Chapter 1: What Do Business Do and What Do Layers for Businesses Do?

A. Why Does someone own a business or an interest in a business?

1. The Epstein-Freer view and the Roberts-Shepherd view
2. Views of other “gonster machers”
3. Views of the court and legislatures
A.P. Smith Mfg. Co. v. Barlow: the court held that corporations’ power to make reasonable charitable
contribution absent statutory provisions is intra vires (within its power) because it would aid in public
welfare as well as advance the interests of the corporation and the community in which it operates.
a. Business in corporate structure is a separate legal entity
b. Both statutory and case law controls the actions of that separate entity
c. Real persons act for that corporation as “agents”
d. A corporate business with more than one owner can distribute and use funds in ways
that are opposed by at lest some of its owners.
B. How does the owner of a business make money from the business?
1. Distributions of all or part of the money the business has earned
2. sell all or part of the ownership interest in the business for more than paid for
C. How does the owner of a business (and her lawyer) know how much money the business has mad
and how much money the business is worth?
1. the income statement: computes profit during a given period based on data about revenues
and costs
2. the cash flow statement: measures the cash made available to a business from its operations
during a given period
3. the balance sheet: shows the company’s assets, liabilities and the owners’ “equity” in the
business
4. cash flow statements
5. financial statements and the value of a business
D. The Sarbanes-Oxley Act and corporate governance
1. the motivation for fraud: bonuses for putting out “good numbers”
2. types of fraud:
a. Enron: “off-balance sheet” transactions: move liabilities off its balance sheet
b. WorldCom: inflate profits by hiding costs so company would meet earning targets
and the price of stock would rise, or at lest remain high
c. Most: Either representing the company’s financial condition as better than it is, or
misappropriating the wealth of the company for private gain
3. the intent of Sarbanes-Oxley
a. Clarify certain responsibilities of auditors, company management, and board and
audit committees, as well as impose new process and responsibilities on these parties
b. Section 404: company must evaluate its own internal controls
c. CEO and CFO must attest to the accuracy of accountability
E. What does a lawyer for a business do?
1. Help the business make money
2. Help her get money from the business
3. help the business and her protect the money from the claims of others
F. What are the legal structures for businesses?
1. What choices are available? (tax treatments and liability exposures are the most important
factors in the decision of choosing the legal structure)
a. Sole proprietorship: the individual and the business are one an the same for tax and
legal liability purposes
b. The partnership
i. General partnership: earnings are distributed according to the partnership
agreement with pass-through taxation; each of the partners are jointly and
severally liable
ii. Limited partnership: has pass through taxation with a general partner that
assumes the management responsibility and unlimited liability for the
 business; there is a limited partner with no voice in management and is
legally liable only for the amount of capital contribution plus any other debt
specifically accepted.
iii. Limited liability partnership:
c. The corporation
i. C-corporation: most common legal structure for large business because the
owners are generally protected from personal liability, but it has double
taxation
ii. S-corporation: has pass-through taxation and protection from personal
liability
iii. Non-profit: operates for public benefit that need no pay corporate income
tax
d. The LLC: pass-through taxation with limited liability for the owners
2. How do you choose?
a. Who will own the business?
b. Who will manage it?
c. Who will reap any profit?
d. Who will bear the risk of any loss?
e. Who will pay income tax on business profit?
Chapter 2: What is a Sole Proprietorship and How Does It Work?
A. What is a sole proprietorship? What is sole proprietorship law? What are the problems in starting a
business as a sole proprietorship?
B. What are the problems in operating a business as a sole proprietorship?
1. Employees and Introduction to Agency Principles:
a. Agency law (RSA 1):
i. Agency is a “fiduciary relation”
ii. There must be some “manifestation of consent by one person [the principal]
to another [the agent] that the other [the agent] shall act on his [the
principal’s] behalf and subject to his [the principal’s] control.”
iii. There also must be “consent by the other [agent] so to act.”
b. Authority
i. actual authority
(1) actual express authority: P expressly gave A the power to undertake the
act on P’s behalf
(2) actual implied authority: A has the authority to do what is reasonably
necessary to get the assigned job done, even if P did not spell it out in
detail
ii. apparent authority (“implied authority”)
(1) creation:
- must be attributable to P
- must get to third party (TP)
- must lead TP reasonably to conclude that A is an agent
for P
(2) does not require detrimental reliance by TP on P’
manifestation
(3) Could be misleading as P does not really authorize A to act on
his behalf; indeed P may have privately forbidden A to act
Problems: Liability of the sole proprietor for contracts of his employee
Problems: liability of the sole proprietor for torts of her employee
2. Other Agency Relationships in Business
a. Attorney-client
Hayes v. national Service Industries, Inc.: where the attorney has apparent authority (but not actual
authority) to enter into binding agreement (here, settlement agreement) on behalf of a client, such
agreement is enforceable against the client.
b. Franchise and other business relationships
Miller v. McDonald’s Corporation: where franchisor-principal has the requisite degree of control over the
franchisee-agent, agency will arise despite the boilerplate provision in the franchising agreement that the
parties doe no intend an agency relationship; here, McDonald’s control over 3k presented factual issues as
to whether actual or apparent agency relationship exists, and thus preclude summary judgment.
C. How does a sole proprietorship grow?
1. Funding by the owner: Money that goes into the business is in the form of an investment
(equity) and not as loan (debt)
2. overview of debt and equity: equity v. debt
a. debt
i. creditor gets both repayment + interest
ii. riskier: lender can sue and force business into bankruptcy
iii. debt has a fixed cost: repayment + interest
b. equity
i. equity holder gets ownership (higher return + higher risk)
ii. less risky: equity owner has no right to repayment
iii. cost is uncertain as the ownership shares the success of the company; also
gives up some control of company
3. borrowing money:
a. Pledge personal or corporate assets again the loan, as a form of collateral to secure
the loan
b. Promise to pay the money back in a short time (easier for creditor to judge the health
of the business)
c. Give creditor some measure of control over the business (seat on the board)

Chapter 3: What is a Partnership and How Does It Work?

A. What is a partnership
1. Unlike sole proprietorship, partnership is composed of multiple owners and is treated legally
as an entity separate from its owners.
a. RUPA 201: “an entity distinct from its partners”
b. UPA: “aggregate theory” an aggregate of its partners
2. Has flow-through taxation; however, the owners are not shielded from the liability of the
business
B. What is partnership law?
1. partnership agreement (if only concerning rights and obligations)
a. if not written, UPA and RUPA is default
b. it’s a contract that can change much of the statutory law that otherwise would govern
(ex: management decisions are to be by majority vote of the partners and profits will
be shared equally regardless of contribution)
2. state partnership statute
3. case law
C. What are the legal problems in starting a business as a partnership?
1. partnership agreement is very important, although many partnerships do not have them.
2. vague language can be very problematic:
a. mutual agreement: unanimous or majority?
b. Partners: majority is default
D. What are the problems in operating a business as a partnership
1. who owns what property?
a. Partnership owns partnership property
b. Owners do not own partnership property
2. partnership decisions
a. disputes between partnership and some “outside” third party
i. relevant provision of partnership statute
ii. common law principles
b. disputes among the partners
i. partnership agreement
 ii. provisions of relevant partnership statute
iii. common law principles
Meinhard v. Salmon: where the defendant’s lucrative position arose from the creation of the joint venture,
the defendant may not take advantage of such position without informing the plaintiff partner. Here, the
plaintiff and defendant were joint venture partners leasing shops and offices, and the plaintiff take
advantage of an opportunity arose from being partners of the JV and entered into an agreement without
disclosing to the defendant; the court held that the defendant was entitled to proceeds as well reasoning that
for joint adventures, like copartners, “not honesty alone, but the punctilio of an honor the most sensitive, is
then the standard of behavrio.”
3. Who is Liable for What to Whom?
a. Liability of the partnership: under RUPA, partnership is a legal person and thus can
be held liable and can sue or be sued; the same is true under UPA although it does
not expressly adopt the “entity” theory
b. Liability of the partners
i. RUPA: partners are jointly and severally liable for all obligations
ii. UPA: partners are jointly (but not severally) liable in contract but jointly
and severally liable in tort.
E. How does a partnership business grow?
1. existing owners (arrangements should be found in the partnership agreement)
a. vote or events that trigger the obligation to contribute
b. amount of contribution of each partner
c. time in which to make the additional contribution
d. the consequences of a failure to contribute
2. “outside” lenders: often they will required guarantees from individual partners
3. new investors
a. financial issues: investors will balance risk and return (return on equity) by
measuring cash flow and assessing the debt of the business (higher debt = higher
risk; leverage: the use of debt to finance a business
b. legal issues: under RUPA, the default is that approval for a new partner requires the
consent of all existing partners; the new partner is not personally liable for all of the
partnership’s existing debts.
4. earnings from business operations: earnings should be distributed unless the partnership has
some lucrative use for the funds
F. How do the owners of a partnership make money?
1. salary
a. RUPA 401 + 103 (pg 107)
b. If salary is in the partnership agreement, any change would require the consent of all
partners, as any change would be a change in the partnership agreement
2. profits:
a. RUPA 401(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.”
b. Distribution rights and voting rights are separate
c. Everyone has equal vote and majority is required for distribution decisions.
3. sale of ownership interest to third party
a. business and legal problems:
i. finding a buyer
ii. gaining any necessary approval from existing partners
iii. dealing with the question of “inherited” obligations
b. RUPA 502: “the only transferable interest of a partner in the partnership is the
partners share of profits and losses of the partnership and the partner’s right to
receive distributions.”
4. sale of ownership interest back to the partnership
a. buy-sell agreements: agreement for sale of partnership interest back to the
partnership or other partners; should answer the following:
 i. are the other partners or the partnership obligated to buy or do they have the
option to buy?
ii. What events trigger this obligation or option?
iii. How is the selling partner’s interest to be valued?
iv. What is the method of funding the payment?
b. withdrawal of a partner: even absent such buy-sell agreements, a partner has the
power to compel the partnership to pay for her partnership interest by withdrawing
from the partnership:
i. is covered by
(1) partnership agreements
(2) partnership statutes
(3) case law
ii. if UPA controls:
(1) dissolution
(2) winding up
(3) termination
iii. if RUPA controls:
(1) dissociation
(2) dissolution
(3) winding up
(4) termination
G. Partnership endgame
1. Dissolution, winding up and termination as endgame for the
partnership
a. RUPA 601, 801, 802(b)
b. Under RUPA, unless partners agree to the contrary
i. They share responsibility not only for the losses
from operation of the partnership business but also for partners’ losses from
investments in the partnership.
ii. The amount of each partner’s loss from her
investment in the partnership is determined from her partnership account, a
bookkeeping device
iii. The partnership is legally obligated to pay each
partner an amount measure by the balance in her partnership account
(1) Value of money or property, but not labor
(2) Minus any distributions
(3) Plus equal share of remaining value of the partnership
(4) Where a partner has a negative balance, that partner will have to
contribute additional funds to the partnership in the amount of the
negative balance.
Kovacik v. Reed: where the plaintiff and defendant entered into a joint venture wherein the plaintiff
contributed money as against defendant’s skill and labor, upon losses of the venture, the plaintiff is not
entitled to recover any part of it from the defendant. Where one party contributes money and the other
contributes services, then in the event of a loss each would lose his won capital—the one his money and the
other his labor, as by their agreement they share equally in profits, they have agreed that the values of their
contribution were likewise equal.
2. Expulsion as an endgame for a partner: RUPA 601(3)-(5)
3. freeze-out as an endgame for a partner: the holders of the majority
interest force a minority owner to sell or otherwise give up her interest
Page v. Page: where the partnership has no definite term or specified any particular undertaking, a partner
can dissolve the partnership by express will, unless there was bad faith by the terminating partner who
violated fiduciary duties by attempting to appropriate to his own use the new prosperity of the partnership
without adequate compensation to his co-partner, in which case, the dissolution would be wrongful and the
terminating partner would be liable. Here, the supplying partner of an oral partnership, which suffered
losses for eight years wanted to terminate the partnership despite slight improvements in the next two years,
was allowed to terminate the partnership absent showing of bad faith, as there lacked a showing that the
improved profit situation was anything more than temporary.
Chapter 4: What is a corporation and how does a business become a corporation?
A. What is a corporation and what is corporation law?
1. A corporation is whatever the relevant state law says it is: corporate charters were granted
primarily for public purposes, including the establishment of towns, churches, cemeteries,
colleges, and charities; general incorporation laws were created to cure the special privileges
conferred by the corporate charters, allowing all those meeting the statutory requirements with
equal access to the corporate form.
a. State statutes provides:
i. A corporation is a separate legal entity
ii. Limited liability: Owners (shareholders/stockholders) are generally not
personally liable for the debts of the corporation
b. Corporation law facilitates wealth creation through innovation of tradable share
interest, centralized management, limited liability, and the entity concept itself.
c. The economics of corporation:
i. a way to reduce “transaction costs” compared to frequent transactions in
markets
ii. not so much as an entity, but as a set of contractual relationship among the
suppliers of all of the corporation’s inputs
iii. control of agency costs
2. Corporate law
a. State statutes
b. Articles of incorporation (certificates of incorporation) , bylaws and other
agreements
c. Case laws
i. Interpret and apply the provisions in corporate statutes and in a
corporation’s articles and bylaws
ii. Fill gaps in the law—resolve problems not covered or not fully covered by
statutes, articles, or bylaws
d. Federal statutes: there are no general federal corporation statute; there are, however,
important federal statutes that govern certain corporate activities
B. What are the legal problems in starting a business as a
corporation?
1. Preparing the necessary papers:
a. a corporation does not exist until the AoI are properly executed and filed with the
appropriate state agent or agency (usually the Secretary of State)
b. traditionally, corporation codes have not required that a corporation have bylaws; the
MBCA, however, mandates a corporation to adopt bylaws (no need to file, as they
are internal); bylaws contains provision for managing the business and regulating the
affairs of the corporation not inconsistent with laws or AoI.
2. contracting before incorporating
a. Promoter liability if corporation is never formed: jointly and severally liable, MBCA
2.04
b. Corporation liability after formation: the corporation will only be liable if it take
some action to adopt it
3. The “secret profit” rule; there is a duty to disclose the promoter’s profit in dealing with the
corporation. (pg. 156: retroactive prohibition?)
4. Issuing stocks: MBCA 6.03(a): A corporation may issue the number of shares of each class or
series authorized by the articles of incorporation. Shares that are issued are outstanding shares
until they are reacquired, converted or canceled.”
a. Preferred stock: class of stock to be treated more favorably than other class of stock
i. Dividend rights
ii. Liquidation
 iii. Redemption rights
b. Common stock: class of stock that is not preferred
c. Par value: the minimum price (not fixed price) for which a corporation can issue its
shares; this provides for the keeping of two separate accounts:
i. “stated capital”: aggregate par value of all issued shares of par value stock
ii. “capital surplus”: funds in excess of par
5. choosing the state of incorporation and qualifying as a “foreign corporation”
a. the law of the state of incorporation will become the default rules that govern the
“internal affairs” of a business (procedures for corporate action and rights and duties
of directors, shareholders, and officers)
b. to qualify to transaction business in a state as a foreign company
i. obtain authorization from appropriate state agent or agency
ii. appointing a registered agent in the state
iii. filing annual statements in the state
iv. paying fees and franchise taxes to the state
Chapter 5: how does a corporation operate?
A. Who is liable to the corporation’s creditor?
- Although shareholders are generally shielded from the
liabilities of the corporation, third parties often refuse to extend credit to the corporation with
limited assets unless that corporation’s shareholders agree to be personally responsible.
- As oppose to in contract and like in torts, a finding of
fraud, injustice or inequity is not necessary to pierce the corporate veil.
DeWitt Truck Brokers, Inc. W. Ray Flemming Fruit Company:
- where injustice occurs when a corporation is incorporated
for illegitimate purposes, the corporate veil will be pierced and the corporation and its
stockholders will be treated as identical; the factors in the balancing test is whether the corporation
was grossly undercapitalized (risked none while standing to gain everything), whether the stock
is owned by one or a few individuals, failure to observe corporate formalities, non-payment of
dividends, the insolvency of the debtor corporation, siphoning of funds of the corporation by
dominant stockholder, non-functioning of officers or directors, absence of corporate records, and
the fact that the corporation is merely a façade for the operations of the dominant stockholder(s).
- Here, the corporate stock is owned by one individual
(Flemming), the corporation was grossly under capitalized, failure to observe corporate
formalities, withdrawal of corporate funds, and assurance to be personally liable for corporate
liabilities (this alone may be enough), and an element of injustice or fundamental unfairness, the
courts have allowed the piercing of the corporate veil to establish liability.
- Is everyone liable now?
In re Silicone Gel Breast Implants Liability Litigation:
- In determining whether a subsidiary may be found to be
the alter ego or mere instrumentality of the parent corporation and thus piercing the corporate veil,
the factors are:
o Common directors
o Common business departments
o File consolidated financial statements
and tax returns
o Parent finances the subsidiary caused
the incorporation of the subsidiary
o Subsidiary operates with grossly
inadequate capital
o Parent pays for salaries and expenses of
the subsidiary
o The subsidiary receives no business
except that given to it by the parent
 o The parents uses the subsidiary’s
property as its own
o The daily operations of the two
corporations are not kept separate
o The subsidiary does not observe the
basic corporate formalities, such as keeping separate books and records and holding
shareholder and board meetings
- Where the subsidiary is potentially undercapitalized, the
companies have common directors and departments, consolidated tax returns, and met many of the
aforementioned factors, and the parents permitted its name to appear on the subsidiary’s products
to improve sales by giving the product additional credibility (parent vouching for the product), the
court found that it would be inequitable and unjust o allow parent to avoid liability.
- Notes:
o piercing the veil liability - pierces
through the corporation and recover from the shareholder
o agency liability – ???
o direct liability - ???
o “enterprise liability” – pierces the walls
of one corporation not to go after the assets of a shareholder, but to go after the assets of
related companies
B. Who gets to make decisions for the corporation?
1. Board of directors and officers
a. “Neither the board of directors nor an individual director of business, is, as such, an
agent of the corporation or its members [shareholders].” Restatement (second) of
Agency
b. Functions of BoD of publicly-held corporation:
i. Select, evaluate, fix compensation of and replace senior executives
ii. Oversee conduct of corporation’s business
iii. Review and approve the corporation’s financial objective and major
corporate plans
iv. Review and approve auditing and accounting principles in preparation of
the corporation’s financial statements
v. Make recommendation to shareholder
vi. See page 196-197
c. Officers of a corporation are agents of the corporation; as such, they are affected by
state corporation law, company bylaws, and agency law.
McQuade v. Stoneham: voting agreement among directors was contrary to public policy and void: “A
contract is illegal and void where it precludes the board of directors, as the risk of incurring legal liability,
from changing officers, salaries, or policies or retaining individuals in office, except by consent of the
contracting parties.” Unlike election of directors where the shareholders may unite, this power is not
extended to board of directors, as they have a duty to the corporation to act according to their best
judgment. Here, the plaintiff was also a city magistrate, which would preclude him from holding position as
a board of directly anyway. (still good law, but irrelevant????)
2. Shareholders’ decisions instead of directors’ decisions: However, many states have statutes
permits shareholders of corporation with relatively few shareholders to enter into agreements
controlling board decisions (include both Delaware and all states that have adopted the
MBCA).
Villar v. Kernan: under Main law, written agreements between shareholders are enforceable even if they (1)
relate to a phase of affairs of the corporation, such as the management of the corporation, payment of
dividends, or employment of shareholders, (2) restrict director discretion, or (3) transfer management duties
to shareholders, as long as such agreements satisfy certain conditions. Here, however, the agreement that
the shareholders would not receive salaries from the corporation was not enforceable as it was oral
agreement, which did not satisfy the statute.
3. Shareholders’ decisions about directors and cumulative voting
 a. Direct voting: voting is on a seat-by-seat basis; majority shareholder will be able to
elect every director
b. Cumulative voting (only for electing and removing directors): voting is based on an
at-large basis and the top vote-getters would be elected to the board; the shareholders
would have to vote intelligently to enable them to elect the desired directors
4. Shareholders’ voting on directors’ decisions on “fundamental corporate changes”
a. Fundamental corporate changes:
i. Amendments of the AoI
ii. Dissolution
iii. Merger with another corporation
iv. Sale of all or substantially all of the assets of the corporation
b. Difference between voting on directors and voting on fundamental corporate changes
i. Former is a shareholder action; later is a shareholder reaction
ii. Former may require a supermajority approval according to the state’s
corporation code or the corporation’s articles for fundamental corporate
changes
iii. There is no cumulative voting on fundamental corporate changes
5. Where shareholders vote, and who votes
a. Annual meeting
b. Special meeting
c. Owner record - person who has the legal right to vote at an annual meeting or
special meeting
d. Record date – a fixed date so that only the record owners as of that date are entitled
to notice of and a vote at the meeting
e. Street name – investors (“beneficiary owners”) buys shares through a broker (“record
owner”); the certificate is held in a depository company, maintained by a group of
brokerage firms and the investor is shown as the owner in the brokerage firm’s
record, commonly referred to as “street name ownership”
f. Proxy – person who is entitled to vote authorizes another person to vote for her
6. Who votes (and what are proxies)?
a. it is a form of agency: the owner is the principal and authorizes the proxy-holder to
be her agent for voting
b. a proxy is revocable, even if it states that it is irrevocable, UNLESS
i. the proxy states that it is irrevocable and
ii. is coupled with some interest in the stock
7. Federal Proxy rules
a. False or misleading statements of fact
Virginia Bankshares, Inc. Sandberg:
- where the directors solicited shareholders stating that the
shareholder would earn a “high” value and a “fair” price for their stock, and minority shareholder
refuses to give proxy for a voting on a merger proposal because of disbelief or undisclosed
motivation was insufficient for liability under Security Exchange Act and SEC rule.
- Statements of reasons, opinions, or beliefs are statements
with respect to material facts, so as to fall within SEC rule prohibiting solicitation of proxies by
means of materially false or misleading statements (may be actionable)
- Proof of mere disbelief or undisclosed motivation is
insufficient
- Director’s desire to avoid bad RP was insufficient to
demonstrate causation of damages which would allow implied private right of action to be
brought under Act by minority shareholder whose votes were not required by law or corporate
bylaw to authorize merger (not enough basis to extend private action pursuant to 15 USCS 78n(a))
James Surowiecki, Gadfly, Inc. (full-fledge proxy):
- gadflies are those people who show up at annual meetings
across the country to ask annoying questions about what the managers are up to.
 - While shareholders can solicit proxies, any shareholder of
a public company that engages in a full-fledged proxy solicitation to elect directors and effect
other changes must comply with the SEC proxy rules
b. Shareholder proposals (proxy)
- rule 14a-9 requires a public corporation to include a
shareholder’s proposal and supporting statement of up to 500 words in its proxy statement
- no-action letter is a recommendation by SEC staff that the
full commission not challenge specified conduct (but does not provide complete protection)
SEC No-Action Letter, Xerox Corporation: in a shareholder proposal to replace the directors without
meeting the requirements, the SEC granted a no-action letter allowing Xerox to exclude the proposal from
its proxy materials.
8. Shareholders’ inspection rights
Kortum v. Webasto Sunroofs, Inc.:
- The plaintiff was director of defendant company and
president of a company that owned 50% of defendant company. The defendant company (really,
the other company with 50% ownership) alleged that the plaintiff director and plaintiff company
had ulterior motives for inspection of defendant corporation’s books and records. The courts held
that (1) the plaintiff director may share the information so far as it did not conflict between his two
fiduciary roles, and (2) that the stockholder’s status as a competitor may limit the scope of
inspection but does not defeat the shareholder’s legal entitlement to relief.
- where a director and a stockholder of a joint venture
corporation demand to see corporation’s books and records, a prima facie showing of entitlement
to the documents has been made and the burdens shifts to the corporation to show why inspection
should be denied or conditioned
- unlike a director, a stockholder who seeks inspection must
prove by preponderance of the evidence that (1) its compliance with the form and manner of
making a demand, and (2) the propriety of its purpose for seeking inspection and the scope of the
requested inspection
9. Shareholders’ voting agreements
Ringling Bros.-Barnum & Bailey Combined Shows, Inc. v. Ringling: where the shareholders have entered
into an agreement over election of directors and later renegade, the court held that the agreement was
binding, and in order to respect the voting rights of shareholders not parties to the agreement, vacated the
votes of the renegade shareholder votes.
C. What are the responsibilities of a corporation’s decision makers and to whom are they
responsible?
1. What are the decision makers’ business responsibilities?
a. Privately-held companies: there is no principal-agent relationship???
b. Publicly-held companies:
i. Financial results are public
ii. Many owners affected by the performance of the company and the price of
the stock
iii. Federal securities law other SEC rules require announcement and
explanation of any material actions or issues as they occur
iv. There are entire industry devoted to analyzing and opining on the
attractiveness of the stock of every publicly trade company.
2. What are the legal responsibilities?
a. Duty of care
i. Breach of duty of care by board action
Shlensky v. Wrigley:
- The court dismissed a stockholders’ derivative suit
against the directors for negligence and mismanagement for not installing lights at the baseball
field and scheduling night baseball games, as directors are protected by the business judgment
rule.
 - The court held that absent showing of fraud, illegality,
conflict of interest, or breach of faith, the business judgment of the directors of corporation enjoys
the benefit of a presumption that it was formed in good faith and was designed to promote the best
interests of the corporation they serve.
Joy v. North:
- shareholder’s derivative suit
o an action against the corporation for failing to bring a specified suit and
o an action on behalf of the corporation for harm to it identical to the one which
the corporation failed to bring.
- Business judgment rule does not limit judicial scrutiny of
recommendations of a special litigation committee to terminate an action in a demand-not-required
shareholder’s derivative suit
Smith v. Van Gorkom:
- Where the board’s decision to approve proposed cash-out
merger was not a product of informed business judgment-- the board acted in grossly negligent in
approving the amendments to merger proposal and that the board failed to disclose all material
facts which they knew or should have known before securing stockholders’ approval of merger--
the business judgment rule protection is not warranted.
- Absent from meeting at which merger agreement and
amendments were approved did not relieve the director from personal liability
- “the determination of whether a business judgment is an
informed one turns on whether the directors have informed themselves on all material information
reasonably available to them.”
ii. Breach of duty of care by board inaction
Barnes v. Andrews:
- plaintiff incumbent-director, suing defendant former
director for general liability for the collapse of the enterprise, must show that the defendant’s
performance would have avoided loss, and what loss it would have avoided.
- “in an action against an inattentive director, a
complaining shareholder must establish some linkage between the director’s bad behavior and
corporate loss—or in legal terms, “causation.” (However, the Sarbanes-Oxley Act adds to the
duty of care that a corporation’s management owes the corporation that all of a corporation’s
annual financial reports must now include a statement that the corporation has implemented an
“adequate internal control structure and procedures for financial reporting.”)
In re Caremark int’l, Inc. Derivative Litigation:
- previously, in Graham v. Allis-Chalmers Mfg. Co., the
court held that directors were not required to set up a monitoring system until they has some
reason to suspect that the employees were not being honest.
- director liability for a breach of duty arises in two distinct
contexts (297)
o liability may follow from a board decision that results in a loss
because that decision was ill advised or “negligent” (“gross negligence” is the standard)
o liability to the corporation for a loss may be said to arise from an
unconsidered failure of the board to act in circumstances in which due attention would,
arguably, have prevented the loss.
- “only a sustained or systematic failure of the board to
exercise oversight—such as an utter failure to attempt to assure a reasonable information and
reporting system exists—will establish the lack of good faith that is a necessary condition to
liability.” (pg 301-302)
- Van Gorkom and In Re Caremark are companion cases
which explore the duty of care that the board of directors owes to the corporation and its
stockholders. Van Gorkom deals with the care required in evaluating the merits of a merger and
determining whether to recommend it to stockholders. Caremark, on the other hand, concerns the
 duty of care applicable to overseeing more routine decisions made by officers and employees of
the corporation.
McCall v. Scott:
- Gross negligence is the standard for asserting director’s
neglect of duty and finding liability
- ???
iii. The special case of executive compensation
b. Duty of loyalty: generally arises when the director (i) competes with the company,
(ii) takes for herself a “corporate opportunity,” or (iii) has some personal pecuniary
interest in a corporation’s decisions.
i. Competing with the corporation
Jones Co., Inc. v. Frank Burke, Jr.:
- the defendant officers lured away clients and key
employees to the new agency and forced the plaintiff founder to either sell his shares or they will
all quit en mass within 48 hours and start the new agency.
- The court held that the defendants breached their
fiduciary duties to plaintiff by conspiring while in its employment to form a new agency and take
with it accounts and employees.
- Notes: MBCA 5.06: directors and executives may not
advance their pecuniary interest by engaging in competition with the corporation unless:
o Harm to corporation < benefit to corporation
o Competition is authorized in advance or ratified
o Etc…(pg 316)
ii. “usurping” a corporate opportunity
Northeast Harbor Golf Club, Inc. v. Harris (standard for defining “corporate opportunity”):
- “line of business test”/ ”Guth test” (321):
o The test: “whether the opportunity was so closely associated with
the existing business activities as to bring the transaction within that class of cases where
the acquisition of the property would throw the corporate officer purchasing it into
competition with his company.”
o Weakness: (1) whether a particular activity is within a
corporation’s line of business is conceptually difficult to answer, and (2) the corporation
must have the financial ability to take advantage of the opportunity
- “American Law Institute (ALI) test” (322):
o Director or senior executive may not take advantage of a
corporation opportunity unless: (1) the corporate opportunity is first offered to the
corporation and the conflict of interest is disclosed; (2) the corporation rejects the
corporate opportunity; and (3) either (a) the rejection is fair to the corporation or (b) the
opportunity is rejected in advance, or (c) the rejection is authorized in advance or
ratified…
o “The central feature of the ALI test is the strict requirement of full
disclosure prior to taking advantage of any corporate opportunity.” (324)
- Where the officer purchased real estate next to the
corporation’s golf course, such purchase was a corporate opportunity under the ALI test, which
only requires that the opportunity be closely related to the business in which the corporation was
engaged. As such, the officer had fiduciary duty to disclose information concerning any potential
conflict of interest, to offer the opportunity to the corporation, and the opportunity must have been
formally rejected, before the officer may take advantage of such opportunity.
Broz v. Cellular Information Systems, Inc.
- using the Guth test, the corporation must have the ability
to make use of the opportunity and must have the intent to do so
- there is no requirement that a fiduciary must present to the
board prior to acceptance of opportunity, if the corporation does not have interest, expectancy or
financial ability to pursue opportunity
 - Here, were the opportunity was presented to the defendant
as stockholder of a competitor and not as a director of corporation, which just filed chapter 11
bankruptcy and has no interest or opportunity to purchase the cellular telephone service license,
the defendant did not need to present the opportunity formally and that there was no breach of
fiduciary duty (did not usurping corporate opportunity.)
iii. Being on both sides of a deal with the corporation (‘interested director
transaction”)
HMG/Courtland Properties, Inc. v. Gray:
- Two defendant officers of HMG both held interests in
another corporation (NAF) in a major real estate deal. Only one of two discloses the interest and
abstained from voting on the proposed deal. On these facts, the court held that this undisclosed,
buy-side interest in the transaction was a classic case of self-dealing, which, “in itself, is sufficient
to rebut the presumption of the business judgment rule and invoke entire fairness review.” (335).
The defendants fialed both parts of the test.
- “where directors stand on both sides of a transaction, they
have the burden of establishing its entire fairness, sufficient to pass the test of careful scrutiny by
the courts” (335) – two components:
o Fair dealing – embraces questions of when the transaction was
timed, how it was initiated, structured, negotiated, disclosed to the directors, and how the
approval of the directors and the stockholders were obtained.
o Fair price – related 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 (336)
D. Who sues and who recovers?
1. what is a derivative suit and why do we have them?
a. A shareholder stands in the shoes of the corporation in asserting the claim. The suit
is “derivative” because the shareholder’s right to bring it “derives” from the
corporation’s right. (350)
b. There are at least 2 reasons why the corporation might not sue (through management
decision). We are concerned about the second:
i. The directors might decide that litigation would strain the relationship
unduly or that litigation is not beneficial.
ii. The directors might refuse to have the corporation bring suit because of
personal reasons
c. “security for expenses” – the shareholder is required to post a bond or other security
to ensure that the corporation’s expenses, including attorney’s fees, are covered if the
shareholder’s suit is unsuccessful. However, many statutes provide an exception to
this security requirement for shareholders who have substantial amounts of stock in
the corporation whose claim they are asserting. (352)
Eisenberg . Flying Tiger Line, Inc. (derivative v. direct suit):
- “suits are derivative only if brought in the right of a
corporation to procure a judgment “in its favor,” and that “where the corporation has no right of
action by reason of the transaction complained of, the suit is not derivative.”
- Here, where a shareholder sues on behalf of himself and
all others similarly situated to enjoin a proposed merger or consolidation, he is no enforcing a
derivative right; he is, by an appropriate type of class suit, enforcing a right common to all the
shareholders which runs against the corporation.”
- “reorganization plan which allegedly deprived
shareholders of right to vote gave rise to personal, not derivative action.” (361)
2. How does a derivative suit compare to a class action (and why are both so controversial)?
a. Derivative suit: the plaintiff is asserting the corporation’s claim and judgment goes
to the corporation
b. Class action suit (a type of direct suit): plaintiff is asserting her own claim and
recovers any judgment
 c. However, for both, the driving force may be lawyers who may have incentives to
settle the suit: as such, there are conflicting motives. Thus there are procedural
requirements imposed on such (derivative) suits for several reasons (363):
i. To avoid frivolous litigation
ii. To deter strike suits
iii. To preserve the role of the directors in decision making
3. procedural requirements of a derivative suit: (joinder of the corporation and alignment of the
parties, stock ownership and other standing requirements, security-for-expense, demand on
directors)
a. Joinder of the corporation and alignment of the parties (the corporation is joined as a
defendant, although in theory as involuntary plaintiff)
i. This is necessary because the recovery needs to go to the corporation
ii. Also, joinder of the corporation helps ensure that the judgment will have
claim preclusive (res judicata) effect.
b. Stock ownership and other standing requirements
i. MBCA 7.41
ii. Need “contemporaneous ownership” v. “continuing wrong” theory
iii. Case law: implied requirement that plaintiff in derivative action must fairly
and adequately represent the interest of others similarly situated
shareholders.”
c. Security-for-expense: as seen in the eisenberg case above; this is because vast
majority of derivative suits brought in NY were filed by shareholders with minor
holdings and were lacking in merit.
d. Demand on directors (important! This is the life and death for the case):
i. FRCP 23.1 and NY 626(c): each imposes upon the derivative suit plaintiff a
requirement that she make a written demand on the directors that they assert
a claim allegedly existing in favor of the corporation. But each also
recognizes the possibility that such a demand might be excused for three
reasons (366) MBCA 7.42:
(1) if director has interest in the transaction
(2) the directors did not fully inform themselves about the challenged
transaction
(3) the transaction was so egregious it could not have been sound business
judgment
ii. The demand requirement (requirement to “exhaust intracorporate
remedies”) places the issue squarely before the people who should be
making the decision. Upon such, the decision makers could file suit or
ignore it. In the later course, the shareholder can assert that the board erred
in its decision not to have the corporation sue; however, this is almost
always a loser, as the shareholder would in essence asserting that the
director has violated the business judgment rule. According to the Delaware
Supreme Court, the fact that the plaintiff made the demand constitutes an
admission that the directors were disinterested (there is no conflict of
interest and that the decision is that of the directors). In other words, making
the demand admitted that demand was not futile.
iii. The route, therefore, would be to NOT make the demand. The directors will
seek to dismiss the action on the grounds that plaintiff should have made the
demand. The issue would be if the demand was excused because it would
have been futile. The motion whether demand was excused then is of life-
and-death importance for the plaintiff’s case.
iv. Special litigation committee (SLC): To avoid having the court dismiss the
directors’ motion to dismiss the derivative suit because the directors have
some interest, the decision would be delegated to a SLC, made up of
 supposedly disinterested directors who weren’t themselves accused of
wrongdoing.
Auerbach v. Bennett: this along with Zapata is the leading competing case… how????
Zapata Corporation v. Maldonado:
- self-interest taint of majority of the board was not per se
bar to delegation of board’s power over litigation decisions to independent committee composed
to two disinterested board members.
- However, courts must inquire into independence and good
faith of the committee and the bases supporting its conclusions
- If independence and good faith were found, the court
must exercise its own independent business judgment in determining whether a motion should be
granted.
e. Demand on shareholders: although required is some states, this is often excused.
(401)
f. Right to jury trial (402)
i. Under federal law: on the underlying claim being asserted in the derivative
suit, there will be a jury trial if there would have been a jury had the
corporation brought the suit
ii. However, this does not apply in state courts; so whether one gets a jury trial
on a derivative suit in state court is a matter of state law.
g. Court approval of settlement or dismissal: unlike routine, non-representative,
litigation, a derivative suit settlement must be approved by the court for fear of the
motives of the prime movers behind the cases.
4. Recovery in derivative suits:
a. Most courts will allow the successful shareholder to recover her costs from the losing
litigant and her attorney fees from the corporation.
b. If the shareholder loses, usually, the shareholder’s attorney will have taken the case
on a contingency fee, and thus will not recover here.
E. Who really pays?
1. Indemnity (405):
a. Under generally agency principles, an agent has a right to be indemnified by its
principal. However, a director is not an agent of the corporation and thus does not
have a common law right to indemnification from the corporation for any judgment
or settlement that they have to pay for the litigation cost they incur in connection
with their corporation duties.
b. Indemnifications of a director are found in indemnification statutes, AoI, the bylaws,
and contracts.
c. See MBCA 8.51 for permitted indemnification and MBCA 8.52 for required
indemnification.
d. Indemnification k (406)
2. Insurance or Directors and officers (D&O) insurance (408):
a. Common questions:
i. Business question: Whether to buy D&O insurance and, if so, what kind?
ii. Legal question: What is covered by the policy and who makes what
decisions with respect to litigation and settling claims
b. Types:
i. Side A (last resort) coverage: it is usually much cheaper than traditional
D&O insurance because it only comes into play when the corporation
cannot, or does not, indemnify the directors and officers.
ii. Side B: the insurer agrees to “pay on behalf of” or “reimburse” the
corporation for amounts the corporation has paid or is required to pay in
indemnifying its directors and officers.
Chapter 6: how does a business structured as a corporation grow?
A. Borrowing more money
 1. who is going to make the loan?
2. what covenants will the lender require?
3. how is the corporation going to service the debt?
4. what happens if the corporation defaults?
B. Issuing more stock
(1) To whom?
a. preemptive rights and other rights of existing shareholders
i. preemptive rights: a share holder with preemptive rights has the right to
purchase that number of shares of any new issuance of shares that will
enable the shareholder to maintain her percentage of ownership; this
protects the shareholder
ii. whether a shareholder has preemptive rights depends upon:
(1) what the state corporation code says about preemptive rights
(2) what the AOI say about preemptive rights, and
(3) what the purpose of the issuance is
iii. Upsides of NOT having preemptive rights? Although the shareholders
would lose some of its control, they would own a piece of the corporation
that is now more valuable because of the issuance of stock.
iv. MBCA 6.30:
(1) by default, shareholders do not have preemptive rights
(2) with preemptive rights, shareholder may acquire proportional shares
(3) no preemptive rights, if shares sold otherwise than for money
Byelick v. Vivadelli:
- 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
- ALI 7.01(d): With closely held corporation, the court in
its discretion may treat an action raising derivative claims as a direct action (and thus exempt it
from restrictions and defenses and allow individual recovery), if it will not
o Unfairly exposes the corporation or the defendants to a multiplicity of actions
o Materially prejudice the interests of creditors of the corporation, or
o Interfere with a fair distribution of the recovery among all interested persons.
- whether or not preemptive rights are elected, however, the
director’s fiduciary duty extends to the issuance of shares.
b. selling to venture capitalists
i. what is venture capital?
(1) Venture capitals:
- venture capital: substantial equity investment in a non-
public enterprise that does not involve active control of
the firm
- “second tier” or “mezzanine”
- “angels”
(2) Success and failure
- 1/3 fails
- 1/3 in limbo
- 1/3 sucessful
ii. How venture capitalists protect their investments
(1) “downside protection”
(2) “upside opportunities”
(3) Voting and veto rights
(4) “exit opportunities”
c. to a person (or a few people) or to the public
2. What are the legal constraints on how a corporation issues its stock?
a. Registration requirements for public offerings
 ii. Some of what your clients might have learned about securities registration
in B-School
(1) the reason to go public: raise money
(2) how much to raise? Fear v. greed
(3) how many additional shares to sell?
iii. Some of what you can learn about securities regulations from the SEC
website
b. Common law fraud and misrepresentation and rule 10b-5 constraints on any
stock issuance 10b-5: it shall be unlawful for any person, directly or…
i. To employ any device, scheme, or artifice to defraud,
ii. To make any untrue statement of a material fact or to omit to state a
material fact necessary in order to make the statements made, in the light of
the circumstances under which they were made, not misleading, or
iii. 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 purpose or sale of any security.
o Debts v. Equity
o Using earnings