot be certainly estimated. The judges are not business experts. It is
recognized that plans must often be made for a long future, for expected competition, for a
continuing as well as an immediately profitable venture. The experience of the Ford
Motor Co. is evidence of capable management of its affairs.
E. Shlensky v. W rigley (Ill. 1968).
1. It appears to us that the effect on the surrounding neighborhood might well be considered
by a director who was considering the patrons who would or would not attend the games
if the park were in a poor neighborhood.
2. The response which courts make to such applications is that it is not their function to
resolve for corporations questions of policy and business management. The directors are
chose to pass upon such questions and their judgment unless shown to be tainted with fraud is
accepted as final. The judgment of the directors of corporations enjoys the benefit of a
presumption that it was formed in good faith and was designed to promote the best
interests of the corporation.
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I. Formation
A. History and Law of Limited Liability Companies
1. Recently Created Form of Bus. Org. Before 1988,31 the world of unincorporated business
organizations had two main players: ordinary general partnership and ordinary limited
partnerships.
a. Limited Liability Company. The first LLC statute was enacted in Wyoming. The
limited liability company is an alternative form of business organization that
combines certain features of the corporate form with others more closely
resembling general partnerships.
2. The Players. In an LLC the investors are called "members." Like the traditional
corporation, the LCC provides a liability shield for its members. It allows somewhat more
flexibility than the corporation in developing rules for management and control.
a. Member-Managed/Manager-Managed. Most LLC statutes dichotomize governance
between “member-managed” LLCs and “manager-managed” LLCs.
(1) Governance in a member-managed LLC resembles governance in a
general partnership. Governance in a manager-managed LLC resembles
governance in a limited partnership.32
b. Single-Member LLC. LLCs can be single-member LLCs (as can a corporation;
partnerships, by definition, cannot).
3. Formalities
a. Articles of Organization. The public filing of which will create the limited liability
company as a legal person.
(1) Most LLC statutes require the articles to state whether the LCC is
member-managed or manager-managed, a characterization that has
important power-to-bind implications. 33
(2) Arkansas’ default rule is that an LLC is member-managed.
b. Operating Agreement. Like a partnership agreement in a general or limited
partnership, an LLC’s operating agreement serves as the foundational contract
among the entity’s owners.
4. Tax Treatment
a. Corporations. Corporate stockholders face “double taxation” on any dividends
they receive.
(1) First, the corporation pays income tax on any profits it earns. Dividends
to shareholders are therefore made in “after-tax” dollars. Second,
dividends are then taxed as they are received by the shareholders.
b. Other Entities. Partnerships, LLCs, Subchapter S Corporations 34 are subject to
31
In 1988, the IRS issued Revenue Procedure 88-76 which classified a W yoming LLC as a partnership, and
caused legislatures around the country to consider seriously the LLC phenomenon.
32
The resemblance is not complete. For example, managers in a manager-managed LLC are not required
by statute to be members, although they usually are. In contrast, the managers of a limited partnership–i.e., the
general partners–are necessarily partners.
33
In a member-managed LLC, all members have the power to bind absent contrary agreement. In a
manager-managed LLC, managers have the power to bind while the members do not.
34
The following requirements must be for a corporation to elect to be taxed as a partnership: (1) for most
practical purposes, all shareholders must be either U.S. citizens or resident aliens; (2) the corporation cannot be a
certain business type or structure, including foreign corporations, a bank or savings and loan association, or an
insurance company; (4) there can only be one class of stock; and (5) there can be no more than 100 individual
shareholders, though certain tax-exempt entities such as employee stock ownership plans, pension plans, and charities
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can be shareholders.
35
Partnerships, by definition, are formed for a business purpose (“association of two or more person to carry
on as co-owners a business for profit).
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36
“If both the existence and identity of the agent’s principal are fully disclosed to the other party, the agent
does not become a party to any contract which he negotiates. But where the principal is partially disclosed (i.e., the
existence of a principal is known but his identity is not), it is usually inferred that the agent is a party to the contract.”
Reuchlein and Gregory, The Law of Agency and Partnership § 118 (2d ed. 1990).
37
Other LLC Act provisions reinforce the conclusion that the legislature did not intend the notice language
of § 7-80-208 to relieve the agent of a limited liability company of the duty to disclose its identity in order to avoid
personal liability. For example, § 7-80-201(1) requires limited liability companies to use the words “Limited Liability
Company” or the initials “LLC” as part of their names, implying that the legislature intended to compel any entity
seeking to claim the benefits of the LLC Act to identify itself clearly as a limited liability company.
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38
The certificate of formation is a relatively brief and formal document that is the first statutory step in
creating the LLC as a separate legal entity. The certificate does no contain a comprehensive agreement among the
parties, and the statute contemplates that the certificate of formation is to be complemented by the terms of the
Agreement.
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Section 13.8 of the Agreement specifically provided that the parties (i.e., Elf) agreed to institute, “[n]o
action at law or in equity based upon any claim arising out of or related to this Agreement” except as action to
compel arbitration or to enforce an arbitration award.
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Annotated section 4-32-402. Subsection (1) of the statute addresses only the fiduciary duty
of care.
a. Court Should Have Looked to the Duty of Loyalty. As is evident from the fact that
they were on both the buy side and the sell side of the planned transaction in this
case, the individual defendants were engaged in self-interested behavior.
Therefore, it is the other principal fiduciary duty— the duty of loyalty— that was
at issue. The duty of loyalty is addressed by subsection (2) of Arkansas Code
Annotated section 4-32-402, set out above. Again, quoting from the drafters of
the Prototype Act, “Subsection [(2)], which is based on UPA § 21, sets forth the
duty of loyalty of LLC managers and managing members— that is, the duty to act
without being subject to an obvious conflict of interest . . . .”
b. Analogous to Limited Partnership Law. In In re USACafes, a Delaware court held
that the directors of the corporate general partner owed some degree of fiduciary
duty directly to the limited partners. W hile the court did not define the limits of
the directors' obligation, it concluded that “it surely entails the duty not to use
control over the partnership's property to advantage the corporate director at the
expense of the partnership.”
V. Dissolution
A. New Horizons Supply Cooperative v. Haack (W is. App. 1999)
1. Facts. Kickapoo Valley Freight, LLC was the “Patron” under a Cardtrol Agreement issued
by New Horizon’s predecessor. Kickapoo agreed to be responsible for all fuel purchased
with the card. The agreement was signed by Haack with no indication of whether she was
signing individually or in a representative capacity. The account soon was in arrears and
when contacted about payment, Haack said she would pay $100 per month but no
payment was ever received. Haack was contacted again but Haack inform New Horizons
that Kickapoo had dissolved and that she was a partner and that Robert, her brother, had
moved out of state and that she would begin payments. No payment was ever received
and subsequent attempts to collect payment proved fruitless. Horizons instituted an action
to recover against Haack.
2. Members of LLCs Not Personally Liable. W is. Stat. § 183.0304 provides that “a member of
manager of a limited liability company is not personally liable for any debt, obligation or
liability of the limited liability company.”
a. May Borrow From Common Law Corporation Principles. W is. Stat. § 183.0304(2)
provides: “Notwithstanding sub. (1) [which sets forth the limitation on member
liability], nothing in this chapter shall preclude a court from ignoring the limited
liability company entity under principles of common law of this state that are
similar to those applicable to business corporations and shareholders in this state
and under circumstances that are not inconsistent with the purposes of this
chapter.”
3. The court disagrees with the trial court’s comments that implied that it erroneously
deemed Kickapoo Valley’s treatment as a partnership for tax purposes to be conclusive.
There is little in the record, moreover, to support a conclusion that Haack “organized,
controlled and conducted” company affairs to the extent that it had “no separate existence
which she “used to evade an obligation, to gain an unjust advantage or to commit an
injustice.”
a. Defendant Failed to Shield Herself After Dissolution. Rather we conclude that entry
of judgment against Haack on the claim was proper because she failed to establish
that she took appropriate steps to shield herself from liability for the company’s
debts following its dissolution and the distribution of its assets.
(1) The record is devoid of any evidence showing that appropriate steps
were taken upon the dissolution of the company to shield its members
from liability for the entity’s obligations.
(a) A dissolved limited liability company may “dispose of known
claims against it” by filing articles of dissolution, and then
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Del. Gen. Corp. Law 102(b)(7) does not permit the reduction of liability for any breach of the duty of
loyalty or for any acts or omissions not in good faith or which involve intentional misconduct or knowing violations
of the law.
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2. Duty, Breach, and Causation. Determination of the liability of Pritchard requires findings
that she had a duty to the clients of Pritchard & Baird, that she breached that duty and that
her breach was a proximate cause of their losses.
3. New Jersey Business Corporation Act makes it incumbent upon directors to “discharge
their duties in good faith and with that degree of diligence, care and skill which ordinarily
prudent men would exercise under similar circumstances in like positions.”
a. Degree of Care Dependent on Business Type. Courts have espoused the principle
that directors owed that degree of care that a business of ordinary prudence
would exercise in the management of his own affairs. In addition to requiring
that directors act honestly and in good faith, the New York courts recognized
that the nature and extent of reasonable care depended upon the type of
corporation, it size and its financial resources.
4. Director Must Be Knowledgeable. As a general rule, a director should acquire at least a
rudimentary understanding of the business of the corporation. Accordingly, a director
should become familiar with the fundamentals of the business in which the corporation is
engaged.
a. Because directors are bound to exercise ordinary care, they cannot set up as a
defense lack of the knowledge needed to exercise the requisite degree of care.
b. Directors are under a continuing obligation to keep informed about the activities
of the corporation.
(1) May not shut their eyes to corporate misconduct and then claim that
because they did not see the misconduct, they did not have a duty to
look.
c. Directorial management does not require a detailed inspection of day-to-day
activities, but rather a general monitoring of corporate affairs and policies.
(1) Should maintain familiarity with the financial status of the corporation
by a regular review of financial statements.
5. Immunity from Reliance in Good Faith. Generally, directors are immune from liability if, in
good faith:
a. “They rely upon the opinion of counsel for the corporation or upon written
reports setting forth financial data concerning the corporation and prepared by an
independent public accountant or certified public accountant or firm of such
accountants or reports of the corporation represented to them to be correct by the
president, the officer of the corporation having charge of its books of account, or
the person presiding at a meeting of the board.:”
6. Duty to Object & Resign. Upon discovery of an illegal course of action, a director has a
duty to object and, if the corporation does not correct the conduct, to resign.
a. Sometimes more may be required, such as seeking advice of counsel or
preventing illegal conduct by co-directors. This may include threat of suit.
7. Fiduciary Relationship. In general, the relationship of a corporate director to the
corporation and its stockholders is that of a fiduciary.
a. W hile directors may own a fiduciary duty to creditors also, that obligation
generally has not been recognized in the absence of insolvency.
8. Causation. Usually, a director can absolve himself from liability by informing the other
directors of the impropriety and voting for a proper course of action. Conversely, a
director who votes for or concurs in certain actions may be liable to the corporation for
the benefit of its creditors or shareholders, to the extent of any injuries suffered by such
persons, as a result of any such action.
a. A director who is present at a board meeting is presumed to concur in corporate
action taken at a meeting unless his dissent is entered in the minutes of the
meeting or filed promptly after adjournment.
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Common Stock: The default rule is that each share receives one (1) vote per share. Common stock receives
dividends, shares are treated identically and are entitled to the residual ownership interest (liquidation rights are in the
following order: secured creditors, creditors, preferred stock, and finally common stock). Common stock can be
issued in multiple classes.
42
Preferred Stock: Some preference over common stock with regards to dividends and liquidation rights.
Preferred stock can have conversion rights that give preferred shareholders the option to convert their preferred into
other stock of the corporation, usually common stock.
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A manager who uses the corporate governance machinery to protect his incumbency effectively diverts
control from the shareholders to himself. Besides preventing shareholders from exercising their control
rights–whether by voting or selling to a new owner–management entrenchment undermines the disciplining effect on
management of a robust market in corporate control.
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(2) CIS was in the business of divesting itself of its cellular license holdings
therefore it is not clear that CIS had a cognizable interest or expectancy in the
license; (3) Finally, the corporate opportunity doctrine is 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 is actualized by the exploitation of the
opportunity.
e. Presentation to the Board Unnecessary. A director or officer must analyze the
situation ex ante to determine whether the opportunity is one rightfully
belonging to the corporation. If the director or officer believes, based on one of
the factors articulated above, that the corporation is not entitled to the
opportunity, then he may take it for himself. Of course, presenting the opportunity
to the board creates a kind of “safe harbor” for the director, which removes the specter of a
post hoc judicial determination 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 element to a finding that a corporate opportunity has not been usurped.
f. The right of a director or officers to engage in business affairs outside of his or her
fiduciary capacity would be illusory if these individuals were required to consider
every potential, future occurrence in determining whether a particular business
strategy would implicate fiduciary duty concerns.
2. In re eBay, Inc. Shareholders Litigation (Del. Ch. 2004).
a. Facts. Omidyar and Skoll founded eBay in 1995. In 1998, Goldman Sachs was
the lead underwriter on an IPO of common stock. Shares of eBay stock became
valuable and the price rose considerably. In 1999, a secondary offering was made
with Goldman Sachs again as the underwriter. Goldman Sachs “rewarded” the
defendants by allocating to them thousands of IPO shares at the initial offering
price. The plaintiffs alleged that Goldman Sachs provided these allocations to the
individual defendants to show appreciation for eBay’s business and to enhance
Goldman Sachs’ chances of obtaining future eBay business.
b. Distinguishing Broz. First, no one disputes that eBay was financially able to exploit
the opportunities in question. Second, eBay was in the business of investing in
securities. Thus, investing was a “line of business” of eBay. Third, the fact
alleged in the complaint suggest that investing was integral to eBay’s cash
management strategies and a significant part of its business. Finally, it is no
answer to say, as do defendants, that IPOs are risky investments. It is undisputed
that eBay was never given an opportunity to turn down the IPO allocations as
too risky.
c. Not Simply a Case of Broker’s Investment Recommendations. This was not an instance
where a broker offered advice to a director about an investment in a marketable
security. The conduct challenged here involved a large investment bank that
regularly did business with a company steering highly lucrative IPO allocations to
select insider directors and officers at that company, allegedly both to reward
them for past business and to induce them to direct future business to that
investment bank. This is a far cry from the defendant’s characterization of the
conduct in question as merely “a broker’s investment recommendations” to a
wealthy client.
d. Conflict of Interest. One can realistically characterize these IPO allocation as a form
of commercial discount or rebate for past or future investment banking services.
Viewed pragmatically, it is easy to understand how steering such commercial
rebates to certain insider directors places those directors in an obvious conflict
between their self-interest and the corporation’s interest.
e. Agent’s Duty to Account for Profits. An agent is under a duty to account for profits
personally obtained in connection with transactions related to his or her
company. Even if this conduct does not run afoul of the corporate opportunity
doctrine, it may still constitute a breach of the fiduciary duty of loyalty.
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(1) Thus, even if one does no consider Goldman Sachs’ IPO allocations to
these corporate insiders–allocations that generated millions of dollars in
profit–to be a corporate opportunity, the defendant directors were
nevertheless not free to accept this consideration from a company,
Goldman Sachs, that was doing significant business with eBay and that
arguably intended the consideration as an inducement to maintaining the
business relationship in the future.
3. Northeast Harbor Golf Club, Inc. v. Harris (Me. 1995).
a. Guth v. Loft Line of Business Test.
(1) 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 a reasonable expectancy, and, by embracing the opportunity, the self-
interest of the officer or director will be brought into conflict with that
of his corporation, the law will not permit him to seize the opportunity
for himself.
(2) W eaknesses. (1) The question whether a particular activity is within a
corporation’s line of business is conceptually difficult to answer (See In re
eBay, Inc. Shareholders’ Litigation); and (2) the Guth test includes as an
element the financial ability of the corporation to take advantage of the
opportunity. Often, the injection of financial ability into the equation
will unduly favor the inside director or executive who has command of
the facts relating to the finances of the corporation.
b. Fairness Test.
(1) The basis of the doctrine rests on the unfairness in the particular
circumstances of a director, whose relation to the corporation is
fiduciary, taking advantage of an opportunity for her personal profit
when the interest of the corporation justly calls for protection. This calls
for application of ethical standards of what is fair and equitable ... in
particular sets of facts.
(2) W eaknesses. Provides little or no practical guidance to the corporate
office or director seeking to measure her obligations.
c. Line of Business/Fairness Hybrid Test.
(1) Two step analysis: (1) Determining whether a particular opportunity is
within the corporation’s line of business; and (2) Scrutinizing the
equitable consideration existing prior to, at the time of, and following
the officer’s acquisition.
(2) W eaknesses. Merely piles the uncertainty and vagueness of the fairness
test on top of the weaknesses in the line of business test.
d. ALI Approach.
(1) The ALI Principles take a disclosure-oriented approach that mandates
informed corporate rejection before a manager can take a “corporate
opportunity.” Under this approach, (1) the manager must have offered
the opportunity to the corporation and disclosed his conflicting interest,
and (2) the board or shareholder must have rejected it. ALI § 505(a).
(2) ALI § 505(b). Definition of a Corporate Opportunity. For purposes of
this Section, a corporate opportunity is:
(1) Any opportunity to engage in a business activity of which a director or senior
executive becomes aware, either:
(A) In connection with the performance of functions as a director or senior
executive, or under circumstances that should reasonably lead the director or senior
executive to believe that the person offering the opportunity expects it to be offered
to the corporation; or
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The Arkansas Supreme Court has traditionally used language indicating that “good faith” is a standalone
obligation. In practical terms, it probably does not make much difference as a violation of the obligation of good faith
will most likely also breach the duties of loyalty and due care.
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director oversight liability:
(a) the directors utterly failed to implement any reporting or
information systems or controls; or
(b) having implemented such a system or controls, consciously
failed to monitor or oversee its operations thus disabling
themselves from being informed of risks or problems requiring
their attention.
IV. Securities Law Overview
A. Introduction
1. Dual Regulation. There is dual regulation at the federal and the state level. Both federal
and state securities laws must be complied with.
a. Federal Law
(1) Securities Act of 1933 (15 U.S.C. §§ 77a et seq.) The 1933 Act governs
the issuance of securities by business to raise capital.
(2) Securities Exchange Act of 1934 (15 U.S.C. §§ 87a et seq.) The 1934 Act
regulates trading in securities and other regulatory matters affecting
publicly-held corporations.
b. State Law
(1) Blue Sky Laws.46 Arkansas, like most states, has its own “blue sky” law,
codified at Ark. Code Ann. §§ 23-42-101 et seq., and the Arkansas
Securities Commissioner has promulgated regulations.
B. W hat is a Security?
1. Broad Definition. The statutory definitions of “security” under the federal acts are very
broad. See generally § 2(a)(1) of the 1933 Act which sets out a laundry list of both specific
instruments and general categories. The determination of whether a particular investment
interest is a security is made on a case-by-case basis.
a. For example, the definition includes “notes,” “stock,” “bond,” “evidence of
indebtedness,” “transferable share,” “fractional undivided interest in oil, gas, or
other mineral rights,” “investment contract,” “certificate of interest or
participation in any profit-sharing agreement,” “or, in general, any interest or
instrument commonly known as a ‘security.”’
2. Traditional Corporate Stock. W hether common or preferred, whether voting or nonvoting,
whether of a publicly held or a closely held corporation -- is certain to be a security under
federal law. Landreth Timber Co. v. Landreth, 471 U.S. 681 (1985).
3. Promissory Notes. A promissory note may or may not be a security. In Reves v. Ernst &
Young, 494 U.S. 56 (1990), the U.S. Supreme Court adopted the so-called "family
resemblance" test used by the Second Circuit. This test seeks to distinguish between notes
that are given by businesses to raise capital for investment (a security) and those that are
given in connection with consumer transactions or given by businesses in exchange for
short-term loans to finance current operations (not a security).
4. Investment Contracts. The federal statutory definition of "security" includes so-called
"investment contracts." This category is, in substance, a catch-all category that brings
within the definition of "security" a variety of investment interests, including partnership
interests; franchise, distributorship, and licensing arrangements; and sales of property, both
personal and real, coupled with management or development agreements.
45
In either case, imposition of liability requires a showing that the directors knew that they were not
discharging their fiduciary obligations. W here directors fail to act in the face of a known duty to act, they breach
their duty of loyalty by failing to discharge their fiduciary obligation in good faith.
46
So named because they were aimed at promoters who “would sell building lots in the blue sky in fee
simple.”
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a. Howey Test. Federal courts apply the "Howey Test" to determine whether a
particular investment interest is an "investment contract" subject to regulation by
the federal securities laws. In SEC v. W .J. Howey Co., 328 U.S. 293, 298-99
(1946), the United States Supreme Court announced:
(1) “An investment contract for purposes of the Securities Act means a
contract, transaction or scheme whereby a person (1) invests his money
(2) in a common enterprise and (3) is led to expect profits (4) solely
from the efforts of the promoter or a third party.”
(2) Applying this test, the Supreme Court held that the offer of small plots
of land in orange groves in Florida to vacationers from New England,
coupled with the offer of a management contract under which an
affiliate of the vendor would cultivate and tend the grove in which the
plot was located, harvest and market the fruit from the entire grove, and
remit a share of the profits to the various owners was the offer of an
"investment contract" under the 1933 Act.
5. Passive Investments. Subsequent cases have established that a passive investment, whatever it
is called, is very likely to be a security.
a. Limited Partnership Interests. For example, most limited partnership interests are
usually held to be securities, because in most limited partnerships the limited
partners have very little management power over the business of the partnership.
b. Race Horse & Property Syndications, Etc. Investments in race horse or property
syndications are likely to be securities. Chinchilla and earthworm raising ventures
have been held to be securities. Businesses using a multi-level distribution model,
where the role of investors is primarily to attract other investors rather than to sell
a product, have been found to be issuers of securities. Ownership interests in
LLCs may be securities, especially in manager-managed LLCs where the
members do not participate in the management of the LLC's business.
6. Under the Arkansas Securities Act. The statutory definition of “security” in the Arkansas Act
is similar to those in the federal Acts. The important difference lies in how the Arkansas
courts have interpreted the Arkansas Act.
a. The Arkansas Supreme Court looks at various factors to determine whether a
given interest - whether it takes the form of corporate stock or some other
interest– is a “security” subject to regulation under the Arkansas Act. It also
looks to the so-called “risk capital” test, a test that some state courts use instead of
the Howey test.
(1) Risk Capital Test. The Arkansas courts have expressed the risk capital
test in terms of five elements: (a) The investment of money or money's
worth; (b) in a venture; (c) the expectation of some benefit to the
investor as a result of the investment; (d) the contribution towards the
risk capital of the venture; and (e) the absence of direct control over the
investment or policy. Carder v. Burrow, 327 Ark. 545, 549, 940 S.W .2d
429, 431 (1997).
(a) Different Results from Federal Law. Applying this test to classify
various investment interests as securities or not securities, the
Arkansas Supreme Court has sometimes reached conclusions
opposite to the conclusions that a federal court would probably
have reached applying federal law. See, e.g., Cook v. W ills, 305
Ark. 442, 447, 808 S.W .2d 758, 761 (1991)(corporate stock
not a security); Casali v. Schultz, 292 Ark. 602, 732 S.W .2d
836 (1987)(general partnership interest a security).
C. Exemption from 1933 Act Registration
1. In General. W hen businesses seek to raise capital by issuing securities, the securities laws
require that the offering be “registered” with the appropriate governmental authority
before the securities are marketed
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Accredited investors include banks, insurance companies, other corporations with total assets in excess of
$5 million, directors or executive officers of the issuer, and individuals who have a net worth over $1 million or who
have an income of $200,000 in the previous two years (or $300,000 jointly with his or her spouse) and who
reasonably expect to reach the same income in the current year.
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5. Resales. Technically speaking, the registration requirements of the 1933 Act potentially
apply to resales of securities as well as to primary offerings by issuers. Exemptions exist
which remove most resales from the reach of the registration provisions, but trouble can
arise if a “control person” of the issuer sells large amounts of securities publicly.
D. Regulation of Reporting Companies by the 1934 Act
1. Companies Required to Register. The companies that have to register under the 1934 Act are
(1) those whose securities are traded on a national securities exchange (e.g., the New York
Stock Exchange), (2) those whose total assets are $10,000,000 or more and who have 500
or more shareholders, and (3) those companies that have issued securities under a 1933 Act
registration statement (although a small company can discontinue 1934 Act registration and
reporting after the first year). Also, a company can voluntarily elect to register under the
1934 Act and thereby become subject to its provisions.
2. Reporting Companies. Companies subject to the 1934 Act are often called “reporting
companies” because they are required to file periodic reports setting forth their financial
and general business condition.
E. Insider Trading
1. Definition. “Insider trading” means buying or selling securities (almost always stock) on the
basis of material, non-public information.
2. SEC’s Advocation for Blanket Rule. The SEC has always advocated for a rule that would
prohibit anyone in possession of inside information from buying or selling stock on the
basis of it.
a. Supreme Court Rejection/Common-Law Rule of Deceit. The Supreme Court has, for
Rule 10b-5 purposes, rejected this view. Instead, the Court has approached the
problem of insider trading as a specific application of the common-law rule of
deceit.
(1) Common-Law. Remember that under the common law, a person is
allowed to buy or sell property on the basis of information that he has
that is unknown to the other party to the transaction. The exception is
where the person has a "duty to disclose" that information to the other
party. One source of a duty to disclose is where there is a fiduciary
relationship or other special relationship of trust and confidence between
the parties. So, for example, an attorney cannot enter into a business
transaction with a client without making full disclosure to the client of
all material information relating to that transaction that the attorney has.
V. Inside Information
A. Goodwin v. Agassiz (Mass. 1933).
1. Facts. Defendants purchased from plaintiff, through brokers, 700 shares of Cliff Mining
Company. Agassiz was president and director and McNaughton was a director and
general manager of the company. They had certain knowledge, material to the value of
the stock, that the plaintiff did not possess. Exploration in 1925 of the property of Cliff
Mining Company proved unsuccessful. However, an experienced geologist formulated a
theory as to the possible existence of copper deposits in 1926. The defendants decided to
test the theory but agreed that if the information became known the price of Cliff
Mining’s stock would soar. The plaintiff learned of the failed exploration through an
article and sold his stock through brokers. The plaintiff didn’t know that the purchase of
his stock was made for the defendants and they did not know his stock was being bought
for them. There was no communication between them
2. The directors of a commercial corporation stand in relation of trust to the corporation and
are bound to exercise the strictest good faith in respect to its property and business.
a. The contention that directors also occupy the position of trustee toward
individual stockholders in the corporation is plainly contrary to repeated decisions
of this court and cannot be supported.
3. W hile the general principle is as stated, circumstances may exist requiring that transactions
between a director and a stockholder as to stock in the corporation be set aside.
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(c) To engage in any act, practice, or course of business which operates or would operate as a
fraud or deceit upon any person, in connection with the purchase or sale of any security.
a. Purpose of the Rule. Rule 10b-5 is based in policy on the justifiable expectation of
the securities marketplace that all investors trading on impersonal exchanges have
relatively equal access to material information.
b. Essence of the Rule. The essence of the Rule is that anyone who, trading for his
own account in the securities of a corporation, has “access, directly or indirectly,
to information intended to be available only for a corporate purpose and not for
the personal benefit of anyone” may not take “advantage of such information
knowing it is unavailable to those with whom he is dealing.” i.e., the investing
public.
c. Insiders, as directors or management officers are, of course, by this Rule,
precluded from so unfairly dealing, but the Rule is also applicable to one
possessing the information who may not be strictly termed an “insider” within
the meaning of Sec. 16(b) of the Act.
(1) Thus, anyone in possession of material inside information must either
disclose it to the investing public, or, if he is disabled from disclosing it
in order to protect a corporate confidence, or he chooses not to do so,
must abstain from trading in or recommending the securities concerned
while such inside information remains undisclosed.
d. An insider is not, of course, always foreclosed from investing in his own company
merely because he may be more familiar with company operations than are
outside investors.
(1) An insider’s duty to disclose information or his duty to abstain from
dealing in his company’s securities arises only in those situations which
are essentially extraordinary in nature and which are reasonably certain
to have a substantial effect on the market price of the security if the
extraordinary situation is disclosed.
(2) Nor is an insider obligated to confer upon outside investors the benefit
of his superior financial or other expert analysis by disclosing his
educated guesses or predictions.
e. The basic test of materiality is whether a reasonable man would attach importance
in determining his choice of action in the transaction in question. This, of
course, encompasses any fact which in reasonable and objective contemplation
might affect the value of the corporation’s stock or securities.
(1) Such a fact is a material fact and must be effectively disclosed to the
investing public prior to the commencement of insider trading in the
corporation’s securities.
(a) Material facts include not only information disclosing the
earnings and distributions of a company but also those facts
which affect the probable future of the company and those
which may affect the desire of investors to buy, sell, or hold the
company’s securities.
(2) In each case then, whether facts are material within Rule 10b-5 when
the facts relate to a particular event and are undisclosed by those persons
who are knowledgeable thereof will depend at any given time upon a
balancing of both the indicated probability that the event will occur and
the anticipated magnitude of the event in light of the totality of the
company activity.
f. The timing of a disclosure is a matter for the business judgment of the corporate
officers entrusted with the management of the corporation within the affirmative
disclosure requirements promulgated by the exchanges and by the SEC.
(1) W here a corporate purpose is thus served by withholding the news of a
material fact, those persons who are thus quite properly true to their
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insider’s duty. As the Court noted in Chiarella, the tippee’s obligation has been
viewed as arising from his role as a participant after the fact in the insider’s breach
of a fiduciary duty.
d. Thus, some tippees must assume an insider’s duty to the shareholder not because
they receive inside information, but rather because it has been made available to
them improperly.
(1) For Rule 10b-5 purposes, the insider’s disclosure is improper only
where it would violate his Cady Roberts duty. Thus, a tippee assumes a
fiduciary duty to the shareholders of a corporation not to trade on
material nonpublic information only when 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.
(a) In determining whether a tippee is under an obligation to
disclose or abstain, it is thus necessary to determine whether the
insider’s “tip” constituted a breach of the insider’s fiduciary
duty. All disclosures of confidential corporate information are
not inconsistent with the duty insiders owe to shareholders.
i) W hether disclosure is a breach of duty depends in
large part on the purpose of the disclosure. The test is
whether the insider will 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 no derivative breach.
D. The SEC & Selective Disclosure. The SEC recently concluded that selective disclosure to analysts
undermined public confidence in the integrity of the stock markets.
1. Regulation FD. In 2000, the SEC adopted Regulation FD to create a non-insider trading-
based mechanism for restricting selective disclosure. If someone acting on behalf of a
public corporation discloses material nonpublic information to securities market
professional or holders of the issuer’s securities who may well trade on the basis of the
information, the issuer must also disclose that information to the public.
a. Intentional Disclosures. Where the disclosure is intentional, the issuer must
simultaneously disclose the information in a manner designed to convey it to the
general public.
b. Non-Intentional Disclosures. W here the disclosure was not intentional, as where a
corporate officer “let something slip,” the issuer must make public disclosure
“promptly” after a senior officer learns of the disclosure.
E. United States v. O’Hagan (S. Ct. 1997).
1. Facts. O’Hagan was a partner in a Minneapolis law firm, Dorsey & W hitney, that was
retained by Grand Met to represent it in a potential tender offer for the common stock of
Pillsbury. On Oct. 4, 1998, Grand Met publicly announced its tender offer for Pillsbury
stock. However, back in Aug. of 1988, O’Hagan began purchasing call options of
Pillsbury stock.48 By the end of September, he owned 2,500 options. W hen Grant Met
announced its tender offer of Pillsbury, the price of Pillsbury stock rose and O’Hagan then
sold his Pillsbury options and common stock, making a $4.3 million profit. The SEC
initiated an investigation that resulted in a 57-count indictment. A jury convicted
O’Hagan on all counts and he was sentenced to 41-months imprisonment. A divided
Court of Appeals reversed, holding that liability under § 10(b) and Rule 10b-5 could not
be grounded on the misappropriation theory of securities fraud on which the prosecution
48
Each option gave him the right to purchase 100 shares of Pillsbury stock by a specified date in September
1988.
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relied and that Rule 14e-3(a)–which prohibits trading while in possession of material,
nonpublic information relating to a tender offer–exceeds the SEC’s § 14(e) rulemaking
authority because the rule contains no breach of fiduciary duty requirement.
2. Under the “traditional” or “classical theory” of insider trading liability, § 10(b) and Rule
10b-5 are violated when a corporate insider trades the securities of his corporation on the
basis of material, nonpublic information. Trading on such information qualifies as a
“deceptive device” under § 10(b), the Court has affirmed, 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 with that corporation.
a. The classical theory applies not only to officers, directors, and other permanent
insiders of a corporation, but also to attorneys, accountants, consultants, and
others who temporarily become fiduciaries of a corporation.
3. The “misappropriation theory” holds that a person commits fraud in connection with a
securities transaction, and thereby violates § 10(b) 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.
a. Under this theory, a fiduciary’s undisclosed, self-serving use of a 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. In
lieu of premising liability on a fiduciary relationship between company insider
and purchaser or seller of the company’s stock, the misappropriation theory
premises liability on a fiduciary-turned-trader’s deception of those who entrusted
him with access to confidential information.
4. The two theories are complementary, each addressing efforts to capitalize on nonpublic
information through the purchase or sale of securities.
a. The classical theory targets a corporate insider’s breach of duty to shareholders
with whom the insider transacts.
b. The misappropriation theory outlaws trading on the basis of nonpublic
information by a corporate “outside” in breach of a duty owed not to a trading
party, but to the source of information.
(1) The misappropriation theory is thus designed to protect the integrity of
the securities markets against abuses by outsiders to a corporation who
have access to confidential information that will affect the corporation’s
security price when revealed, but who owe not fiduciary or other duty
to that corporation’s shareholders.49
5. The Court agrees with the Government that misappropriation, as just defined, satisfies §
10(b)’s requirement that chargeable conduct involve a “deceptive device or contrivance”
use “in connection with” the purchase or sale of securities.
a. Misappropriators deal in deception. A fiduciary who pretends loyalty to the
principal while secretly converting the principal’s information for personal gain
dupes of defrauds the principal.
b. Full disclosure forecloses liability under the misappropriation theory: Because the
deception essential to the misappropriation theory involves feigning fidelity to the
source of 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 may remain liable under state law
for breach of a duty of loyalty.
6. The element that the misappropriator’s deceptive use of information be “in connection
with the purchase or sale of a security is also satisfied because the fiduciary’s fraud is
consummated, not when the fiduciary gains the confidential information, but when,
49
The Government could not have prosecuted O’Hagan under the classical theory, for O’Hagan was no an
“insider” of Pillsbury, the corporation in whose stock he traded.
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without disclosure to his principal, he uses the information to purchase or sell securities.
a. The securities transaction and the breach of duty thus coincide. This is so even
though the person or entity defrauded is not the other party to the trade, but is,
instead, the source of the nonpublic information.
b. A misappropriator who trades on the basis of material, nonpublic information, in
short, gains his advantageous market position through deception; he deceives the
source of the information and simultaneous harms members of the investing
public.
F. Supreme Court’s Previous Consideration of Misappropriation Theory. The Supreme Court in Carpenter v.
United States (1987), affirmed R. Foster W inans’ convictions on all counts, though the securities
fraud count was affirmed only by an evenly divided court (4-4). W inans published the Wall Street
Journal’s “Heard on the Street” column which provided investing advice and information. The
column had a short-lived effect on the price of stocks it covered. Though it was the Journal’s
policy to keep the contents of the column confidential before publication, W inans disclosed the
contents of his columns to several friends who then traded the affected stocks.
G. Rule 10b5-2. Rule 10b5-2 provides “a non-exclusive list of three situations in which a person has a
duty of trust or confidence for purposes of the ‘misappropriation’ theory.”
1. First, such a duty exists whenever someone agrees to maintain information in confidence.
2. Second, such a duty exists between two people who have a pattern or practice of sharing
confidences such that the recipient of the information knows or reasonable should know
that the speaker expects the recipient to maintain the information’s confidentiality.
3. Third, such a duty exists when someone receives or obtains material nonpublic
information from a spouse, parent, child, or sibling.
VI. Short-Swing Profits
A. Reliance Electric Co. v. Emerson Electric Co. (S. Ct. 1972).
1. Section 16(b) of the Securities Act of 1934 provides, among other things, that a
corporation may recover for itself the profits realized by an owner of more than 10% of its
shares from a purchase and sale of its stock within any six-month period, provided that the
owner held more than 10% “both at the time of the purchase and sale.”
2. The history and purpose of § 16(b) have been exhaustively reviewed by federal courts on
several occasions since its enactment in 1934.
a. Those courts have recognized that the only method Congress deemed effective to
curb the evils of insider trading was a flat rule taking the profits out of a class of
transactions in which the possibility of abuse was believed to be intolerably great.
b. Congress did not reach every transaction in which an investor actually relies on
inside information. A person avoids liability is he does not meet the statutory
definition of an “insider,” or if he sells more than six months after purchase.
3. Among the “objective standards” contained in § 16(b) is the requirement that a 10%
owner be such “both at the time of the purchase and sale ... of the security involved.”
a. Read literally, this language clearly contemplates that a statutory insider might sell
enough shares to bring his holdings below 10%, and later–but still within six
months–sell additional shares free from liability under the statute.
(1) Indeed, commentators on the securities law have recommended this
exact procedure for a 10% owner who, like Emerson, wishes to dispose
of his holders within six months of their purchase.
B. Foremost-McKesson, Inc. v. Provident Securities Company (S. Ct. 1976).
1. Issue. W hether a person purchasing securities that put his holdings above the 10% level is a
beneficial owner “at the time of the purchase” so that he must account for profits realized
on a sale of those securities within six months.
2. Section 16(b) provides that a corporation may capture for itself the profits realized on a
purchase and sale, or sale and purchase, of its securities within six months by a director,
officer, or beneficial owner.
3. Section 16(b)’s last sentence, however, provides that it “shall not be construed to cover any
transaction where such beneficial owner was not such both at the time of the purchase and
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“A trustee is held to something stricter than the morals of the marketplace.” Meinhard v. Salmon.
51
The court also concludes, in the alternative, that the agreement was invalid because at the time of the
contract, McQuade was also a city magistrate. A New York City criminal statute prohibited from holding other
employment during his government service.
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doctrine that there may be no variation, however slight or innocuous, from that
norm, where salaries or policies or the retention of individuals in office are
concerned?
b. Basis of McQuade Nebulous. Apart from its practical administrative convenience,
the reasons upon which it is said to rest are more or less nebulous. Public policy,
the intention of the Legislature, detriment to the corporation, are phrases which
in this connection mean little. Possible harm to bona fide purchasers of stock or
to creditors or to stockholding minorities have more substance; but such harms
are absent in many instances.
c. No Harm in Agreements. If the enforcement of a particular contract damages
nobody-not even, in any perceptible degree, the public-one sees no reason for
holding it illegal, even though it impinges slightly upon the broad provision of §
27.
3. Directors as Sole Stockholders–Agreement Enforceable. Where the directors are the sole
stockholders, there seems to be no objection to enforcing an agreement among them to
vote for certain people as officers. There is no direct decision to that effect in this court,
yet there are strong indications that such a rule has long been recognized.
4. Agreement Did Not Sterilize the Board. Except for the broad dicta in the McQuade opinion,
we think there can be no doubt that the agreement here in question was legal and that the
complaint states a cause of action. There was no attempt to sterilize the board of directors,
as in the Manson and McQuade cases.
5. McQuade Confined to Its Facts. If there was any invasion of the powers of the directorate
under that agreement, it is so slight as to be negligible; and certainly there is no damage
suffered by or threatened to anybody. The broad statements in the McQuade opinion,
applicable to the facts there, should be confined to those facts.
G. Agreements Requiring Election of Directors. Agreements by which the shareholders simply commit to
electing themselves, or their representatives , as directors, are generally considered unobjectionable,
and are now expressly validated in many jurisdictions. They do not interfere with the obligations of
the director to exercise their sound judgment in managing the affairs of the corporation.
1. Agreements Requiring Appointment of Particular Officers/Employees. The courts have had 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.
H. Voting Trust. Another device that can be used for control is the voting trust, a device specifically
authorized by the corporation laws of most states. W ith a voting trust, shareholders who which to
act in concert turn their shares over to a trustee. The trustee then votes all the shares, in accordance
with instructions in the document establishing the trust.
1. The general requirements for creating a voting trust are as follows: (1) a written agreement,
signed by the trustees and the beneficiary; (2) property is conveyed into the trust, i.e., the
shareholders transfer some or all of their shares to the trustee; (3) the books of the
corporation are changed to reflect that the trustees have the right to vote the stock; and (4)
the voting trust issues certificates to the beneficiaries.
a. Early Hostility. Early courts were hostile to voting trusts because they separated
shareholders’ voting power and economic ownership interests. Today, statutes
specifically authorize voting trusts in virtually all jurisdictions.
(1) MBCA § 7.30 sets a maximum term for such a trust at ten years. This is
in contrast with the Delaware corporation law which does not contain a
sunset provision.
b. W hy a Voting Trust? (1) Provides cohesion and certainty to management in large
companies with a large number of shareholders; (2) Regulatory agencies want
assurance that control of the business isn’t transferred without consent; (3)
Closely-held family corporations; (4) Creditors may insist as a condition of
making loan the power along with the power to appoint trustee.
2. Proxy. A written grant of authority that grants the right to vote stock.
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MBCA § 7.22(d) gives a catalog of people who will be deemed to hold a suitable “interest”: (1) a pledgee
(e.g., a holder pledges his share in return for a loan from bank, and gives bank, the pledgee, his proxy); (2) a person
who has purchased or agreed to purchase the shares; (3) a creditor of the corporation (e.g., creditor says he won’t give credit to
corporations unless the controlling shareholder gives creditor a proxy that’s irrevocable while the debt is outstanding;
and a party to a voting agreement (e.g., A, B, and C are the shareholders in a closely-held corporation; they sign a voting
agreement to vote their shares together, which impliedly gives the two shareholders in the majority on any ballot an
irrevocable proxy to vote the shares of the third).
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his ‘express will at any time’ and recover his share of partnership assets and accumulated
profits. By contrast, the stockholder in the close corporation or ‘incorporated partnership’
may achieve dissolution and recovery of his share of the enterprise assets only by
compliance with the rigorous terms of the applicable chapter of the General Laws.
a. The minority stockholders may be trapped in a disadvantageous situation. No
outsider would knowingly assume the position of the disadvantage minority. The
outsider would have the same difficulties. This is the capstone of the majority
plan. Majority ‘freeze-out’ schemes which withhold dividends are designed to
compel the minority to relinquish stock at inadequate prices.
6. Close Corp. Stockholders Owe One Another Fid. Duty. Because of the fundamental
resemblance of the close corporation to the partnership, the trust and confidence which are
essential to this scale and manner of enterprise, and the inherent danger to minority
interests in the close corporation, the court holds that 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.
7. Equal Opportunity in a Close Corporation. W e hold that, in any case in which the
controlling stockholders have exercised their power over the corporation to deny the
minority such equal opportunity, the minority shall be entitled to appropriate relief.
a. Remedy. (1) The judgment may require Rodd to remit $36,000 with interest at
the legal rate to Rodd Electrotype in exchange for forty-five shares of Rodd
Electrotype treasury stock or (2) The judgment may require Rodd Electrotype to
purchase all of the plaintiff’s shares for $36,000 without interest.
B. W ilkes v. Springside Nursing Home, Inc. (Mass. 1976).
1. Facts. Four men (W ilkes, Riche, Quinn, and Pipkin) each invested $1,000 and acquired
10 shares of a Mass. corp. called Springdale, which was incorp. for the purpose of running
a nursing home out of an old hospital. It was understood by the four parties, at the time of
incorp., that they would each participate in management of the corp. It was also
understood that they would receive money in equal amounts as long as each assumed his
responsibility. The business became profitable. In ‘59, Pipkin sold his shares to Connor,
president of F.N. Agr. Bank, due to illness. In ‘65, Quinn purchased a portion of the
corp. property. W ilkes apparently helped inflate the price and his and Quinn’s relationship
deterioated. W ilkes was not given a salary when the board exercised its right to establish
them and not reelected as a director or officer at the ‘67 annual meeting. He was informed
his presence was not welcome. The master found that this exclusion was not due to
neglect or misconduct but rather because of bad personal relationships.
2. In Donahue, we held that “stockholders in the corporation owe one another substantially
the same fiduciary duty in the operation of the enterprise that partners own to one
another.”
a. As determined in previous decisions of this court, the standard of duty owed by
partners to one another is one of “utmost good faith and loyalty.”
3. Thus, we concluded in Donahue, with regard to “their actions relative to the operations of
the enterprise and the effects of that operation on the rights and investments of other
stockholders, [s]tockholders in close corporations must discharge their management and
stockholder responsibilities in conformity with this strict good faith standard. They may
not act out of avarice, expediency, or self-interest in derogation of their duty of loyalty to
the other stockholders and to the corporation.”
a. Freeze-Outs. In the Donahue case we recognized that one peculiar aspect of close
corporations was the opportunity afforded to majority stockholders to oppress,
disadvantage or “freeze out” minority stockholders. 53
53
In Donahue itself, for example, the majority refused the minority an equal opportunity to sell a ratable
number of shares to the corporation at the same price available to the minority. The net result of this refusal was that
the minority could be forced to “sell out at less than fair value,” since there is by definition no ready market for
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nominated herself for director. Jordan and Barbuto voted against her election. She also
asked for a valuation of the company, which was denied.
2. “Stockholders in a close corporation own one another substantially the same fiduciary duty
in the operation of an enterprise that partners owe one another. That is, a duty of “utmost
good faith and loyalty.” Donahue v. Rodd Electrotype Co. Of New England.
a. Majority shareholders in a close corporation violate this duty when they act to
“freeze-out” the minority.
(1) Freeze Outs. The squeezers [those who employ the freeze-out
techniques] may refuse to declare dividends; they may drain off the
corporation's earnings in the form of exorbitant salaries and bonuses to
the majority shareholder-officers and perhaps to their relatives, or in the
form of high rent by the corporation for property leased from majority
shareholders; they may deprive minority shareholders of corporate
offices and of employment by the company; they may cause the
corporation to sell its assets at an inadequate price to the majority
shareholders.
(a) W hat these examples have in common is that, in each, the
majority frustrates the minority's reasonable expectations of
benefit from their ownership of shares.
b. Shareholder’s Reasonable Expectations. W e have previously analyzed freeze-outs in
terms of shareholders' “reasonable expectations” both explicitly and implicitly. See
Bodio v. Ellis Mass. 1987) (thwarting minority shareholder's “rightful expectation”
as to control of close corporation was breach of fiduciary duty); W ilkes v.
Springside Nursing Home, Inc. (Mass. 1976) (denying minority shareholders
employment in corporation may “effectively frustrate [their] purposes in entering
on the corporate venture”).
(1) A number of other jurisdictions, either by judicial decision or by statute,
also look to shareholders' “reasonable expectations” in determining
whether to grant relief to an aggrieved minority shareholder in a close
corporation.
3. Remedy for Freezed Out Minority Shareholder. The proper remedy for a freeze-out is to
restore the minority shareholder as nearly as possible to the position she would have been
in had there been no wrongdoing.
a. If, for example, a minority shareholder had a reasonable expectation of
employment by the corporation and was terminated wrongfully, the remedy may
be reinstatement, back pay, or both.
b. Similarly, if a minority shareholder has a reasonable expectation of sharing in
company profits and has been denied this opportunity, she may be entitled to
participate in the favorable results of operations to the extent that those results
have been wrongly appropriated by the majority.
E. Smith v. Atlantic Properties, Inc. (Mass. App. 1981).
1. Facts. W olfson purchased property in ‘51 for $350,000 ($50,000 down and a note, payable
in 33 months, for the remainder). He offered a 1/4th interest in the property to Smith,
Zimble, and Burke, who each paid $12,500. Smith, an attorney, organized Atlantic to
operate the property. Each of the four investors received 25 shares. The articles of
incorporation and by-laws included an 80% provision and had the effect of giving any one
of the investors a veto in corporate decisions. Atlantic, after selling some assets, retained
about 28 acres. Atlantic showed a profit during subsequent years and the mortgage was
paid. Disagreements arose between W olfson and the other stockholders as a group.
W olfson desired repairs to structures on the property, the other stockholders desired
dividends. He exercise his veto power in spite of potential IRS penalties–which were
soon assessed in ‘62, ‘63, and ‘64. Further penalties were assessed in ‘65, ‘66, ‘67, and ‘68.
2. Donahue Rule. The court in Donahue relied on the resemblance of a close corporation to a
partnership and held that stockholders in the close corporation owe one another
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substantially the same fiduciary duty in the operation of the enterprise that partners owe to
one another. That standard, the court said, was the utmost duty of good faith and loyalty.
The court went on to say that such stockholders may not act out of avarice, expediency, or
self-interest in derogation of their duty of loyalty to the other stockholders and to the
corporation.
3. Majority Shareholders May Seek Protection. In the Donahue case, the court recognized that
cases may arise in which, in a close corporation, majority stockholders may ask protection
from a minority stockholder.
a. Such an instance arises in the present case because Dr. Wolfson has been able to
exercise a veto concerning corporate action on dividends by the 80% provision
(in Atlantic's articles or organization and by-laws) already quoted. The 80%
provision may have substantially the effect of reversing the usual roles of the
majority and the minority shareholders. The minority, under that provision,
becomes an ad hoc controlling interest.
4. W hatever may have been the reason for Dr. W olfson's refusal to declare dividends (and
even if in any particular year he may have gained slight, if any, tax advantage from
withholding dividends) we think that he recklessly ran serious and unjustified risks of
precisely the penalty taxes eventually assessed, risks which were inconsistent with any
reasonable interpretation of a duty of “utmost good faith and loyalty.
F. Nixon v. Blackwell (Del. 1993). 54
1. The tools of good corporate practice are designed to give a purchasing minority
stockholder the opportunity to bargain for protection before parting with consideration. It
would do violence to normal corporate practice and our corporation law to fashion an ad
hoc ruling which would result in a court-imposed stockholder buy-out for which the
parties had not contracted.
2. It would be inappropriate judicial legislation for this Court to fashion a special
judicially-created rule for minority investors when the entity does not fall within those
statutes, or when there are no negotiated special provisions in the certificate of
incorporation, by-laws, or stockholder agreements.
G. Jordan v. Duff and Phelps, Inc. (7th Cir. 1988).
1. Facts. Jordan began work at Duff in ‘77. By ‘83 he had purchased 188 of 20,100 shares
outstanding. The shares were purchased at book value and he was required to sign an
agreement before purchase. The agreement provided that upon certain events, the
corporation would buy back the stock. A board resolution, however, provided an
exception allowing the stock to be kept for five years after termination. Jordan, seeking a
move because of family strife, inquired about transferring and was denied. Jordan
subsequently took a job in Houston. He finished the year out at Duff, however, to have
his stock valued at the end of the year. A merger between Duff and SP was soon
announced however, after Jordan had received a check for his stock. His stock would
have been valued much higher under the merger. He refused to cash the check and asked
for his stock back. This was denied and he filed suit. The merger, nevertheless, fell
through after the Fed disapproved. Jordan amended his complaint to ask for rescission
rather than damages.
2. Close corporations buying their own stock, like knowledgeable insiders of closely held
firms buying from outsiders, have a fiduciary duty to disclose material facts. The “special
facts” doctrine developed by several courts at the turn of the century is based on the
54
The equal opportunity rule is at odds with the premise that equity investments in the corporation are
permanent and are not subject to easy withdrawal, as in a partnership. That is, parties often choose the corporate form
because it assures the stability of corporate resources. Shareholders can withdraw their investment only by selling to
another investor. Based on this, some recent courts have refused to infer partnership-type duties in close corporations
of the theory that parties could have contracted for them and, absent an agreement, corporate principles apply. Nixon
v. Blackwell is representative of this trend.
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principle that insiders in closely held firms may not buy stock from outsiders in
person-to-person transactions without informing them of new events that substantially
affect the value of the stock.
a. Because the fiduciary duty is a standby or off-the-rack guess about what parties
would agree to if they dickered about the subject explicitly, parties may contract
with greater specificity for other arrangements. It is a violation of duty to steal
from the corporate treasury; it is not a violation to write oneself a check that the
board has approved as a bonus.
(1) No Agreement, Express or Implied, Regarding No Duty to Disclose. The
stock was designed to bind Duff & Phelps's employees loyalty to the
firm. The buy-sell agreement tied ownership to employment. The
Agreement did not ensure that employees disregard the value of the
stock when deciding what to do, and neither did the usual practice at
Duff & Phelps. So the possibility that a firm could negotiate around the
fiduciary duty does not assist Duff & Phelps; it did not obtain such an
agreement, express or implied.
(2) Employment at will is still a contractual relation, one in which a
particular duration (“at will”) is implied in the absence of a contrary
expression. The silence of the parties may make it necessary to imply
other terms-those we are confident the parties would have bargained for
if they had signed a written agreement. One term implied in every
written contract and therefore, we suppose, every unwritten one, is that
neither party will try to take opportunistic advantage of the other. “The
fundamental function of contract law (and recognized as such at least
since Hobbes's day) is to deter people from behaving opportunistically
toward their contracting parties, in order to encourage the optimal
timing of economic activity and to make costly self-protective measures
unnecessary.”
3. Dissent. The mere existence of a fiduciary relationship between a corporation and its
shareholders does not require disclosure of material information to the shareholders. A
further inquiry is necessary, and here must focus on the particulars of Jordan’s relationship
with Duff and Phelps.
a. Jordan’s deal with Duff and Phelps required him to surrender his stock at book
value if he left the company. It didn’t matter whether he quit or was fired,
retired, or died; the agreement is explicit on these matters. The majority
hypothesizes about “implicit parts of the relations between Duff & Phelps and its
employees. But those relations are totally defined by:
(1) The absence of an employment contract, which made Jordan an
employee at will
(2) The shareholder agreement, which has no “implicit parts” that bear on
Duff & Phelps’ duty to Jordan, and explicitly tie his rights as a
shareholder to his status as an employee
(3) A provision in the stock purchase agreement between Jordan and Duff
& Phelps that “nothing herein contained shall confer on the Employee
any right to be continued in the employment of the Corporation.”
V. Control, Duration, and Statutory Dissolution
A. Dissolution
1. Voluntary. In a corporation, a minority shareholder cannot dissolve the corporation. This
requires a board proposal and majority shareholder approval. See MBCA § 14.02. 55
Articles of dissolution are then filed with the Secretary of State.
2. Administrative. The corporation is dissolved for failure to pay its franchise taxes. The
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Two-thirds is required in some jurisdictions.
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corporation can, however, pay its back taxes and be reinstated (resurrected). See Ark.
Code Ann. § 4-27-1420 et seq.
3. Judicial. Modern corporate statutes provide a minority shareholder another
option–involuntary dissolution. The minority shareholder can ask a court to dissolve a
corporation, and she would receive a final disposition after the corporation’s assets are
liquidated and its affairs are wound up. A court in its discretion56 may order involuntary
dissolution if the shareholder shows one of the statutory grounds:
a. Board Deadlock. The directors cannot agree and the shareholders have been
unable to break the impasse on the board–and the corporation’s business is
suffering as a result (irreparable injury to the corporation threatened or suffered).
b. Misconduct. Those in control have acted in a way that is “illegal, oppressive, or
fraudulent.” See MBCA § 14.30(2)(iv).
(1) Oppressive. Most litigation is over the meaning of oppression.
(a) Unfairness.
c. Shareholder Deadlock. The shareholders are deadlocked–that is, the shareholders
have been unable to elect new directors for a specified period, such as two
consecutive meetings. See MBCA § 14.30(2)(iii)
(a) Arkansas courts have tied oppression to reasonable expectations
of the minority shareholder. Smith v. Leonard, 317 Ark. 182,
876 S.W .2d 266 (1994).57
B. Alaska Plastics, Inc. V. Coppock (Alaska 1980).
1. No Market For Close Corp. Shares. In a corporation with publicly traded stock, dissatisfied
shareholders can sell their stock on the market, recover their assets, and invest elsewhere.
In a close corporation there is not likely to be a ready market for the corporation's shares.
a. The corporation itself, or one of the other individual shareholders of the
corporation, who are likely to provide the only market, may not be interested in
buying out another shareholder. If they are interested, majority shareholders who
control operate policy are in a unique position to “squeeze out” a minority
shareholder at an unreasonably low price.
2. From a dissatisfied shareholder's point of view, the most successful remedy is likely to be a
requirement that the corporation buy his or her shares at their fair value. Ordinarily, there
are four ways in which this can occur:
a. Articles of Incorporation. First, there may be a provision in the articles of
incorporation or by-laws that provide for the purchase of shares by the
corporation, contingent upon the occurrence of some event, such as the death of
a shareholder or transfer of shares.
b. Involuntary Dissolution. Second, the shareholder may petition the court for
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Therefore, shareholders are not entitled to dissolution even if they prove a ground to do so. Courts are
reluctant to dissolve a corporation: (1) dissolution is the ultimate form of corporate punishment, and (2) courts fear
that corporations, if dissolved, will be sold piecemeal and become worthless.
57
Court considers "oppressive actions to refer to conduct that substantially defeats the 'reasonable
expectations' held by minority shareholders in committing their capital to the particular enterprise. A shareholder
who reasonably expected that ownership would lead him or her to a job, a share of corporate earnings, a place in
corporate management, or some other form of security, would be oppressed in a very real sense when others in the
corporation seek to defeat those expectations and there exists no effective means of salvaging the investment."
A court considering a claim of oppression "must investigate what the majority shareholders knew, or should
have known, to be the petitioner's expectations in entering the particular enterprise. Majority conduct should not be
deemed oppressive simply because the petitioner's subjective hopes and desires in joining the venture are not fulfilled.
Disappointment alone should not necessarily be equated with oppression."
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“Because of the fundamental resemblance of the close corporation to the partnership, the trust and
confidence which are essential to this scale and manner of enterprise, and the inherent danger to minority interests in
the close corporation, we hold that 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. In our previous decisions, we have
defined the standard of duty owed by partners to one another as the ‘utmost good faith and loyalty.’ ” Donahue.
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6. Trial Court’s Remedy Inappropriate. W e are not aware of any authority which would allow a
court to order specific performance on the basis of an unaccepted offer, particularly on
terms totally different from those offered. Such a rule would place a court in the impossible
position of making and enforcing contracts between unwilling parties.
a. Appropriate Remedy–Equal Opportunity. Donahue and Ahmanson suggest the
appropriate form of a remedy, however. In Donahue the court stated that where a
controlling shareholder took advantage of a special benefit, the fiduciary duty
owed to the other shareholders required that the corporation offer such a benefit
equally: “The rule of equal opportunity in stock purchases by close corporation
provide equal access to these benefits for all stockholders.”
7. Derivative Suit Claim/Business Judgment Rule. Judges are not business experts, a fact which
has become expressed in the so-called “business judgment rule.” The essence of that
doctrine is that courts are reluctant to substitute their judgment for that of the board of
directors unless the board’s decisions are unreasonable.
a. Unfair Distribution of Corp. Funds W ill Trump Bus. Judg. Rule. If a stockholder is
being unjustly deprived of dividends that should be his, a court of equity will not
permit management to cloak itself in the immunity of the business judgment rule.
Thus, there is authority for concluding that an unfair distribution of corporate
funds would be a proper subject for a derivative suit.
C. Meiselman v. Meiselman (N.C. 1983).
1. North Carolina statute allowed a court to order dissolution where such relief was
“reasonably necessary for the protection of the rights and interests of the complaining
shareholder.” As an alternative, the court could order a buy-out of the complaining
shareholder’s shares.
2. Reasonable Expectations. The Supreme Court held that, at least in cases involving close
corporations, the complaining shareholder need not establish oppressive or fraudulent
conduct by the controlling shareholder or shareholders. Instead, “rights and interest,”
under the statute include “reasonable expectations,” which include expectations that the
minority shareholder will participate in the management of the business or be employed by
the company but limited to expectations embodied in understandings, express or implied,
among the participants.
D. Note on Limited Liability Companies
1. Under the Delaware Limited Liability Co. Act § 18-604:
[U]pon resignation any resigning member is entitled to receive any distribution to which such member
is entitled under a limited liability company agreement and, if not otherwise provided in a limited
liability company agreement, such member is entitled to receive, within a reasonable time after
resignation, the fair value of such member's limited liability company interest as of the date of
resignation based upon such member's right to share in distributions from the limited liability
company.
2. Thus, while in a corporation the default rule generally will be one of no right of
dissolution or buyout, under the LLC default rule members are granted that right.
E. Haley v. Talcott (Del. Ch. 2004).
1. Facts. Haley and Talcott were members of Greg Real Estate, LLC, which owned the land
that a second company, Delaware Seafood (a.k.a. Redfin Grill), occupied. Haley and
Talcott chose to create and operate the Redfin Grill as an entity solely owned by Talcott.
However, due to a series of contracts between the two, the relationship was more similar
to a partnership than a typical employer/employee relationship. The business grew into a
profitable one. The two parties exercised an option to purchase the land on which the
business was situated and both signed personal guaranties for the mortgage. A rift evolved
between the two due to Haley’s expectance to receive a share in the Redfin Grill. Letters
were exchange, revolving around Haley’s alleged resignation. A stalemate ensued due to
Haley’s mere 50% interest in the LLC. While the agreement contained a detailed exit
mechanism, it did not express any details about releasing the party from the personal
guaranty or whether the party could resort to judicial dissolution in lieu of the exit
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The relevant portion of § 273(a) reads: If the stockholders of a corporation of this State, having only 2
stockholders each of which own 50% of the stock therein, shall be engaged in the prosecution of a joint venture and if
such stockholders shall be unable to agree upon the desirability of discontinuing such joint venture and disposing of
the assets used in such venture, either stockholder may, unless otherwise provided in the certificate of incorporation of
the corporation or in a written agreement between the stockholders, file with the Court of Chancery a petition stating
that it desires to discontinue such joint venture and to dispose of the assets used in such venture in accordance with a
plan to be agreed upon by both stockholders or that, if no such plan shall be agreed upon by both stockholders, the
corporation be dissolved.
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F. Pedro v. Pedro (Minn. App. 1992).
1. Closely Held Corp. Shareholders Analogous to Partners. The relationship among shareholders
in closely held corporations is analogous to that of partners. Shareholders in closely held
corporations owe one another a fiduciary duty. In a fiduciary relationship “the law imposes
upon them highest standards of integrity and good faith in their dealings with each other.”
Owing a fiduciary duty includes dealing “openly, honestly and fairly with other
shareholders.”
2. Inasmuch as appellants’ breaches of fiduciary duty forced the buyout, they cannot benefit
from wrongful treatment of their fellow shareholder and must disgorge any such gain.
a. Breach of Fiduciary Duty. Appellants claim no breach of fiduciary duty can exist
because there has been no diminution in the value of the corporation or the stock
value of respondent's shares. In support of this assertion, appellants cite several
cases where actions by an officer or director did reduce the value of the
corporation, constituting a breach of fiduciary duty.
(1) An action depleting a corporation's value is not the exclusive method of
breaching one's fiduciary duties. Moreover, loss in value of a
shareholder's stock is not the only measure of damages.
3. Damages Calculation. Moreover, the measure of damages for the buyout was proper.
a. If the fair value of the shares is greater than the purchase price for the buyout as
calculated from the formula in the SRA, the difference is the measure of
respondent's damage resulting from having been forced to sell his shares in the
company.
4. Lifetime Employment. Minnesota statute provides, “In determining whether to order
equitable relief, dissolution, or a buy-out, the court shall take into consideration the duty
which all shareholders in a closely held corporation owe one another to act in an honest,
fair and reasonable manner in the operation of the corporation and the reasonable
expectations of the shareholders as they exist at the inception and develop during the
course of the shareholders' relationship with the corporation and with each other.”
a. Employment Part of Reasonable Expectations. This section allows courts to look to
respondent's reasonable expectations when awarding damages. In addition to an
ownership interest, the reasonable expectations of such a shareholder are a job,
salary, a significant place in management, and economic security for his family.
b. Double Recovery? Even appellants concede respondent has two separate interests,
as owner and employee. Thus, allowing recovery for each interest is appropriate
and will not be considered a double recovery.
G. Stuparich v. Harbor Furniture Mfg., Inc. (Cal. App. 2000).
1. Issue. The issue is whether plaintiffs raised a triable issue of material fact as to whether
dissolution is “reasonably necessary” to protect their rights or interests.
2. On this undisputed record, we cannot say that the trial court erred in finding as a matter of
law, that the drastic remedy of liquidation is not reasonably necessary for the protection of
the rights or interests of the complaining shareholder or shareholders.
VI. Transfer of Control
A. Frandsen v. Jensen-Sundquist Agency, Inc. (7th Cir. 1986).
1. Merger Not a Sale. A sale of stock was never contemplated. The transaction originally
contemplated was a merger of Jensen-Sundquist into First W isconsin. In a merger, as the
word implies, the acquired firm disappears as a distinct legal entity. In effect, the
shareholders of the merged firm yield up all of the assets of the firm, receiving either cash
or securities in exchange, and the firm dissolves. In this case, the shareholders would have
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The result in this case is curious because the court finds a breach of fiduciary duty to make up the
difference between the SRA buyout price and the fair market value of the shares. The Minnesota statute, however,
explicitly states that the court may order a buy-out of the shares of either party at “fair value” is “those in control have
acted fraudulently, illegally, or in a manner unfairly prejudicial toward one or more shareholders.”
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received cash. Their shares would have disappeared but not by sale, for in a merger the
shares of the acquired firm are not bought, they are extinguished.
a. The distinction between a sale or shares and a merger is such a familiar one in the
business world that it is unbelievable that so experienced a businessman as
Frandsen would have overlooked it.
b. A sale of the majority bloc’s shares is not the same thing as a sale of either all or
some of the holding company’s assets. The sale of assets does not result in
substituting a new majority bloc, and that is the possibility at which the protective
provisions are aimed.
B. Zetlin v. Hanson Holdings, Inc. (N.Y. 1979).
1. Premium Price for Majority Shares. Absent looting of corporate assets, conversion of a
corporate opportunity, fraud or other acts of bad faith, a controlling shareholder is free to
sell, and a purchaser is free to buy, that controlling interest at a premium price.
a. Premium Price is for Privilege of Controlling Corp. Certainly, minority shareholders
are entitled to protection against such abused by controlling shareholders. They
are not entitled, however, to inhibit the legitimate interests of the other
stockholders. It is for this reason that control shares usually command a premium
price. The premium is the added amount an investor is willing to pay for the
privilege of directly influencing the corporation’s affairs.
C. Perlman v. Feldmann (2d. Cir. 1955).
1. Facts. Feldmann owned 32% of the shares of Newport Steel and sold his shares for $20 per
share–a two-thirds premium over the then-market price of $12. A minority shareholder
brought a derivative suit claiming Feldmann had sold a corporate asset, namely Newport’s
steel supplies, during the Korean W ar’s steel shortage, when steel prices were controlled
and access to steel commanded a premium. Feldmann had invented a way to skirt the
price controls (known in the industry as the “Feldmann Plan”) by having buyers make
interest-free advances to obtain supply commitments. The buyer (W ilport), a syndicate of
steel end-users, wanted Newport’s steel supplies free of the Feldmann plan. The court
held that Feldmann had breached a fiduciary duty to the corporation because his sale of
control sacrificed the favorable cash flow generated by the Feldmann Plan.
2. Both as director and as dominant stockholder, Feldmann stood in a fiduciary relationship
to the corporation and to the minority stockholders as beneficiaries thereof.
3. It is true that this is not the ordinary case of breach of fiduciary duty. W e have here no
fraud, no misuse of confidential information, no outright looting of a helpless corporation.
a. But on the other hand, we do not find compliance with that high standard which
we have just stated and which we and other courts have come to expect and
demand of corporate fiduciaries. The actions of defendants in siphoning off for
personal gain corporate advantages to be derived from a favorable market
situation do not betoken the necessary undivided loyalty owed by the fiduciary to
his principal.
b. W e do not mean to suggest that a majority stockholder cannot dispose of his
controlling bloc to outsiders without having to account to his corporation for
profits or even never do this with impunity the buyer is an interested customer,
actual or potential, for the corporation’s product. But when the sale necessarily
results in a sacrifice of this element of corporate good will and consequent
unusual profit to the fiduciary who has caused the sacrifice, he should account for
his gains.
c. So in a time of market shortage, where a call on a corporation’s product
commands an unusually large premium, in one form or another, we think it
sound law that a fiduciary may not appropriate to himself the value of this
premium.
4. Dissent. Concededly, a majority or dominant shareholder is ordinarily privileged to sell his
stock at the best price obtainable from the purchaser. In so doing he acts on his own
behalf, not as an agent of the corporation. If he knows or has reason to believe that the
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See also Handout on Mergers and Acquisitions: Diagrams.
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(1) One advantage of assets acquisition is that the acquiring corporation does
not succeed to unforeseen liabilities of the acquire 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).
(a) There is authority, however for holding an acquiring
corporation in an assets acquisition liable for product liabilities
of the acquired corporation that did not arise until years after
the asset transfer. See, e.g., Knapp v. North American Rockwell
Corp. (3d. Cir. 1974).
(2) Corp B will be left with nothing but shares of Corp. A. Ordinarily, it
would then liquidate and distribute the share to its shareholders. Corp.
B would cease to exist.
3. Farris v. Glen Alden Corporation (Pa. 1958). 62
a. Facts. Glen Alden acquired the assets of List in a stock-for-assets exchange
approved by both companies’ boards and the List shareholders, but not the Glen
Alden shareholders. The transaction doubles the assets of Glen Alden, increased
its debt sevenfold, and left its shareholders in a minority position. To
b. W hen use of the corporate form of business organization first became widespread,
it was relatively easy for courts to define a “merger” or a “sale of assets” and to
label a particular transaction as one or the other.
(1) But prompted by the desire to avoid the impact of adverse, and to
obtain the benefits of favorable, government regulations, particularly
federal tax laws, new accounting and legal techniques were developed by
lawyers and accountants which interwove the elements characteristic of
each, thereby creating hybrid forms of corporate amalgamation. Thus, it
is no longer helpful to consider an individual transaction in the abstract
and solely by reference to the various elements therein determine
whether it is a “merger” or a “sale.”
(2) Instead, to determine properly the nature of a corporate transaction, we
must refer not only to all the provisions of the agreement, but also to the
consequences of the transaction and to the purposes of the provisions of
corporate law said to be applicable.
c. Appraisal Rights. Section 908(A) of the Penn. Bus. Corp. Law provides: “If any
shareholder of a domestic corporation which becomes a party to a plan or merger
or consolidation shall object to such plan of merger or consolidation, such
shareholder shall be entitled to ... [the fair value of his shares upon surrender of
the share certificate or certificates representing his shares].”
d. Fundamental Change? Does the combination outlined in the present
“reorganization” agreement so fundamentally change the corporate character of
Glen Alden and the interest of the plaintiff as a shareholder therein, that to refuse
him the rights and remedies of a dissenting shareholder would in reality force him
to give up his stock in one corporation and against his will accept shares in
another?
(1) If so, the combination is a merger within the meaning of the corporation
62
Glen Alden was incorporated in Pennsylvania and List in Delaware. Delaware law at the time provided
that a sale of substantially all of the assets of List required the approval of a majority of the List shareholders, but the
List shareholders did not have appraisal rights. Under Pennsylvania law, if Glen Alden had sold it assets to List,
approval by a majority of the Glen Alden shareholders would have been required and dissenting shareholders would
have had appraisal rights. Under present Delaware law, appraisal is not available in a merger if the shares relinquished
are “(i) listed in a national securities exchange or (ii) held of record by more than 2,000 stockholders,” and if the
shares received have similar characteristics (e.g., voting and dividend rights). Del. Gen. Corp. Law § 262(b)(1).
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law.
e. The amendments do not provide that a transaction between two corporations
which has the effect of a merger but which includes a transfer of assets for
consideration is to be exempt from the protective provisions of the statute. They
provide only that the shareholders of a corporation which acquires the property
or purchases the assets of another corporation, without more, are not entitled to the
right to dissent from the transaction.
4. Hariton v. Arco Electronics (Del. 1963). 63
a. Equal Dignities. The sale-of-assets statute and the merger statute are independent
of each other. They are, so to speak, of equal dignity, and the framers of a
reorganization plan may resort to either type of corporate mechanics to achieve
the desired end. This is not an anomalous result in our corporation law.
B. Freeze-Out Mergers
1. Tender Offers. A tender offer is a public offer made by a bidder to a target’s shareholders, in
which the bidder offers a substantial premium above market price for most or all of the
target’s shares.
a. Oversubscribed. More shareholder tender their stock than needed. The wanted
shares have to be purchased pro-rata.
2. Authorized, Issued, & Outstanding. Shares are (1) authorized by the articles of incorporation;
(2) issued, meaning they have at some time been sold by the corporation to an investor; or
(3) outstanding, meaning that the stock is currently owned by someone other than the
corporation.
a. Authorized, Issued But Not Outstanding. “Treasury stock.”
3. W einberger v. UOP, Inc. (Del. Sup. 1983).
a. The 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.
b. The ultimate burden of proof is on the majority shareholder to show by a
preponderance of the evidence that the transaction is fair. Nevertheless, it is first
the burden of the plaintiff attacking the merger to demonstrate some basis for
invoking the fairness obligation.
(1) However, 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.
(2) But in all this, the burden clearly remains on those relying on the vote to
show that they completely disclosed all material facts relevant to the
transaction.
c. In considering the nature of the remedy available under our law to minority
shareholders in a cash-out merger, we believe that it is, and hereafter should be,
an appraisal under 8 Del.C. § 262 as hereinafter construed.
d. Complete Candor. In assessing this situation, the Court of Chancery was required
to: examine what information defendants had and to measure it against what they
gave to the minority stockholders, in a context in which “complete candor” is
required. In other words, the limited function of the Court was to determine
whether defendants had disclosed all information in their possession germane to
the transaction in issue. And by “germane” we mean, for present purposes,
information such as a reasonable shareholder would consider important in decided
whether to sell or retain stock.
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Most courts have rejected the de facto merger doctrine and have refused to imply merger-type protection
for shareholders when the statute does not provide it. In fact, in many states where courts have used the de facto merger
analysis, the legislature has later abolished the doctrine by statute.
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(1) Completeness, not adequacy, is both the norm and the mandate under
present circumstances.
(2) This is merely stating in another way the long-existing principle of
Delaware law that these Signal designated directors on UOP’s board still
owed UOP and it shareholders and uncompromising duty of loyalty.
e. There is no “safe harbor” for such divided loyalties in Delaware. W hen directors
of a Delaware corporation are on both sides of a transaction, they are required to
demonstrate their utmost good faith and the most scrupulous inherent fairness of
the bargain.
f. The concept of fairness has two basic aspects: fair dealing and fair price. 64
(1) Fair Dealing. The former embraces questions of when the transaction
was time, how it was initiated, structured, negotiated, disclosed to the
directors, and how the approvals of the directors and the stockholders
were obtained.
(a) Part of fair dealing is the obvious duty of candor required by
Lynch I. Moreover, one possessing superior knowledge may
not mislead any stockholder by use of corporate information to
which the latter is not privy.
i) Delaware has long imposed this duty even upon
person who are not corporate officers or directors, but
who nonetheless are privy to matters of interest or
significance to their company.
(2) Fair Price. The latter aspect of fairness 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 a company’s stock.
(a) Delaware Block/W eighted Average Method. Elements of value,
i.e., assets, market price, earnings, etc., were assigned a
particular weight and the resulting amounts added to determine
the value per share. This procedure has been used for decades.
i) However, to the extent that it excludes other
generally accepted techniques used in the financial
community and the court, it is now clearly outmoded.
It is time we recognize this in appraisal and other
stock valuation proceedings and bring out law current
on the subject.
(b) More Liberal Approach. W e believe that a more liberal approach
must include proof of value by any techniques or methods
which are generally considered acceptable in the financial
community and otherwise admissible in court, subject only to
our interpretation of 8 Del.C. § 262(h). 65
i) Fair price obviously requires consideration of all
64
Not Bifurcated. The test for fairness is not a bifurcated on as between fair dealing and price. All aspects of
the issue must be examined as a whole since the question is one of entire fairness. However, in a non-fraudulent
transaction we recognize that price may be the preponderant consideration outweighing other features of the merger.
Here, the court addresses the two basic aspects of fairness separately because it finds error as to both.
65
The Court of Chancery “shall appraise the shares, determining their fair value exclusive of any element of
value arising from the accomplishment or expectation of the merger, together with a fair rate of interest, if any, to be
paid upon the amount determined to be the fair value. In determining such fair value, the Court shall take into
account all relevant factors. (emphasis added).
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Castiel controlled both Holdings and Ellipso. Sahagen, LLC was controlled by Peter Sahagen, an
aggressive venture capitalist.
67
On the same day as the merger, Sahagen executed a promissory note to the corporation in exchange for
two million shares of stock. VGS also issued 1,269,200 shares of common stock to Holdings, 230,800 shares of
common stock to Ellipso, and 500,000 shares of common stock to Sahagen Satellite. Thus, Holdings and Ellipso went
from having a 75% interest in the LLC to having only a 37.5% interest in VGS.
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before Sahagen and Quinn could act by written consent. The LLC
Agreement does not purport to modify the statute in this regard.
(2) Purpose of W ritten Consent. Section 18-404(d) has yet to be interpreted
by this court or the Supreme Court. Nonetheless, it seems clear that the
purpose of permitting action by written consent without notice is to
enable LLC managers to take quick, efficient action in situations where a
minority of managers could not block or adversely affect the course set
by the majority even if they were notified of the proposed action and
objected to it.
(a) Not Intended to Clandestinely Deprive. The General Assembly
never intended to enable two managers to deprive,
clandestinely and surreptitiously, a third manager representing
the majority interest in the LLC of an opportunity to protect
that interest by taking action that the third manager’s member
would surely have opposed if he had knowledge of it.
(b) Action by W ritten Notice Only By Constant Majority. Application
of equity requires construction of the statute to allow action
without notice only by a constant or fixed majority. It cannot
apply to an illusory, will-of-the wisp majority which would
implode should notice be given.
c. Duty of Loyalty. Sahagen and Quinn each owed a duty of loyalty to the LLC, its
investors and Castiel, their fellow manager.
(1) Agreement Doesn’t Rely on Equity Interest Voting. It may seem somewhat
incongruous, but this Agreement allows the action to merge, dissolve or
change to corporate status to be taken by simple majority vote of the
board of managers rather than rely upon the default position of the
statute which requires a majority vote of the equity interest.
(a) However, Sahagen and Quinn Knew of Castiel’s Control Plan.
Instead, the drafters made the critical assumption, known to all
the players here, that the holder of the majority equity interest
has the right to appoint and remove two managers, ostensibly
guaranteeing control over a three-member board.
(b) W hen Sahagen and Quinn, fully recognizing that this was
Castiel’s protection against actions adverse to his majority
interest, acted in secret, without notice, they failed to discharge
their duty of loyalty to him in good faith.
d. Breach of Duty of Loyalty Abrogates Protection of Bus. Judgment Rule. It should be
clear that the actions of Sahagen and Quinn, in their capacity as managers
constituted a breach of their duty of loyalty and that those actions do not,
therefore, entitle them to the benefit or protection of the business judgment rule.
II. Takeovers
A. Introduction
1. Cheff v. Mathes (Del. Ch. 1964).
a. Purpose of Entrenchment. In an analogous field, courts have sustained the use of
proxy funds to inform stockholders of management’s views upon the policy
questions inherent in an election to a board of directors, but have not sanctioned
the use of corporate funds to advance the selfish desires of the directors to
perpetuate themselves in office.
b. Maintain Proper Business Practices. Similarly, if the action of the board were
motivated by a sincere belief that the buying out of the dissident stockholder was
necessary to maintain what the board believed to be proper business practices, the
board will not be held liable for such decision, even though hindsight indicates
the decision was not the wisest course.
2. The court in Cheff essentially applies the business judgment rule.
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Hence the term “cash-out merger.” The tender offer is “front-end loaded” because the front end offers a
higher price ($65) than the back end ($55). A two-tiered offer can be “coercive” even if the front end is any-and-all
offer rather than an offer for 51 percent of the stock.
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